Forum Comments:

Riba and Financial Statement Equation

Dr. Mohammad Omar Farooq
Associate Professor of Economics and Finance
Upper Iowa University 

IBF-Net; 2/9/07; Message #6244

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In response to:
Dear Br. Irfan,
"It may or may not be immediate, but you have avoided asserting any of its effect by defusing it in income statement, however when you identified it as an expense in the income statement, will that expense be counted towards cost? Where that expense will be accounted for?"
First, thank you for acknowledging that the effect of interest on loan is neither immediate nor directly on the balance sheet. Another word, it can't be shown as balance sheet entries as your original framing of this issue attempted. As long as you realize and acknowledge this, the next issue then is how does it work through the income statement. That's a legitimate query.

"If adjusting the expense is not feasible due to any market reason like price war etc., and the borrower’s financial strength (net worth) has the capability to absorb the expense, then the borrower will not increase the price at the cost of debiting its net worth. There are other scenarios possible that the borrower has managed increased efficiency and able to offset the extra expense in some other account. These are all relative factors with limits and not true for every borrower, the Interest Expense has to be accounted for some where? Where you will adjust it? I would like to see that."

I think there is a confusion here in terms of cost and price of the product. Part of the answer you yourself have provided. Please correct me if I am wrong, but essentially what you are trying to do is connect the dot between interest (on loan) and inflation.
The first problem with connecting the dot between interest and inflation is that inflation is a macro phenomenon (reflected in the general price level). You have to keep in mind that inflation is defined as, "The rate at which the general level of price for goods and services is rising." [Link, for example]
Second, cost of production is an aggregate, where all component cost may go up, all cost may go down, some may go up while others remain the same, or some may go up while others may go down - all such possibilities are there. Interest expense may not increase the final cost, if there are compensating changes (lower expenses for other resources).
Third, cost of production may go up without any interest expense. If inflation is understood as merely due to cost going up, then we have to conclude that inflation can be caused not just by interest, but also by any other aspect of production cost. If that is so, there is no unique, one-to-one connecting of dots between interest and inflation.
Fourth, it is important to note that even higher cost on the part of an individual business (a micro picture) does not necessarily translate into higher price the same business can charge to the customers, let alone having a macro-level impact. Whether a business can shift any higher cost to the consumers in the form of higher prices depend of price elasticity of demand as well as many other economic factors, including competition.
That's why your original framing of the relationship between interest expense and inflation does not necessarily hold. Of course, as has already been explained, trying to show the effect (especially immediately and directly through balance sheet) is erroenous. I know your work of illustration at your website is partially based on this premise of interest -> inflation connection, which has also been argued by several others on this forum. However, I hope that it is quite clear by now that that argument is just polemical. It is neither theoretically accurate nor empirically corroborated.
Fi amanillah.
Dr. Mohammad Omar Farooq

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