Islamic Accounting and Reporting - Assignment Example

?Islamic Accounting and Reporting Table of Contents Table of Contents 2 Ijarah contract and conventional leasing 3 Accounting treatment of different transactions in Ijarah contract 5 Accounting treatment compared between AAOIFI and IFRS (International Financial Reporting Standard) 6 Suggestions and conclusion 9 References 11 Ijarah contract and conventional leasing In Arabic the term “Ijarah” means to give something on a rent and in conventional accounting this term is referred to leasing. Ijarah is a mode of leasing contract which involves a lessor known as mu’ajjir, who transfers the right to use a specified asset to the lessee known as musta’jir for a stipulated time period and in return asks for some periodical rent payment. The time period is also referred to as Ijarah period (Siddiqui, n.d.). The Ijarah contract is based on Islamic principles and has emerged as a popular asset financing concept. This contract is also used for transactions related to employment and hire of services. This contract of Ijarah is a mode of financing which provides customers with short to medium term financing to lease items such as buildings, real estates, computers, equipments, machineries and other items which are not forbidden of haraam. The contract is almost similar to conventional leasing contract but not identical to it (Ibrahim, 2001). The Ijarah rental amount is paid in installments over the time to cover the costs or the value of the investment for the bank in addition to the fair return on the investment (Ghuddah, 2007). In Ijarah the ownership of the asset is not transferred to the lessee. Risk associated with the ownership of the assets should remain with the banks and the asset is supposed to be reverted to the bank at the end of Ijarah period. The cash flows of the asset are structured in such a way that they cover the price of the asset and provide a return on the same. Some of the important features of the Ijarah contract are as follows: The asset which has been leased must have a valuable use that is compliant with the Shari’a laws. The asset which is leased must be returned in the original form at the end of the lease period. The ownership of the asset remains with the mu’ajjir and only the usufruct is transferred to the musta’jir. Usufruct means the right of using another’s property for profit (Abdullah, 2010). The rental payment must occur after the delivery of the leased asset. For example by giving the keys of the building to the lessee musta’jir. If there is a loss to the usufruct then the Ijarah contract stands terminated (Shariff and Rahman, n.d.) Islamic accounting is less accepting towards the concept of time value of money and that is why in Ijarah accounting the lease and the transfer amount will be accounted as separate transaction even if these transactions are linked with each other (Malaysian Accounting Standards Board, 2010). In conventional leasing it is acceptable to have a lease and sale in one accounting transaction; however to have more than one accounting transaction with more than one result is prohibited in Islamic accounting. The results derived from the lease transaction differ from the sale transaction and that is why they cannot be combined into a single transaction under Islamic accounting which is also known as Akad. In conventional leasing finance there are usually two types of leases known as operating lease and financial lease. In operating lease the lessor owns the asset and bears the risk and the maintenance costs. In financial lease the ownership of the asset remains with the lessor and the risk and operating costs are borne by the lessee. Conventional leasing provides options to the lessor and lessee to terminate the lease contract unanimously. Ijarah contract on the other hand gives option to the lessor and lessee to terminate the contract within a stipulated time frame. This option is valid for a particular time period under the framework of Al-Khiyar. In conventional leasing, in case of termination of the contract, the remaining rental payment of the asset becomes due on the lessee. On the other hand in case of Ijarah contract the ownership of the asset is reverted back to the lessor and the lessee will pay the rental amount up to the date of the termination of the contract. Ijarah contract does not allow transactions of certain category of assets. For example consumables and money are not considered as leasable assets. The Ijarah contract is similar to the conventional leasing contract in many ways like both the methods allow transferring the right to utilize and enjoy the asset to the lessee or musta’jir while the ownership remains with the lessor or mu’ajjir. The Ijarah contract is also similar to certain components of the financial lease contract in terms of the transfer of ownership of title. In financial lease and Ijarah contract there is a possibility of transferring the title of the asset to the lessee at the end of the leasing or Ijarah period in return for additional payment. The transfer of title of ownership of the leasing asset and additional payment is presented in a separate document. We can observe that the basic principle of Ijarah contract is that it is slightly opposed to the conventional leasing financing method as profit is generated when something having intrinsic value is sold. Money does not have intrinsic value and thus money cannot generate profits until and unless converted into assets. Accounting treatment of different transactions in Ijarah contract As per the traditional finance leasing, the asset is generally transferred to the lessee at the end of the period either at a minimal cost or at a token price. As mentioned before, more than one accounting transactions with contradicting results is prohibited as per the Shariah law because results derived from a sale and lease transaction is not the same. These transactions have different types of accounting treatment. Islamic accounting standards do not treat these transactions as financial leases. For example leased assets will be presented in the lessor statement of the financial statement under the under Ijarah Muntahia Bittamleek Assets and shall be measured at their book value. The transfer of assets to the musta’jir can be done through four ways and the accounting treatment for the following would be as follows: S.no Particular Accounting treatment 1 Transfer through gift The leased assets are depreciated as per the normal depreciation policy. However, the residual value of the leased assets will not be subtracted to determine the depreciable costs of the assets since they are being transferred as a gift. 2 Transfer through sale of a token for a consideration or other amount as mentioned in the contract. The residual value of the assets to the lessor shall be subtracted to determine the depreciable cost of the assets. 3 Transfer through the sale prior to the end of the lease term for the cost equivalent to the remaining Ijarah rental payment. The legal title of the asset will pass to the lessee when he/ she buys the leased assets before the end of the lease term for a price that will be equivalent to the remaining Ijarah rental installments and the lessor shall recognize any profit or loss resulting from differences in net book value and the selling price of the assets. 4 Transfer through gradual sale of the leased assets. The net book value of the sold portion of the leased assets will be removed from the leased asset account and the lessor shall recognize the value of the asset in the income statement which results from the difference between net book value and selling price of the assets. Once all the rental Ijarah payments are received by the lessor the related accounts to the leased assets will be closed. Although the above mentioned accounting treatment may be not complying with the International Accounting Standard (IAS) these accounting transactions are in compliance with the Ijarah contract of leasing. As per Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) the transfer of ownership and other components of Ijarah are treated as separate transactions rather than a joint transaction. Accounting treatment compared between AAOIFI and IFRS (International Financial Reporting Standard) AAOIFI is an autonomous nonprofit corporate body which was founded in the year 1991 that prepares accounting, ethical, auditing and Sharia standards for the Islamic financial institutions and other industries (Deloitte, 2013). It is noticeable that the accounting treatment for leasing differs between AAOIFI and IFRS accounting standards. As per IFRS the accounting transactions need to be accounted for and presented in accordance with their substance even if their legal form is different. For some of the accounting transactions substance and form are same except for certain Islamic finance products. For example from the conventional leasing accounting perspective the risks and rewards are borne by the lessor while in Islamic accounting the lessor is responsible for the assets. Therefore, the leased assets do not get recorded in accounts of lessee. AAOIFI does not consider the above prescribed treatment of operating lease to be significant because in the traditional lease financing method the leased assets is recognized in the books of the lessee including a lease payment. The leased assets are depreciated in the accounting books of the lessor. As per the AAOIFI standards all the components of the Ijarah contract are to be considered as operating leasing. We will analyze the key differences in the accounting treatment of Ijarah contract between AAOIFI and IFRS. Basis of difference IFRS AAOIFI 1 Classification of leases Lease is termed as a financial lease if it transfers all the risks and rewards which is incidental to ownership. All types of leases should be considered as operating leases. 2 Leases in the financial statement The lessee will recognize the financial lease as assets and liabilities at the end of the lease period at an amount that is equivalent to the fair value of the leased asset. If the amount is lower than the fair value of the leased asset then the lessee will pay the present value of the minimum lease payment. The discount rate will be used to calculate this present value of the minimum lease payment. In the minimum lease payment the direct costs are added to the value recognized as leased asset. The Ijarah contract which ends with a transfer of ownership should be treated as two separate accounting transactions of operating lease and not as financial lease. 3 The financial statements of lessor Lessor shall recognize the value of the assets which are held under the financial lease in their financial statements and are presented as a receivable at an amount equal to the net investment value in the lease. In cases where the Ijarah ends with a transfer of ownership of assets, the lesser would present an asset in its financial statement and recognize lease installments as revenue in the entire lease period (Atmeh and Serdaneh, 2012). According to the AAOIFI standard, the Ijarah contract should be allocated over the financial period in the entire lease term and realize it as an Ijarah expense. At the end of the lease period when the asset is transferred to the lessee as a gift then the leased assets will be recognized in the books of lessee and measured at its cash equivalent value and a corresponding credit will be made to the retained earnings. It is evident from above that throughout the leasing term the Ijarah rental payments are recognized as expenses. However if the leased assets are damaged before the title passes to the lessee and the damage was not caused due to the action of lessee then the difference between what lessee has paid towards the purchase of the assets and its rental amount will be recognized as a receivable due from the lessor in the accounts of lessee. The lessor pays more amount of rental value for the ownership of the leased asset and the amount which exceeds the fair rental value are recognized as assets in the book of the lessee. AAOIFI does not recognize this asset value throughout the lease period (Tag El-Din, 2004). Therefore we can state that there are two basic AAOIFI accounting treatment differences, first is to increase the retained earnings in the case of the leased asset and second is to increase the receivables. Although, AAOIFI recognizes these two differences but does not give any justification for using these two different methods (Bank Negara Malaysia, 2010). Suggestions and conclusion At the evolvement of the Ijarah contract, rental payment is considered as a part of ownership. However, this should be considered as liability at each installments rather than revenue generated. This can be recognized as a difference between fair value of the rent and the rental payment. Depreciation expense should be determined as per the useful life of the asset rather than the lease period. Allocating the depreciation expense over the useful life of the asset would enhance the view that lessor is the real owner of the leased asset which will help in distinguishing between the Ijarah leasing and traditional leasing method. When the legal title of ownership of the leased asset passes to the lessee at the end of the lease period then the lessor closes down two accounts outstanding balance of the contingent liability and the book value of the leased assets (Mirza and Baydoun, 1999). Transferring the legal title of the ownership of the leased asset to the lessee can be seen as the lessor selling the asset in exchange for relieving him from the contingent liability, rather than the asset being donated as a gift to him. This approach is almost similar to the matching principle and achieves a proper representation. The assets and liabilities that are presented in the balance sheet reflect the true economic substance of the accounting transaction. Thus we can say that the Ijarah contract is different from the traditional financial leasing in two aspects, structure and accounting treatment of the Ijarah contract. As observed by the Ijarah Muntahia Bittamleek contract the lessor retains the ownership and the risks and rewards related to the leased asset. Therefore, as per the Ijarah Muntahia Bittamleek contract the leased asset is presented in the balance sheet of the lessor while in the traditional financial leasing the leased asset will be presented in the accounts of lessee (Abdullah and Dusuki, 2004). Moreover the Ijarah rental installments will be allocated throughout the lease period and shall be recognized as an expense in the lessee books or vice versa. This approach will be almost similar to the matching principle and also meet the specification in the Ijarah contract. Although, the documents for all the transaction will be maintained separately as this will help in providing clarity and transparency. Since the Shariah concept is very consistent with the religious and ethical principles care should be taken that the there is no inclusion of the interest rate (Riba). The exclusion of interest rate in Islamic accounting may lead to a different result from that of the traditional leasing but the formation of financial tools like Musharaka, Mudaraba and Murabaha has made it easier to calculate the transactions without the interest rate. These tools are appropriate for those Islamic banks which give interest free mortgage loans to the customers. References Abdullah, D.V., 2010. The effects of Shariah principles on accounting methods [pdf] Available at: < http://www.iasplus.com/en/binary/islamicfinance/islamicaccounting.pdf> [Accessed 09 April 2013]. Abdullah, N.I. and Dusuki, A.W., 2004. A critical appraisal of Al-Ijarah Thumma al-Bay’ (AITAB) operation: Issues and prospects. [pdf] Available at: < http://www.kantakji.com/fiqh/files/accountancy/v105.pdf> [Accessed 09 April 2013]. Atmeh, M.A. and Serdaneh, J.A., 2012. A proposed model for accounting treatment of Ijarah [pdf] Available at: < https://mail.google.com/mail/u/0/?shva=1#inbox/13de999387871c3a> [Accessed 09 April 2013]. Bank Negara Malaysia, 2010. Shariah resolutions in Islamic finance [pdf] Available at: < http://www.bnm.gov.my/microsites/financial/pdf/resolutions/shariah_resolutions_2nd_edition_EN.pdf [Accessed 09 April 2013]. Deloitte, 2013. Islamic accounting [pdf] Available at: < http://www.iasplus.com/en/resources/resource64> [Accessed 09 April 2013]. Ghuddah, A.S.A, 2007. Ijarah (lease) [pdf] Available at: < https://mail.google.com/mail/u/0/?shva=1#inbox/13de999387871c3a > [Accessed 09 April 2013]. Ibrahim, S.H.M., 2001. Islamic accounting – A primer [pdf] Available at: < http://www.iium.edu.my/iaw/Articles/ISLAMIC%20ACCOUNTING%20a%20primer.htm> [Accessed 09 April 2013]. Malaysian Accounting Standards Board, 2010. Financial reporting issues relating to Islamic finance [pdf] Available at: [Accessed 09 April 2013]. Mirza, M. and Baydoun, N., 1999. Accounting policy choice in an interest-free environment [pdf] Available at: < http://www.kantakji.com/fiqh/files/accountancy/v105.pdf> [Accessed 09 April 2013]. Shariff, R.A.M and Rahman, A.R.A., n.d. An exploratory study of Ijarah accounting practices in Malaysian financial institutions [pdf] Available at: < http://kantakji.com/fiqh/Files/Accountancy/v109.pdf> [Accessed 09 April 2013]. Siddiqui, A.A, n.d. Islamic financial accounting standard-2 IJARAH [pdf] Available at: < https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=5&cad=rja&ved=0CEoQFjAE&url=http%3A%2F%2Fccsenet.org%2Fjournal%2Findex.php%2Fijbm%2Farticle%2Fdownload%2F17370%2F13505&ei=yNdjUcurKYXprQesiIG4Ag&usg=AFQjCNHU_r4ezvO3oeWNi-Da94S5G2r90g&bvm=bv.44990110,d.bmk> [Accessed 09 April 2013]. Tag El-Din, S.I., 2004. Issues in accounting standards for Islamic financial institutions. [pdf] Available at: [Accessed 09 April 2013]. Read More