Islamic Banking as a Banking System - Essay Example

?Islamic Accounting Table of Contents Introduction 3 Ijarah 3 Usage of Ijarah Contract in Islamic Financial s 4 Similarities and Differences Between Conventional and Ijarah Leasing 6 Accounting Treatments for Ijarah 8 AAOIFI Standards and IFRS for Ijarah Contract 8 Conclusion 9 Introduction Islamic Banking involves a banking system that follows the ways of Islam. The principles stated in Islamic finance are very old. Islamic banking rules and regulations are based on the teachings of Islam religion. In Islam, short-selling, gambling, or uncertain money investments for abnormal profit maximisation are strictly prohibited. As such, financial products are also designed according to such principles. Accumulating wealth is not against the law, but making money through unfair or fast means is not supported. Although Islamic banking is conservative in many ways, it is also safe. In Islamic banking, all transactions must be interest-free. There are several sets of rules for transactions, leasing, joint ventures, and partnerships. These laws are formulated with the Islamic religious sayings of the Quran and religious scholars in mind. In Islamic Banking, an Ijarah denotes the activity of leasing a property, is conducted by the bank. The bank takes possession of the property from its owner and leases it to a third party for rent; no interest is charged, as per the stated norms of Islamic banking. Even the maintenance cost is borne by the bank. The Islamic regulation is against making money through unfair means. For example, if the lessee pays a fine for late payment, the money goes to charity, not to the bank. Transactions in Islamic banking are considered Salam if the buyer pays the full amount to the seller. It is important that the buyer demonstrate that he is not in debt. Islamic banking offer many products that must be passed by the Shariah Supervisory Board. This board regulates and coordinates the operational activities of banking institutions functioning under Islamic banking rules (Hassan & Lewis, 2006, p. 1-4). Ijarah The term Ijarah refers to a lease, wage, or rent. It denotes the opportunity to use an asset or service at a predetermined price or wage. Under this type of contact, the bank makes the asset available to the customers by lending them for a fixed time period and at a fixed price or rent. Ijarah is derived from the word Al Ajr, which means compensation, substitutes, or counter value. It involves transferring the usufruct but not the ownership, of the asset. In Islamic banking, the bank and the customers are involved in the lending contract. The bank transfers the usufruct to another person for a predefined period of time and consideration. Under Ijarah, the asset to be lent should be non-perishable and non-consumable. Any assets that do not follow the criteria cannot be treated as subjects for lending. Ijarah is used in two different kinds of situations: first, for providing services to other people in exchange for wages, and second, as hired services, where the employer is called 'musta jir' and the employee is called 'ajir'. The second situation deals with the lending of assets by banks to the third party in return for fixed rental charges from the party. Both types of Ijarah are formulated according to the laws of Islam. Ijarah is not only a mode of financing but also a medium for sales. This form of transaction is also followed in other, non-Islamic western countries (Ahmed, I. & Shabbir, n. d., p. 26). Ijarah wa Iktina In this type of lease, the leasor enters into an agreement with the lessee and agrees to buy the property after the completion of the leased period. The contract can be terminated even before the due date for the completion of the lease. The lessee can also buy the property before the date of commencement. The purchase price is determined by the market value of the asset. Ijarah Thumma Al-Bai This combines both the contracts that are Ijarah, meaning leasing and Bai, which means the purchase of the asset. Ijarah wa Iqtina In this form of Ijarah contract, the client takes ownership of the property after the commencement of the lease period. The previous price paid is considered part payment for the property (Jonson, 2006, p. 540-541). Usage of Ijarah Contract in Islamic Financial Institutions In the Islamic economy, a person can reduce or diversify their risk with the help of banks and financial institutes. The Islamic banks are developing several financial instruments to suit the changing needs of people. For functions of these types, Ijarah contract was introduced. It involves leasing an asset to the third party by the bank in return for a fixed rent for a particular period of time. The main benefit of Ijarah contract is that ownership of the asset remains with the bank, the lessor. Another reason is that the financing is not dependant on the size of the asset held for lease, the capital base of the third party, or the lease. It mainly depends on the rent paid by the lease for the asset. Ijarah plays a vital role in economic development. It has a special characteristic that can replace existing forms of financing. Ijarah helps to boost investments in the private sector. It also supplements the financial requirements for modernizing the industry. Ijarah will also lead to future improvements in utilizing capacity, quantity, profitability, and production cost. Ijarah is basically used as a substitute for lending based on interest. The banks or financial institutions give the plants and machinery to companies on lease in exchange for rent. Ijarah contract is useful for those entrepreneurs who have small capital for their business and are unable to buy plants and machinery. Also important is that the lease can accrue tax advantages against the contract (Iqbal, 2009, p. 207-208). The Islamic bonds, also known as Sukuk Ijarah bond, are also floated in the market, and represent leased assets. They do not represent any corporate body. In this case, the asset of the company is leased and it can be represented by a thousand bondholders. The bond holders are not the shareholders of the company, but they own the leased asset. The bondholders receive regular income due to regular rent payment assigned by the lease. As such, there is almost no risk of losing money in this kind of investments. Ijarah-based securities are floated when such assets are found, which is suitable for purchase as well as for leasing on rent. Ijarah contract is not restricted to Muslims; several western countries have adopted it. People prefer Islamic banking for several reasons. The Ijarah model acts as a better alternative for Muslims residing in other countries that seek home ownership and want the security and stability found in this method of leasing. People lease property on a monthly rental basis. The rent is revised after a fixed interval, such as 12 months. People can also pay a percentage of the price of the asset to purchase it, the remainder of which is borne by the bank or financial institution. After full payment of the purchase price, the ownership of the property moves on to the lease. This is a form of property mortgage facility provided in Ijarah (Adam, Abdulkader & Adam, 2004, p. 7-8). Similarities and Differences Between Conventional and Ijarah Leasing When Ijarah is considered from the point of utilisation, it can be segregated into the following two forms of leases: Operational Lease Financial Lease The basic differences between these two leases are stated below: Basis Operational Lease Financial Lease Asset Ownership The lessor (banks or financial institutes) has the legal, as well as the beneficial, ownership. Here the bank only possesses the beneficial ownership. Risk Factors If any damage is caused to the leased asset without any fault of the lease, then the lessor (the banks) will be responsible for the damage and its repair. Any damage caused to the property leased, whether by the lease or the lessor, is to be borne by the lessor (the banks). Obligations The lessor is responsible for the damages and all administrative tasks related to the asset. It is the duty of the lessor to bear the basic maintenance of the asset. The leaser will only be responsible for paying the rent for the leased asset and bearing the daily maintenance cost of the asset. The entire responsibility of asset or property maintenance is shouldered by the lease. Termination The termination process is easy. The contract can be terminated any time. There is no requirement for the payment of any arrears on the rent. The property is handed back to the owner after the termination. The termination is possible only after the lease pays a sum of money as an arrear for rent. The property returns to the lessor. Source: (Kettell, 2011, p. 3-4) Islamic banking is based on Sharia's law. In Islamic banking, rent payment for the use of a property is never objected. The lessor purchases the property and leases it to the lessee for a particular amount of rent until a pre-decided period of time. However, there are a few points of comparison that can be made between a conventional lease and an Ijarah lease contract. First, when the property is leased, the lessor usually passes on the floating risk rate to the lessee in the form of rentals. In Islamic banking, there is no provision for payment of interest on loans or similar activities. As such, this cannot be mentioned as interest on a leased asset. In this case, the lessor provided the asset and the lessee the rent. In Ijarah contract, the amount and time are predefined. Second, in case of conventional leases, a late payment penalty is applicable. Also, default interest payment is charged with a penalty. This does not apply to Ijarah. Third, in Ijarah, the lessor is responsible for the maintenance of the property; however, in a conventional lease, the lessor is not responsible for this duty. There are similarities between conventional leases and Ijarah leases with respect to the sharing of profit and interest-based lending techniques. There are certain differences as well. In this case, the debtor pays the capital and the fixed, decided interest, irrespective of the financial conditions or market condition. As such, the probability of bearing the loss is more on the side of the borrower (Kettell, 2011, p. 97-98). Accounting Treatments for Ijarah Ijarah Asset Recognition The transactions that take place for all Ijarah contracts are to be recorded under the account of the sum total of all the incurred cost. The depreciation of the asset is to be calculated according to the economic benefits of the leased property in the future. For calculating the depreciation in Ijarah, the month in which the property is acquired and in which it is finally commenced are taken as bases (Siddiqui, n.d.). Expense recognition Expenses include depreciation and cost of carrying. Any other incurred expenses related to acquiring the contract are considered in the expense side of the income statement (Siddiqui, n.d.). Revenue Recognition The rent received by the lessor for lending the property to the lessee. The accrued rent is considered revenue (Siddiqui, n.d.). AAOIFI Standards and IFRS for Ijarah Contract The Accounting and Auditing Organisation for the Islamic Financial Institute (AAOIFI) developed the auditing and accounting standards while keeping the laws of Islam in mind. They carry out this function in accordance with perceptions based on the Islamic Shari ‘a. In 1990, the organisation was created to deal with issues and formulate standards that would create transparency in the field of Islamic banking. The organisation did make various contributions, including the formation of accounting and auditing standards for Islamic banking. Between 1998 and 2002, many countries, such as Sudan, Jordan, and Bahrain, adopted the standards formed by the AAOIFI. Even banks in Saudi Arabia take guidance from AAOIFI standards, as the standards are mainly Shari ‘a based (Grevning, 2008, p. 211-214). The IFRS are a set of accounting standards formulated by the International Accounting Standards Board, an organisation based in London, UK. The IFRS approach focuses more on the economic aspect of any transaction. The primary objective of the IFRS is that the financial statement of organisations should reflect the true picture of their economic condition. For this reason, it authorises the following three basic accounting models: Current Costing Accounting Model The Globally-Implemented Historical Cost Accounting Constant Item Purchasing Power Accounting The IFRS model is used in many countries, including European countries. About 113 countries in the world permit the use of the IFRS model. It is assumed that the IFRS model is beneficial to investors and others who are involved in working with financial statements. It reduces the cost of comparing alternative investments and, thus, provides quality information to the company (Nandakumar, et. al., 2012, p. 2). Islamic bank employees are trained in conventional banking and become less familiar with the issues of Islamic banking. As per the AAOIFI accounting standards, Ijarah should be based on the operational lease and financial lease. Even if the bank receives the rent from the lessee in advance, it cannot be considered as income. The auditor's duty is to check that the lessor receives the property on the commencement of the leased period, along with all the accruals. If the bank receives any penalty for late payment of rent, the amount will go to charity, not to the bank. The AAOIFI standards state that Ijarah lease is treated as operational lease; however, in the IFRS, it is treated as financial lease. Conclusion Ijarah is a contract that enables the bank to purchase property from the seller. Then, it leases the property to a third party for a predetermined rent for a particular period of time. The literal meaning of Ijarah is to give something on rent. Moreover, in Islamic banking, there is no concept of charging interest or Riba. As such, Ijarah only considers the payment of the lessee as rent. Even if it receives money for late payment, it has to be donated to charity. The core feature of Ijarah is the exchange of an asset for rent. Organisations, such as AAOIFI and IFRS, have stated certain standards for Ijarah contracts. Ijarah lease contracts should function as operational lease contracts. Though an AAOIFI standard states that Ijarah contracts should function as operational lease contracts, the IFRS considers it to be following the financial lease strategy. These are the slight differences between the points of views of these two regulating bodies. Both organisations aim to spread Islamic banking functions all over the world. Moreover, the functioning should remain smooth and transparent. References Adam, N. J., Abdulkader, T. & Adam, N. J. (2004). Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk. New Delhi: Euromoney Books. Ahmed, I. & Shabbir, G. (n.d.). Frequently Asked Questions on Islamic Banking. [Pdf]. Available at: http://www.sbp.org.pk/departments/ibd/FAQs.pdf. [Accessed on May 11, 2012]. Grevning, H. V. (2008). Risk Analysis for Islamic Banking. Washington, D.C.: World Bank Publication. Hassan, K. & Lewis, M. (2006). Handbook of Islamic Banking. Cheltenham: Edward Elgar Publishing. Iqbal, J. (2009). Islamic Finance Management. New Delhi: Global Vision Publishing House. Jonson, D. J. (2006). Islamic Economics and the Final Jihad: The Muslim Brotherhood to the Leftist/Marxist - Islamist Alliance. Maitland, New South Wales: Xulon Press. Kettell, B. B. (2011). Case Studies in Islamic Banking and Finance. New York: John Wiley & Sons. Kettell, B. B. (2011). Introduction to Islamic Banking and Finance. New York: John Wiley & Sons. Nandakumar, A., et. al. (2012). Understanding IFRS Fundamentals: International Financial Reporting Standards. New York: John Wiley & Sons. Siddiqui. (n.d.). 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 11, 2012]. Read More