CHAPTER 10

Istisna

Learning Outcome
1. What is Istisna
2. Islamic Principles of Istisna
3. Rules of Istisna
4. Istisna Process Flow.
5. Accounting entries of Istisna
6. Issues in Istisna
7. Sample Case Study

Introduction

Istisna is an exceptional sale transaction where goods are sold before being manufactured. In
other words an order is placed for manufacturing of a commodity or goods to be purchase in
future. It is a sale transaction where a manufacturer sells an assets before its existence to a buy
for specific price agreed. The manufacturer will use his own material for manufacturing purpose
and can also hire sub-contractor for manufacturing. Istisna can be used for social sector
development and for public welfare projects i.e. roads, bridges, ports, schools, hospitals etc.

Rules of Istisna
1. In Istisna transaction payment have flexible option, can be made in trenches or can be
deferred as well.

2. For Istisna transaction it is necessary that commodity should require manufacturing.

3. In Istisna transaction the contract can be canceled unilaterally before the start of the
work. However once the work is started it cannot be cancelled unilaterally.

4. In Istisna transaction price and specification of the goods, delivery to be manufactured

shall be agreed upon to avoid any ambiguity.

5. For Istisna transaction the material required for manufacturing shall be purchased by the
manufacturer himself. If it is provided by the bank than the transaction will be Ijarah not
Istisna.

6. Subject matter can be refused in case it is not in confirmatory to the Istisna contract.

7. The goods manufactured can not be sold back to the same manufacturer and it buyer
should be a third party.

8. Manufacturer can act as an agent for onward sale of the manufactured goods.

9. Parallel Istisna contract can be created however both there should not be any link
between both the Istisna contracts.

10. It is not permissible that the price of goods once agreed shall be increased due to increase
in cost of production.

11. Penalty clause can be incorporated in Istisna agreement if the manufacturer fails to
deliver the goods in stipulated time.

12. It is not allowed that manufacturer incorporate a clause that he is not liable for the defects
in manufactured goods.
Difference between Salam & Istisna

1. For Istisna the commodity should be of manufacturing nature however this is not a
condition for Salam.

2. For Salam it was necessary that full payment to be made in advance however this
condition is not applicable on Istisna as payment can be made in trenches.

3. After execution of Salam contract it cannot be cancelled unilaterally however in Istisna

before start of the manufacturing it can be cancelled us unilaterally.

4. The terms of delivery needs to be fixed or agreed upon while executing Salama
agreement however it not necessary condition of Istisna.

2 Process Flow of Istisna

Istisna transaction involve different steps to make the transaction according to shariah principles.
These steps are shows in Fig 7.1 and discussed in detail in the following section.

2.1 Istisna Agreement

The first step is to execute Istisna agreement between bank and client. It is an agreement in which
bank and client decide about terms of the Istisna. After the approval of the facility from the bank
and completion of charge/ security documentation the bank is in position to disburse the funds
under Istisna mode of Islamic finance. Istisna agreements sets out terms and conditions
regarding contract prices, responsibilities of manufacturer, penalty or default in case of not
being able to manufacture agreed goods etc. The detail agreement is provided in Annexure-1.
 Figure 7.1

Istisna
Agreement
1

Repayment Offer &

Acceptance
7 2

Sale of
Payment
Goods
3
6

Agency Goods
Agreement Receiving
5 4

2.2 Offer and Acceptance

The second step is offer and acceptance from both the parties bank and client/ manufacturer.
where the client intends to enter into Istisna transaction with the bank. In offer and acceptance
both the parties jointly agree on some goods to be manufactured. Offer and acceptance comprises
of following issues in order to avoid any ambiguity.

 Specifications:
 Quantity:
 Quality:
 Contract price:
 Terms of Delivery:
 Terms of Payment:
 Place of Delivery
2.3 Payment

After offer and acceptance payment of contract price is made to the client. Payment can be made
in trenches or lump sum as mutually agreed. Acknowledgement of the payment receipt from the
manufacturer needs to be obtained.

2.4 Goods Receiving

Once the goods are manufactured the manufacturer informs the bank about completion of
manufacturing goods. The bank takes the possession of the goods which should be documented
as well. The goods can be taken to any warehouse of the bank for onward further sale of the
goods. The goods can also be stored at client’s premises however it should ne ensured that goods
stored separated and identified clearly as banks stock.

2.5 Agency agreement

Once the bank has taken the possession of the goods the next stage is the sale of goods. To sell
the goods the bank can appoint client as a banks agent through an agency agreement for sale of
goods.
In agency agreemt the terms of the are mentioned to avoid any ambiguity as shown below.

 Quantity
 Quality
 Contract price
 Terms of Payment
 Expected Profit on Assets
 (Any profit exceeding this will be given to the agents as an incentive):
 Expected Period of Sale: _____________________To______________________
2.6 Sale of Goods

The client acting as an agent of the bank will sell the goods as per agency arrangements.
The minimum price. The agent have to sell above the minimum price as provided by the
principal in agency agreemt. If there is any change in sale price than the consent of the principal
is required otherwise this act will be against the spirit of agency agreemt and agent can be held
responsible for any loss to the principal/ bank.

2.7 Repayments

Sale proceeds as per agency agreement needs to be paid to the bank as goods are sold.

Istisna Flow Chart

 Sale of goods (6)

Agency Agreement (5)

Repayment (7)
Bank Client/
Manufacturer
Istisna Agreement (1)

Offer & Acceptance (2)

Payment (3)

Goods Receiving (4)

3 Accounting Entries

Istisna work in process (DR)

Client A/c (CR)
Payment to
Manufacturer

Istisna Goods manufactured (DR)

Istisna work in process (CR)
Goods Istisna Asset Revaluation (CR)

Received

Istisna asset Revaluation (Dr)

Month End Profit on istisna (Cr)
entry

Client Account (Dr)

Istisna goods manufactured (Cr)
Recovery of Istisna asset revaluation (CR)
Instalment
Istisna Sample Case

Mr. ABC has applied for Istisna Finance Facility from XYZ Bank. Mr. ABC requires Istisna
facility for manufacturing of goods. The bank has carried out credit approval process which
requires detail scrutiny regarding client’s repayment capacity and security offered to the bank.
The credit approval process is not the scope of this book however it should be acceptable to the
bank according to its credit policies. After credit approval process Murabaha finance facility
amounting to PKR 200,000,000/- has been sanctioned to the client. The detailed process flow
along with all documentation and accounting entries are given below.

1. The first Step is the signing of Istisna agreement where general terms and conditions
of the Istisna Facility are agreed upon. The agreement shall be signed by both the
parties and dully witnessed.

2. Istisna agreement also comprises of annexures which are executed at different stages
of the transaction. After Istisna agreement. The second step is the offer and acceptance
document to be executed. This is the main contract which provides all the details of the
goods to be manufactured and contract price agreed between both the parties.
This is very important annexure as it sets out all the terms agreed by bank and the
client. This annexure contains information regarding quality, quantity, terms of
delivery etc. Accordingly contract price i.e. Rs. 2000,000,000/- is paid to the client.

Dr Cr
Istisna work in progress Client A/c
Rs. 200,000,000/- Rs. 200,000,000/-

3. Once the goods are ready for delivery a notice of delivery is served by the client to the
bank. This notice informs the bank regarding the goods and delivery. The bank
accordingly takes the delivery of the goods and place a visit report /good receiving
report.

Dr Cr
Istisna Goods Manufactured Istisna work in progress
Rs. 215,000,000/- Rs. 200,000,000/-
Istisna Asset Revaluation
Rs. 15,000,000/-
4. Agency agreement is signed between client and bank where bank appoints the client as
his agent for onwards selling the goods on banks behalf.

5. When the goods are sold on behalf of the bank the following entry is made by the bank
to record the monthly accruals. For current example the entry has been made for a
whole profit. However in case there is monthly or quarterly repayment schedule than
the monthly accruals can be incorporated according to the number of days outstanding
for the respective month.

Dr Cr
Istisna asset revaluation Profit on Istisna
Rs. 15,000,000/- Rs. 15,000,000/-

6. Agent after selling the goods provide the sale proceeds to the bank. The sale price paid
to the bank is according to the agency agreement.

Dr Cr
Client’s A/c Istisna goods manufactured
Rs. 215,000,000/- Rs. 200,000,000/-
Istisna asset revaluation
Rs.15,000,000/-