Diminishing Musharaka Contract - Research Paper Example

 Diminishing Musharaka Contract Introduction Today, Diminishing Musharaka (DM) is the most desired mode of Islamic financing, particularly because of the profit-and-loss sharing feature. However, it is a prevalent mode of financing and applies extensively in transactions of fixed assets such as vehicles and homes (Mohammad, 2012). The DM’s protocols and processes make it unique especially because it advocates for shared ownership among the involved parties. Typically, the DM contract applies when a person who wants to purchase a certain asset does not have sufficient funds. A second person assists in paying the full price of the house or vehicle and owns it partly for a set period. The first person has full ownership even after acquiring assistance in paying the full price. During their ownership, second parties must comply with certain Sharia rules (Abdul, 2010). The most common application of the DM is in housing finance because it is different as compared to mortgages; in fact, in most occasions it appears as a sale-back arrangement. This essay focuses on establishing the advantages and constraints of diminishing Musharaka contract to small and medium enterprise. Moreover, the evaluation and assessment of the DM bases on contractual and financial perspectives as an attempt to create clarity in the arguments. Overview of Diminishing Musharaka Currently, multiple financial organizations, economists and other parties show increased concern about DM contracts especially in purchases and sales of houses. The idea of calling upon a second financier and the relationship bestowed upon the two parties make it convenient for people willing to purchase houses or start businesses (Boulam, 1995). Moreover, the joint ownership that goes on for a while is fair for both the borrower and financier since the Sharia laws protect them in case the partnership faces challenges. From a financial perspective, the borrower and financer have limitations to the contributions they make but mostly the divisions are in a number of units, which depends on the time of the agreement between the two. After the contract, it is an obligation for the buy to purchase gradually the financier’s units until they have full ownership of the asset. The payments/purchases take place in specific time intervals as per the original agreement. Acquisition of sole ownership by the borrower does not necessary require them to make full payments but also follow terms and conditions of the contract. However, during the purchasing period the contract identifies the financier and borrower as joint owners of all modules of the business or certain assets (Abdullah, 2007). This prohibits them from declaring sole ownership certain part of the property excluding the other partner. These are the basics of the DM contract but they are few changes that the involved parties can change relative to their interests.   The Diminishing Musharaka Contracts have different forms depending on the agreements that the financier and borrower make. The most popular DM contract is where the distribution of profits reflects extensively on the equity distribution between the borrower and the financier, which also applies when the businesses faces losses or gradually depreciates. This form of contract mostly reflects on the financial contributions of the two parties as per the original agreement (Mohammad, 2012). However, the contract does not apply automatically; the Sharia laws require them to indicate specifications or exact terms before and during the implementation of the contract because in some cases, there are variations to the profit and loss sharing agreement (Abdul, 2010). The financier or borrower might misapprehend the terms during the executions when the contract does not specify leading to conflicts later on. Another common form of contract is the Diminishing Musharaka that does not put any effort in specifying the distribution ratio for the profit and loss. In such agreements, both the financier and borrower take risks because the share of a certain property or business does not reflect when it comes to dividing of the profits or losses. In the contrary, it can also be rewarding because even with little financial contributions during the purchasing process can guarantee excellent profits (Boulam, 1995). In most cases, the financier leases his/her share to the borrower who pays rent instead before they gain sole ownership i.e. for motor vehicles or houses. Typically, during the leasing period, the borrower makes double payments; for purchasing the shares and renting them. The rent continues to decrease as the borrowers buy shares from the financier and in the long last, the leasing becomes void and so does the contract; the borrowers gets sole ownership. The DM contracts do not only vary depending on the interests of the involved parties but also on the sub-contracts that apply in the different facets of the association. The Sharia law has vast laws about sub-contracts because they are the sources of most conflicts or disagreements between the financier and the borrower (Abdul, 2010). However, the sub-contracts are not prevalent and the come up mostly in situations when the contract indicates co-ownership of certain unit shares between two or more people or when one of the involved parties decide to lease part of their share. In other cases, the borrower and financer decide to sell their share to external partners; they have to evoke sub-contracts. The application of the Diminishing Musharaka has been a source of arguments in the past, especially on where it is and not pertinent. However, due to the increased attention the DM contract is now valid in extended projects under Islamic financing especially for assets who shares are easily leasable. The reason why the contract is pervasive in share-leasing projects is that the practice effortlessly accommodates fluctuating or adjustable rates of return. This creates a platform for financial institutions inside the Islamic borders where they can adopt projects with cumulative financial gains, even when the economies show signs of inflation (Mohammad, 2012). The new approaches and applications mark a scope extension beyond the common dominion of small and medium enterprise; however, this remains as the chief valuable aspect of the DM contracts. Nonetheless, current evaluations of the DM show significant potential in the demesne of financial partnerships, especially since it paves ways for more investments that have technical and economic stability. Advantages and Constraints of the Diminishing Musharaka Contract Advantages 1. Profit and Loss System The profit and loss system of the diminishing Musharaka contract has multiple advantages for the small and medium enterprises. According to the Islamic laws, earning interest from financial activities is a felony; however, in the DM contract the financier is in a position to earn profits. Typically, the only restriction from earning profits is only if the profits do not relate with the initial risk of investing in the borrowers assets. The profits for the financier are permissible if they directly relate with the risk (Abdullah, 2007). However, in some situations, the financer is not part of any risk hence the financials gains they receive represent interest. Understanding the system is rather complex but differentiation between profit and interest comes in through evaluation of economic ideology (Boulam, 1995). In most commercial systems, the investment and capitalist are two varying entities that also differ under the aspect of returns. For instance, the results (returns) of an investment are profits and the entrepreneur who makes that investment risks losing capital but gets profits in return. In the end, most commercial systems favor the lenders (financiers) through the provision of a secure return system as an acknowledgement of the risks. Unfortunately, taking risks, especially for small and medium enterprises can lead to losses or making undeserved interest payments to large financial institutions that act as lenders. The Diminishing Musharaka, through the Sharia laws counters this threat for the micro-enterprises; however, it does not consider the financiers and borrowers as separate entities of production (Abdul, 2010). Typically, the DM contract considers both parties as risk takers through their financial contributions and entering into an agreement via the contracts. The financier and borrower are all entitle to equal shares, whether they are profits or losses. This gives equal power to all parties and aspects such as being a national financial institution or a micro enterprise are not determinants of the division of profits (Mohammad, 2012). The DM contract and financial system is protective of all parties but medium and small enterprises are at a greater advantage, particularly in making interest repayments. In a commercial system, financial institutions advocate for the payment of mixed interests even when the investment is losing money unlike in the case of the DM contract where the venture derives profit. The risk-taking factor is more prevalent in the agreement between the borrower and financier. Equal distribution of profits among the contributors of capital makes the Islamic economic system easier for medium and small enterprises to enter into contracts such as the Diminishing Musharaka. Essentially, the Islamic economy varies from the common capitalist system and in conjunction with the DM contract enterprises get to enjoy multiple benefits. One particular difference is the usage of money; in the commercial economy, it has no intrinsic value, just a medium of exchange but the Islamic economy is extensively against this. The Diminishing Musharaka contract is mostly applicable in the acquisition of assets hence the Islamic financing system takes this as a chance to advocate of financing that has assets backing the whole process. The financier makes financial contributions knowing that they can easily convert to assets; in fact, it is mostly a guarantee hence the medium of exchange acquire intrinsic value. This turns out particularly well for the enterprises and any other parties who act as financiers and borrowers. On a different perception, the profit and loss system of the DM contract has a history with scholar-approved practices. The Arabs introduction of the current Islamic financial system created a sustainable and stable platform for economic strategies without any illegitimacy issues. The system has only had a few developmental changes and most enterprises opt for it because of the instrumental services it facilitates (Boulam, 1995). With the current developments in the economy, most businesses, corporations and enterprises want to invest in systems that guarantee security overall financial transactions. Moreover, the DM advocates for dependability between two parties, which extensively risky for some economic systems. However, agreements in the contract together with the Sharia laws believe in the use of the Islamic system that is authentic and promising. Evidently, it acts as advantage for the medium and small enterprises in terms of security and the prevalent sharing of profits and losses. 2. Capital Contribution by All Partners In most joint ventures, the contributors (financier and borrower) face challenges on the percentages to provide or the common issue when one party signs the contract and they are unable to meet the different agreements. The Diminishing Musharaka contract counters such issues in capital contribution through the requisition that the financier and borrower confirm the availability of the funds before making any summary agreements. The financial contributions must also be in form of cash or non-monetary assets; however, the non-monetary assets have restrictions that enforce legitimate transactions under the DM contract (Abdullah, 2007). The value of assets in varying currencies converts to as per the agreed currency in the contract. In cases where the partners disagree on the value of certain non-monetary assets, a third party decides on the mechanisms to apply and the final valuation. Mostly, this does not happen because the contract covers all probable causes of disagreements before the borrower and financer make any conclusions. Debts do not count as capital for the DM agreements or any other contributions that the borrower or financier relates with a third party, matter of fact, they are just a form of debt (Mohammad, 2012). Decisively, medium and small enterprises interested in applying the DM contract have a guarantee of contractual and financial security even before the process takes any significant progression. It is a requirement that the borrowers and financers contribute specific amounts according to the initial agreement but due to the equal profit and loss systems, some of them might engage in belligerent acts as ways of getting more profit than deserved. The contract indicates that the contributions by each partner should be among the prompt decisions. Moreover, the partners specify the terms of contribution; whether it is once after a certain period or in installments. This creates fewer chances of fraud and other financial crimes; moreover, it encourages the financier and borrower to keep individual records in case there are variations or they need to revise the comprehensive contract or a sub-contract (Abdullah, 2007). Definitely, this is advantageous for micro-enterprises as an advocator of equity creating opportunities for them to engage in ventures that similar enterprises in other economies cannot access. Finally, breaching the contract, especially under the contribution clause is consequential for all parties without any exemption whatsoever; in fact, the result after such an occurrence is termination of the agreement. 3. Trustworthiness The Islamic economy has multiple financial instruments and contractual practices, most of which attract the attention of other economies based on their effectiveness. Nonetheless, the Diminishing Musharaka provides micro-enterprises with a platform where the investments are authentic and through the approval of the Sharia. The contractual agreement between the borrower and the financier extensively operates under a system that eliminates the widely encountered problem of interest (Abdul, 2010). Large corporations and institutions are popularly in control of their economies hence creating a gap between them and the micro-enterprises that stand no chance. The DM contract enforces the Islamic financial systems as the only option for the partners. This creates room for development for the Islamic contractual practices and parties such as medium and small enterprises that apply these practices in their ventures. Constraints 1. Reliability The Diminishing Musharaka is a subject of multiple criticisms as being hoary practices that cannot meet the standards of the modern world activities, particularly with vast developments. The unjustified criticisms could act as hindrance for the medium and small enterprises borrowing funds from financial institutions that believe in the inefficiency of the DM. However, its prevalence in Islam economies alone is the cause of these but with its potential and promising practices; this threat might wear out eventually. Relatively, the financial and contractual features of the contract only accommodate Islamic procedures and the only way that micro-enterprises could utilize the DM contract more is after alterations on the subject. Definitely, alterations would make the DM contract compatible with modern practices and micro-enterprises that have a better chance with such agreements would not face rejection from potential financers. However, today, the accommodation and compatibility factor remains a challenge and the Sharia laws are in the best position to sort this out. 2. Profits Guaranteed by Financial Institutions Diminishing Musharaka has a good reputation when it comes to authenticity especially because the contract guarantees equal profits for the financer and borrower; typically, it is the best example for the popular and respected Islamic financing systems. However, for the financial institutions, which the micro-enterprises depend on, have a different organizational policy in the sharing of losses (Mohammad, 2012). Moreover, they use the desperation of the medium and small enterprises against them by making their products more appealing. Obviously, this a disadvantage because at the end of all contractual processes, the major agreement is between the two involved parties. As much as this is a misuse of the link between rewards and risks policy the Islamic finance and Sharia laws lack no jurisdiction on these practices hence leaving micro-enterprises in a rough position (Abdul, 2010). Bibliography Abdul, G. 2010. Sharia Parameters for Musharakah Contract: International Journal of Business and Social Science, vol.1, no.1, pp.145-61 Abdullah, J. 2007. Diminishing Musharakah: National Conference in Islamic Finance, Islamic Science University of Malaysia, viewed 11 March 2015, https://comaif.files.wordpress.com/2014/02/ncif-2007_diminishing-musharakah.pdf Boualem, B.1995. Economics of Diminishing Musharakah: Islamic Research and Training Institute, viewed 11 March 2015 from http://www.irtipms.org/PubText/42.pdf Mohammad, D. 2012. Diminishing Musharakah: Academy for International Modern Studies, viewed 11 March 2015, http://www.academia.edu/4246103/Diminishing_Musharakah Read More