Islamic Accounting - Ijarah Contract - Essay Example

?ISLAMIC ACCOUNTING Table of Contents Table of Contents 2 Introduction 4 Ijarah Contracts 4 Ijarah 4 Ijarah wa Iqtina 4 Ijarah Thumma Al-Bai 5 Ijarah-wa-Iktina 5 Features of Ijarah Contract 5 Services and Usufruct 5 Assets under Ijarah 6 Liabilities and Ownership Rights 6 Utilisation of Assets under Lease 6 Period of Lease 6 Payment of Lease Amounts 6 Enhanced Features 7 Default and Compensation 7 Promise in Ijarah Contract 7 Termination of Ijarah Contract 7 Selling of Leased Assets 8 Takaful for Ijarah 8 Leasing and Ijarah – Similarities and Differences 8 Differences in Accounting Treatment of Ijarah and Financial Lease 10 Ijarah – Accounting Treatments 11 Asset Recognition 11 Revenue Recognition 11 Expense Recognition 11 IFRS and AAOIFI Standards 11 Conclusion 12 References 14 Bibliography 16 Introduction The contract of leasing in Islamic accounting is termed as Ijarah contract. Its accounting procedures are very much similar to lease accounting procedures. There can be various types of Ijarah contracts which have been discussed in this study. The features of Ijarah contracts have also been studied in details. Although Ijarah contracts are similar to leasing contracts, still some differences exist. Accounting and Auditing Organisation for Islamic Financial Institutions, (AAOIFI), sets out standards for accounting of Ijarah contracts. The impact of International Financial Reporting Standards (IFRS) on Ijarah contract accounting has also been discussed in this study. Ijarah Contracts Ijarah It means leasing. It includes a contract where the financial institution buys equipment, machinery and other different assets and then leases it to the owner of a business firm for a rent or fee. The contract has provisions for the lease duration and the amount of fees to be set out in advance. The financial institutions possess the ownership title of the leased assets during the lease period. From the view of Islamic finance, financial contracts like real estate financing, project financing, vehicle financing, etc. are usually included in the Ijarah concept (Bank Negara Malaysia, n.d., p. 3). Ijarah wa Iqtina Ijarah wa-Iqtina contract is another version of the Ijarah contract where on completion of the lease contract the client can take over the ownership of the leased asset (Abou-Gabal, Khwaja & Klinger, 2011, p.10). It is implied as lease-to-purchase. It is similar to hire purchase system. Here the lessor can purchase the asset at the end of the contract. It is very much identical to Ijarah contract with the exception that the business owner has the option to buy the asset at the end of the contract. Previously paid fees are considered to be a portion of the purchase price of the asset. These types of lease agreements are very common in case of home financing. Ijarah Thumma Al-Bai This is a combination of two types of contracts. One is the Ijarah contract meaning leasing of the assets. The other one is Bai contract meaning the contract of purchasing the assets. Ijarah-wa-Iktina This is a type of lease contract where there is an agreement and undertaking taken by the lessor to purchase the assets at an agreed predetermined price during the tenure of the lease contract. It is also similar to the agreement related to hire purchase with one exception that the lease agreement can be terminated before the completion of the tenure of the contract and the asset can be bought by the client. On expiry of this type of lease contract, the leased asset is transferred to the lessee on fulfilment of all the terms and conditions of the contract. The lessee also has the option to buy the asset during the tenure of the lease contract at a price which was set out when the lease contract was formulated. The purchase price is usually set with reference to the market value of the asset or the residual value of the asset and is agreed in advance during the signing of the lease contract (Jonson, 2006, p.540-541). Features of Ijarah Contract Ijarah contract comprises of various features. Some of its primary features have been discussed below: Services and Usufruct Ijarah is a contract that is applicable to both leasing and hiring of goods and services. Usufruct of the assets and rendered services constitute the type of benefits associated with Ijarah. The usufruct derived from of assets can be utilised to form an Ijarah contract by transferring the utilisation right of the usufruct of an asset to the lessee for a definite period of time and an agreed amount as rent. Two models of Ijarah have been developed by the Islamic Financial Institutions. One is operating lease and the other is operating lease in structured format. The amount of rent that is received by the lessor can be earned only on the delivery of usufruct effectively to the lessee. Assets under Ijarah The assets that are leased under Ijarah contract can be either tangible assets or intangible assets like trademarks, copyrights, etc. The parties who make the contract are liable to clearly specify and identify the leased asset. Lessor has the liability of incurring all relevant expenses while acquiring the asset that is to be given in lease. The lessor will hold the ownership title of the leased asset. There can be transfer of lessor along with the lease contract. Liabilities and Ownership Rights Ownership rights and liabilities will be in the hands of the lessor in an Ijarah contract. However the rights and liabilities associated with asset utilisation will be in the hands of the lessee. Lessee will own the leased asset as trust or amanah. Lessor will borne the impairment loss related to the leased asset during the tenure of the lease contract except for the misconduct by the lessee. While the asset is being restored by the lessor, the rent that is to be paid by the lessee during that period would be waived off. Utilisation of Assets under Lease From the perspective of Shariah, it is only valid that the usufruct of the asset which is leased is transferred from lessor to the lessee. The leased asset is required to be utilised by the lessee only in accordance with the specifications as mentioned in the Ijarah contract. If the leased asset is utilized for any purpose which is not in compliance with the Shariah, then the lessee is liable for such activities. Compensation will be paid by the lessee in case of any impairment caused to the leased asset because of negligence made by the lessee. Period of Lease The terms of the Ijarah contract would include the specifications regarding the lease period. The commencement of lease period will take place only from the day when the usufruct of the asset is realised by the lessee and will not depend on the actual utilisation of the asset by the lessee. On maturity of the lease period, the lease contract will come to an end. Termination of the lease period may occur even if both the parties in the contract agree to rescind the lease contract. Payment of Lease Amounts The payment options for paying the rent are either in kind, or by cash or through services offered by the lessee. The amount of rentals will be decided upon by both the parties of the contract at the time of making the lease agreement and there will be no variations in the rental amount during the lease period. There can be a variation in the rental amount during the lease period only in the event where both the contracting parties have agreed to make such changes during signing of the contract. The payment of lease is accounted for on an accrual basis. Enhanced Features Default and Compensation In case of default of an Ijarah contract, the rental payment which becomes outstanding is considered to be as debt in the hands of the lessee. Hence, defaults in rental payment of an Ijarah contract by a lessee will follow all the rules related to defaults in any other debt instruments. However no additional amount can be charged by the lessor regarding late payment of the rental amount. Lessor can claim compensation that arises because of incurrence of actual loss due to default in debt payment. Promise in Ijarah Contract The unilateral promise made by the lessee is also termed as “Wad”. The execution of Wad is made separately before the Ijarah contract is executed. Sometimes security deposit may be asked to be paid by the customer to the Financial Institution so as to give a guarantee that the asset is leased by the customer when it is bought by the Financial Institution. There can be an agreement in the Ijarah contract about the transfer of ownership of the asset that has been leased to the lessee at a mutually agreed price during the signing of the contract. Termination of Ijarah Contract Premature termination of the Ijarah contract can happen only with the consent of both the parties involved in the contract. Otherwise it will be considered as a breach of the contract. On violation of any agreement terms by the lessee, the lessor has the option to terminate the lease contract. On the death of either of the contracting parties in the Ijarah contract, the legal heirs have the option to either terminate or continue the contract. Selling of Leased Assets The lessor has the right to sell the asset to anyone except for the case when it has been agreed upon in the Ijarah contract that the asset would be sold to the lessee. On completion of the contract of sale between the lessor and the lessee, the lease contract would terminate and the lessee would become the legal owner of the asset. The asset can be sold to anyone during the lease period. However, the purchaser of the asset has the right to rescind the contract of sale if he is not informed about the lease contract during the signing of the sale contract. Takaful for Ijarah The lessor can take part in a takaful scheme in order to cover up any risks associated with the leased asset. However, lessor would bear the cost incurred in such activities. These costs can be included in the lease rental payment to be paid by the lessee (Bank Nagara Malaysia, 2009, p.4-23). Leasing and Ijarah – Similarities and Differences The various similarities and differences between Ijarah contract and conventional leasing contracts based on different characteristics are discussed below (Fatima, 2006): 1. Ownership: Leasing: In case of conventional leasing contract, the creditor institution possesses the ownership of the leased asset during the lease period. Ijarah: The lessor also known as “Muajjir” holds the ownership right of the leased asset. 2. Risk Bearer: Leasing: The risks associated with the leased asset are borne by the lessor. Ijarah: Here also the risk is borne by the “Muajjir” during the lease period except in situations of negligence in the part of lessee or “Mustajir”; the loss is to be borne by the “Mustajir”. 3. Rental Obligation Starting Point: Leasing: The rental payments become due as and when the lessee accepts the asset or during the time when funding is made (AAOIFI, n.d.). Ijarah: The rental becomes due when the asset is handed over to “Mustajir”. 4. Property Usefulness: Leasing: Leases asset should not constitute a “limited use” asset. Ijarah: The leased asset should be re-usable. 5. Penalty: Leasing: Delayed payment by lessee may attract penalty. Ijarah: Penalty can recovered by the lessee on delayed payment by the lessor but the amount has to be utilised for charitable purposes. 6. Asset Repossession: Leasing: The lease contract should not have option where the leased asset can be purchased at a bargain price. Ijarah: There is no provision for having two contracts in a single contract. 7. Value of Asset on termination of Lease Period Leasing: The asset should have a residual value on termination of the primary lease contract. Ijarah: Same. 8. Premature Termination: Leasing: It is allowed if the lessee does not perform according to the terms of the lease contract. Ijarah: Same. 9. Impact of Premature Termination: Leasing: There is no obligation in the part of any contracting party. Ijarah: Same. 10. Selling and Leasing Back in single Transaction: Leasing: This type of transaction includes leasing back of the asset to the original seller who has sold the asset to the lessor. Ijarah: It is allowed but has to take place in two separate transactions. 11. Basis of determination of Rent: Leasing: Market interest rates are considered as basis for determination of lease rents. Ijarah: Same. 12. Sale equivalent: Leasing: Selling profit is not recognised by the dealer and lease contract is not considered as equivalent to the contract of sale. Ijarah: Same. Differences in Accounting Treatment of Ijarah and Financial Lease Finance Lease Ijarah The Lessor or the Financial Institution records lease as financing in its books of accounts. The income which has not been earned, that is the aggregate rentals which are in excess of the asset’s cost are recorded at the beginning when the lease contract is made and then amortized in subsequent years during the lease term. Provisions of doubtful debts are also recorded. Disclosure of the leases is made after taking into account the suspense income and the income which is not realised. Revenue is recognised to an extent equivalent to the rental income which gives return at a constant rate. Assets under Ijarah are recorded in the books of accounts as which are net of the depreciation accumulated. Rentals are recognised on accrual basis as income generated from it. Depreciation and other costs are recorded in the income statement. The classification of assets is made according to its nature. Regular impairment testing of the leased asset is required to be done in accordance with IAS 36 (Siddiqui, n.d.). Ijarah – Accounting Treatments Asset Recognition All transactions related to Ijarah are recorded as the sum total of all incurred costs related to it. The value of the assets to be stated as net cost after deducting the accumulated depreciation or any impairment costs associated with it. Depreciation is calculated in accordance with the changes in the economic benefits of the leased assets in future. The month when the leased asset is acquired and the month in which its disposal takes place are considered for depreciation calculation (Siddiqui, n.d.). Revenue Recognition The rentals of the Ijarah contract serve as the basis of income recognition and are done on accrual basis over the period of the lease contract (Siddiqui, n.d.). Expense Recognition All the expenses related to Ijarah contract like, carrying costs, cost of depreciation are required to be recognised in the income statement as the expenses incurred (Siddiqui, n.d.). IFRS and AAOIFI Standards IFRS accounting requirements and accounting standards related to lease financing are: a. IAS 17: Related to Leases. b. SIC 15: Related to operating leases and the incentives associated with it. c. SIC 27: Related to lease and its legal forms and evaluation of substance of lease transactions. d. IFRIC 4: Related to the determination of a lease contract (dhsspsni.gov.uk, 2007, p.1). Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), sets out different standards and requirements for accounting procedures to be followed by Islamic Financial Institutions. AAOIFI have developed several standards including the standards for Ijarah and Ijarah Muntahia Bittamleek (AAOIFI, 2010). Under AAOIFI, all the Ijarah contracts are needed to be considered as transactions which are identical to operating leases. This prohibition of reporting of financial leases in Ijarah contracts under AAOIFI would lead to significant differences between the financial statements of organisations which follow standards related to IFRS in Ijarah contracts and those organisations which do not follow the same. It implies that for some organisations which follow Islamic accounting standards, the reporting of lease liabilities would not be in accordance with IFRS requirements (AOSSG, 2011, p.21). Exposure draft related to lease accounting that is put forward by IFSB is trying to remove operating lease concept. Hence it could bring in rapid changes for accounting of Ijarah contracts (Ernst & Young, 2011, p.20). Conclusion Ijarah contract as followed in Islamic accounting is very much similar to conventional lease accounting in many aspects. Typically under this contract machinery and financial equipments are financed. A financier lends a product to his client on lease for a cost which is predetermined. The lease duration is explicitly mentioned in the Ijarah contract. Through the contract it can also be clearly understood that the responsibility of maintenance and ownership lies with the financial institution. Termination of the contract occurs when the no service is rendered by the asset taken on lease or if the duration of the contract is over. It is quite evident from the study that Ijarah contract and operating lease are similar but still some differences exist. AAOIFI sets out standards of Ijarah contracts and other Islamic accounting practices. The recent adoption of IFRS has brought about significant impacts on Ijarah contracts. Operating lease reporting standards would cease to exist in IFRS requirements. There are a few contradictions between AAOIFI standards and IFRS requirements which are needed to be resolved so that there is no anomaly in the reporting of lease liabilities in the financial statements of different organisations. References AAOIFI. (2010). AAOIFI Key Publications. [Online]. Available at: http://www.aaoifi.com/aaoifi/Publications/KeyPublications/tabid/88/language/en-US/Default.aspx#account. [Accessed on May 1, 2012]. AAOIFI. (no date). Ijara {Islamic Leasing}. [Pdf]. Available at: http://www.aaoifi.com/aaoifi/pdf%20forms/conference/p/6s.pdf. [Accessed on May 1, 2012]. Abou-Gabal, N., Khwaja, A. I. & Klinger, B. (2011). Islamic Finance and Entrepreneurship: Challenges and Opportunities Ahead. [Pdf]. Available at: http://belfercenter.ksg.harvard.edu/files/EFL%20Final.pdf. [Accessed on May 1, 2012]. AOSSG. (2011). AOSSG Survey: Accounting for Islamic Financial Transactions and Entities. [Pdf]. Available at: http://www.aossg.org/docs/Publications/AOSSG_Survey_Report_2011_FINAL_CLEAN_29_12_2011.pdf. [Accessed on May 1, 2012]. Bank Nagara Malaysia. (2009). Draft of Shariah Parameter. Reference 2: Ijarah Contract. [Pdf]. Available at: http://www.bnm.gov.my/documents/conceptpaper/Ijarah_contract_20090715.pdf. [Accessed on May 1, 2012]. Bank Negara Malaysia. (no date). Part 1: Shariah Contracts. Shariah Resolutions in Islamic finance. [Pdf]. Available at: http://www.bnm.gov.my/microsites/financial/pdf/resolutions/07_part01.pdf. [Accessed on May 1, 2012]. Dhsspsni. (2007). Lease Accounting under IFRS GAAP. [Pdf]. Available at: http://www.dhsspsni.gov.uk/rabig_2007_22a_lease_accounting_under_ifrs_gaap_p1.pdf. [Accessed on May 1, 2012]. Ernst & Young. (2011). Islamic Accounting: Need for Formality. [Pdf]. Available at: http://www.icib-riu.org/2011/downloads/Omar%20Mustafa%20Ansari%20-%20Islamic%20accounting%20need%20or%20formality.pdf. [Accessed on May 1, 201]. Fatima, M. (2006). Differences and Similarities between Ijara and Conventional Operating Lease Contracts. [Pdf]. Available at: http://www.pafkiet.edu.pk/LinkClick.aspx?fileticket=%2B8mYfQWNHFw%3D&tabid=151&mid=1552. [Accessed on May 1, 2012]. Jonson, D. J. (2006). Islamic Economics and the Final Jihad: The Muslim Brotherhood to the Leftist/Marxist - Islamist Alliance. Fairfax, VA: Xulon Press. Siddiqui. (no date). Islamic Financial Accounting Standard-2 IJARAH: Interpretation and Implementation. [Pdf]. Available at: http://www.assaif.org/content/download/5119/42906/file/Islamic-Financial-Accounting-Ijarah%20by%20MEZAAN%20BANK.pdf. [Accessed on May 8, 2012]. Bibliography Ayub, M. (2009). Understanding Islamic Finance. New Jersey: John Wiley & Sons. Recchia, G. (2008). Basics of Islamic Banking. [Pdf]. Available at: http://pdf.usaid.gov/pdf_docs/PNADQ078.pdf. [Accessed on May 1, 2012]. Read More