The Similarities and Differences between Ijarah and Leasing - Essay Example

? The Similarities and Differences between Ijarah and Leasing The Similarities and Differencesbetween Ijarah and Leasing Introduction Islamic finance has become a centre of attention in the global financial market with its practice mainly focused on being ethical which is based on the teachings of Prophet Mohammad (P.B.U.H) and the Holy Scripture of the Muslims with the principle consistent with Shariah (Islamic law), The Holy Qur’an. Since the banking crisis around the world, many countries have shifted to an alternate banking system such as the Islamic banking system in which there is a mechanism of sharing profit and loss and using fixed service charges instead of interest charges which eases the pressure on the economy. Some prohibitions and certain guidelines have been drawn by the Shariah law, which makes a clear comparison between the conventional finance system and Islamic finance system. The unlawful charging of the interest, Riba, is the foremost concept that is prohibited by the Islamic Shariah, while it also prohibits gharar, an uncertainty in activities and has made gambling, Maisir, forbidden which makes it to differ from the conventional finance system in which interest is considered to be a common ground. In an Islamic term, Ijarah is an agreement to offer something for a lease, rent, or wage. According to a different meaning in Islamic fiqh, Ijarah is also referred to as a payment offered to a person for the services that were delivered by the same person. However, if the term Ijarah is considered in the setting of Islamic banking, it is referred to as the process of transference of a particular property from one person to another in exchange of a lawful return or rent from the owner. The procedure involves the lawful transference of the asset from the owner to the lessee and ends with the purchase of the leasing object. Ijarah in the context of Islamic banking is known as Ijarah Thumma Al-Bai or Ijarah Muntahia Bittamleek, which is a type of leased contract that can only be ended with the purchase of the leased asset. The paper discusses the two concepts relating to the finance system, the convention form of financing system and the Islamic way of financing. Moreover, the paper will discuss the leased contracts based on Ijarah, which is consistently being used by the Islamic institutions. Furthermore, the study will differentiate between the concept of Ijarah leasing and financial and operating leases. The study will also highlight the accounting systems which have been recommended by the Accounting and Audition Organization for the Islamic Financial Institutions (AAOIFI) and the International Financial Reporting Standards (IFRS). Lastly, the paper will give recommendations to conciliate between these approaches. Lease is defined as a rental agreement between the two parties in which the owner of the asset gives rights to the lessee to use the asset, and it would be the responsibility of the lessee to compensate timely and contractual payments to the lessor (Brealey et al., 2006(. There are many benefits in leasing over obtaining external borrowing or purchasing assets by making full payment, and it can benefit in terms of the saving of the taxes, costs associated with the use of assets, and mitigation of risks (Ross, Westerfield and Jaffe, 2005). Leasing can create a positive impact as it reduces the cost of financial distress and minimizes the chances of bankruptcy. Even if the lessee occurs to be a defaulter, the lessee would be given a higher priority than a creditor who just borrows money. Leasing generally helps in the sharing of inflation risk, business risk, and residual value risk. The residual value risk is considered to be the risk associated with the market value of the asset at the maturity date which can be transferred from the lessee to the lessor who has the authority to adjust the lease payments to cover the risk. If the lessor can earn an advantage from the secondary market, the lease payments will be reduced. This means that if the lessor sells the asset in the secondary market at the maturity at a higher value, which reduces the lease payment that is charged to the lessee by the lessor. If, in the case of metering agreement, the inflation and business risk could be reduced, the lease payments can stabilize business risk because it fluctuates according to the sales of the store. Furthermore, it is noted that the payments under lease agreement can help in hedging against the business risk as they tend to chance according to the store’s sales (Pike and Neale, 2006). Financial lease and the operating lease are the two types of lease arrangement. The operating lease is referred to as the short-term lease, which can only be live up to 5 years (Brealey et al., 2006). As the expected life of the asset is greater than the term, it cannot be amortized. At the maturity level, the asset is considered to have a significant market value, and, as the present value is smaller than the purchase price, the lessor can sell the asset to gain the asset value or he can recover the original cost of the asset by reviving the lease. Financial lease is considered to be the opposite of the operating lease in terms of residual value, contract option, maintenance commitment, and transaction cost. In this type of lease, the lessee has to cover the value of major taxes: for example, the property tax, sales tax, maintenance and service cost, and user tax as it gives the right to the lessee to make a renewal of the lease. The estimated life of the asset under this type of lease is in close proximity to the duration of the lease, which implies the transfer of the ownership to the lessee, and the present value of the total lease payments under the arrangement is higher than the initial cost. Therefore, the lease cannot be cancelled because it is fully amortized, or, if there were a possibility that it would be cancelled, then the lessee would have to face bankruptcy (Pike and Neale, 2006). 3. Islamic Leasing Ijarah tends to agree with some of the concepts of conventional leasing, as in financial institutions and Islamic banking the lessor buys the asset and then leases it to the lessee. The structure and lease payment is confirmed at the beginning of the agreement, and the amount is then paid according to the term that would be used of the existing asset. However, Ijarah lease contract under the Islamic rules is considered to be the most appropriate, permissible, and desirable by the people, which gives right to the lessee to derive benefits from its holding under the Ijarah terms and conditions (Ebrahim and Joo, 2001). Wade (2000) raises a point that three problems which can occur in the Islamic leasing which deals with riba and gharar can differentiate between the term Islamic leasing and the conventional form of leasing. In Islamic banking, the owner has the responsibility for the maintenance and the insurance of the asset, whereas in the conventional mode of leasing the contract will decide who will have the responsibility for the asset which is considered to be one of the biggest benefits while choosing a lease contract. But if the asset is in intangible form, it makes the future of the asset in extending as risky and unstable. The Shariah allows that, if the asset proves to be not as valuable as it was expected, the lessee has the right to cancel the lease. In conventional leasing there are also many types of future sales and options which help to end the residual value at maturity. However, the Islamic law suggests that this agreement is to be considered and written separately from the lease contract. Ijarah (operating lease) and Ijarah Muntahia Bittamleek (financial lease) are the two types of Islamic lease (Hairetdinov, 1998). Simple Ijarah Simple Ijarah is often considered as the operating lease and has some traits in resemblance with the operating lease. These are mainly used in the case of leasing high value assets which are leased to the customers and are highly marketable. As the operating lease gives lessor the authority to consider ownership and maintain the asset and the bank, it is held responsible for maintaining the cost and the depreciation of the asset. But in Simple Ijarah, it is not the requirement during the lease period, which is considered to be short term, that the full cost is to be amortized. The lessee has the authority to call off the lease at any time in legal manner with a proper notice to the lessor, and, if the lease period is ended, the assets are reverted back to the owner and the person who holds the contract, and it has the power to lease it to the other customer if the asset is in a proper condition. However, if the asset has become useless or not in the state for being used again, then it will be disposed of or scraped (Ebrahim and Joo, 2001). 3.1 Ijarah Muntahia Bittamleek The idea behind the Ijarah Muntahia Bittamleek is that a bank or the lessor purchases an asset for the purpose that it can rent out or make a lease agreement with the customer so that it could get rents or lease payment for a specific period of time. But when the lease is ended, it is reverted back to the customer, and he or she claims the ownership, and the asset cost is amortized during this period. However, the lessee should keep in mind that the lease contract cannot be cancelled until it pays the compensation to the bank. This makes the Ijarah Muntahia Bittamleek base on two independent agreements (Warde, 2000). The first is considered as an Ijarah (leasing) contract with a unilateral promise that the owner will transfer the ownership to the customer according to the methods that were described above. The other independent agreement is the selling contract, which means that the owner would have to oblige to its promise and redirects the ownership to the customer. It entirely depends on the lessee if he has to carry on with the option of setting the ownership or not, but, eventually, the lessor will become the owner of the asset when the lease period ends. The lessor will, therefore, pay the cost and handle all the responsibilities associated with the ownership of the asset during the lease period, but the customer is responsible for the rent that he has to pay for as long as he utilizes the assets (Ebrahim & Joo, 2001). 4. The similarities and differences between Islamic lease and conventional lease Operating lease is very similar to the simple Ijarah in which the payment of lease begins when the lessee starts utilizing the asset. Similarly, the bank claims the ownership and it is responsible for all the maintenance and the risk associated with the ownership of the asset. The lessee has the authority to cancel the contract at any time unless it specifically mentioned in the agreement that the lessor has to approve the guidelines of the contract during the lease period. The most prominent difference between a simple Ijarah and the conventional lease is that in conventional leasing, the owner could penalize the lessee for the late payments such as charging 1% of the lease payment only if it is specifically mentioned in the lease contract. In the Simple Ijarah, the bank has the authority to charge the lessee with the penalty to cover the losses that were borne by the lessor in the delay of the payment. Conversely, the banks only charge late penalty payments to the lessee under the sample Ijarah due to delay in payments, which are aimed at compensating the losses incurred by the lessor in the course of the lease arrangement (Qureshi and Millett 1999). The conventional mode of finance and the Ijarah Muntahia Bittamleek mostly have a similar concept. Both the concepts facilitate that the transference of the asset from the owner to the customer only when the leasing period is ended. During the lease payment period, the both type of leases amortise the full cost of the asset. But there are some key differences, which can be found in differentiating the terms. One most common difference is that, the Ijarah Muntahia Bittamleek has the two types of contracts, which are separated. The first is known to be a lease contract and the second is known to be a selling contract but in the conventional mode of finance, both these contracts are contained in a single contract. The lessor or the owner is responsible for all the risks and the damages of the asset that have been caused by someone else except for the damages that are caused by the customer due to the misuse of the asset or any negligence during the contract period. If the customer has done the damages, he or she would be responsible for compensating to the bank and should make possible that the asset is restored to its original state. On the other hand, in conventional lease, the losses are transferred to the customer and the owner is free from all the costs. In the Ijarah, owner bears the cost of insurance through a procedure of Islamic insurance and Takaful unless the damages have been done by the customer. And the banks would have to bear the cost associated with purchasing, the duties that have been implemented by the customs, the registration fees, and the cost of import (Maurer, 2002). 5. AAOIFI and IFRS The lease documents such as the IAS plus and IAS 17 are considered to be transactions more than simple forms. If all the risks and the rewards are transferred to the lessee then it will categorise the lease agreement as the finance lease (Deloitte Global Services Limited, 2012), but if the lessor or the owner agrees to share a part of the risk or rewards then the lease will be considered to as the operating lease. IAS plus recommends that the lessor or the owner should mark the lease payment as receivable in its balance sheet and that particular amount noted is equal to the net investment in the lease as noted by Deloitte Global Services Limited (2012). The revenues from the lease payment should be shown in the lessor’s income statement. But in the balance sheet of the lessee, the lease is shown as the liability and the amount is equal to the present value of the minimum lease payments and the fair value of the lesser. The payments are recorded as an expense in the income statement of the lessee and the lessee has to depreciate the leased assets by obliging to the normal depreciation policy. The principles of Shariah consider more than the form of the transaction, unlike IAS plus and IAS 17. As the Shariah law believes in the distribution of losses and the risks, the lessor must share the risk. Therefore, the finance lease is treated as the operating lease in which the owner would have to transfer the ownership to the lessee when the contract is ended which also relates to the concept of Ijarah Muntahia Bittamleek. Hence, there would remain two separate contracts, the lease and the sale contract. The owner would have to bear all the costs associated with the asset till the end of the agreement and keep the asset in better condition. It is totally different from the methods that were identified in the IAS plus and IAS 17. AAOIFI suggests that owner should enter the agreement of leased asset as an Ijarah Muntahia Bittamleek to look after the historical cost and its book value (Deloitte Global Services Limited, 2012). If it happens that the lessee acquires the existing asset at the end of the contract, the lessor would calculate the depreciated value of the leased asset which is to be equal to the entire amount of lease, and, in the end, it should be noted that the residual value would be equal to zero. But if the leased asset has been transferred for an exchange of the payment as it was described in the lease contract then the amount that is underling will be deducted from the depreciation cost when it will be calculated. The lease payments would be described as Ijarah revenue on accrual basis and the lessee would be able to record lease payments as an Ijarah expense in the income statement (Deloitte Global Services Limited 2012). The lease / Ijarah contracts are treated differently in the accounting terms. If for example, two businesses have applied for the financial lease contracts to acquire the use of a similar asset in a way that one business acquires it from the conventional bank and the other business enters an agreement with the Islamic bank. Upon cancellation of the contract by the business that was associated with the Islamic bank, the bank would calculate the depreciation of the asset so as to make sure that the asset is consistent with the productive life. The gain and loss in the income statement would be recorded in the bank and the customer would have to compensate for previous instalments that were incurred and there would be a loss to the customer. This is considered to be a financing cost rather than operating cost but the other firms does not have the authority to cancel the contracts because it legally owns the contract. The recommended accountings treatment made by IFRS and AAOIFI for simple Ijarah (operating lease) contracts is often similar. The owner of the leased asset remains the same and the existing asset would be shown as an asset in the lessor’s balance sheet. The payment of the lease is recorded as revenues in the income statement for lessor’s account and the payment of the lease is recorded in the income statement as lease expense for lessee’s account (Deloitte Global Services Limited 2012). 6. Conclusion In the modern world of today, Islamic finance is getting a higher privilege because it is considered to be ethical and fair to all the parties. The Islamic finance system has a concept that the business should be operated through the development of profit and the losses should be shared which should decrease the pressure on the output of the economy, and as the Islamic Shariah is strictly against the interest charges, it is replaced with the fixed service charges. Islamic contracts can be differed from the conventional mode of leasing contract in many ways. Islamic Shariah avoids the use of interest charges and the gambling; it focuses people for upright activities (halal) and prohibits the uncertainties in the activities, which makes the Islamic contracts more prominent and effective. The importance of the paper is due to the importance of the Islamic finance system and its two types: simple Ijarah, which is also known as operating lease, and Ijarah Muntahia Bittamleek, which is known as the financing lease and their difference between the two terms. The paper also highlighted the comparison between the IFRS and AAOIFI and the recommendations for its treatment. Reference list Brealey, R. A, Myers, S. C. and Allen, F., 2006. Corporate finance. 8th ed. New York: McGraw Hill. Deloitte Global Services Limited, 2012. IAS plus: IAS 17 leases. [Online] available from: [Accessed on 26th April 2012]. Ebrahim, M. S. and Joo, T. K., 2001. Islamic banking in Brunei Darussalam. International Journal of Social Economics, vol. 28, no. 4, pp. 314-337. Hairetdinov, R., 1998. Islamic Financial System. [Online] available from: [Accessed on 26th April 2012]. Maurer, B., 2002. Anthropological and accounting knowledge in Islamic banking and finance: Rethinking critical accounts. The Journal of Royal Anthropological Institute, Vol. 8 (4), pp. 645-667. Pike, R. and Neale, B., 2006. Corporate finance and investment: Decisions and strategy. 5th ed. London: Prentice Hall- Financial Times. Qureshi, F. and Millett, M., 1999. An Introduction to Islamic Finance. Harvard Business School. NR-200-002. Ross, S. A, Westerfield, R. W. and Jaffe, J., 2005. Corporate finance, 7th ed. New York: McGraw Hill Companies. Warde, I., 2000. Islamic finance in the global economy, Edinburgh: Edinburgh University Press. Read More