Islamic Accounting: Ijarah Contracts - Assignment Example

Islamic accounting & Financial Reporting Assignment: Ijarah Contracts Introduction The term ijarah refers to a contract in Islamic financing. It is a financing system that is compliant with Islamic sharia banking requirements. As Saleem (2012) says, in Islamic banking requirements, parties, corporate or individuals are not supposed to lend their money for interest. As a result, there are other arrangements that help banks or even individuals to gain economically even when they lend their money out to people. This takes a contract of lease that is called ijarah. Ijarah means rent or wage in Arabic. This kind of financing is different from the non sharia kind of banking. However, it has a number of similarities that can be identified. The main difference between these two is can be seen in the focus each of the two standards. For instance, the ijarah contracts as standardized by the AAOFI are geared towards making it possible for the firm to be able to report its income in such a way that it shows the honesty of its operations, especially with regard to the principles outlines in the Quran. The IFRS standards on the other hand focus on the economic aspect of any business transaction between the firm and the customer. This means that minor differences will arise while trying to compare the two statements of accounts prepared by either of the standards. However, this does not lead to a full dichotomy of the two standards but only leads to some minor differences that can be reconciles when preparing he books of accounts. Ijarah based contracts As has been discussed, ijarah is a form of banking arrangement that allows banks and individuals to gain some form of profit after giving a loan to another individual. Instead of the lender charging an interest, they enter into an agreement with the lessee. The agreement is made in a way that allows the lender to gain some profit by the end of the transaction. Basically, ijarah based contracts have two phases (Ismal, 2013). For instance, when a person goes to the banks to take a car loan in a Sharia compliant bank, the bank will finance the purchase of the car and instead of requiring the customer to pay interest, the bank will hire out the car to the customer. The first phase of the contract, there will be an agreement with regard to how long the lease period will last (Karim, 2010). Once the period of the lease is over and the cusromern has aid al the lease charges, the first contract ends the second contract, or the second phase of the ijarah kicks in. This second part of the ijarah is the sale of the car. The value of the car is priced by calculating the residual value of the car after the it has been used through the lease period. The customer will buy car at this price. The way the contract is designed is that the bank will gain some profit indirectly through the leasing as well as through the eventual sale of the car after the lease period. By achieving this, the firm is able to make a profit for lending out money while at the same time conforming to the sharia banking requirements that prohibits the lending of money at a profit. Differences between ijarah and conventional leasing (contracts) One of the major differences between the ijarah and the conventional leasing is the fact that in conventional leasing and contracts, the lease commences on the date the bank pays for the price of the assets which the customer wants. On the other hand, for ijarah, the lease is only recognized as having commenced after the customer has received the product. This has a fundamental impact on the accounting procedure for both AAOFI and IFRS. The second difference is the fact that in conventional leasing, the customer will be the one who will take care of any other costs that go with acquiring the product. For ijarah, these costs the banks, it being the owner of the product is the one that pays for the extra expenses. However, as has been discussed, the way the contract is designed is such that the bank will be able to recover these cost s by including them in the lease agreement. The other major difference is the fact that in a conventional lease, the bank does not differentiate between wear and tear damage caused by the customer and or the ones caused by natural disasters (Greuning & Iqbal, 2008). The customer will be expected to take care of the costs that arise from such wear and tear. For ijarah on the other hand, the customer is only required to take care of damage of wear and tear that he caused by being careless or reckless. This difference arises from the fact that the customer ends up owning the product at the end of the else, as opposed to the conventional leasing where at the end of the lease, the bank will get back its product. With regard to the conventional leasing and contracts, any charges that may arise such as from customers being unable to pay the premiums on time are taken by the bank as income. With regard to ijarah however, such penalties are collected an given to charity and the bank cannot take it as its income. The other problem is that in most cases, conventional leases gives the bank much power over the customer and the bank can decide to either terminate the lease, or even adjust the rate even when the customer has not done anything wrong or violated the terms of lease. This is geared towards protecting the banks from unexpected issues that may rise during the time of the else, such as if he inflation shoots up unexpectedly. However, with regard to ijarah, cancellation of the contract can only happen when there is enough evidence that the customer has violated the term of lease. However, it is good to note that in ijarah contracts, when the lessee defaults to pay the lease fees agreed, the bank cannot compound the premium interests (Essvale Corporation Limited, 2010). On the other and, in conventional leasing, if he customer defaults on pay his premiums on time, the bank not only has a right to charge the lessee and take the penalties as profit, but also has the right to charge interest based on a compounded basis. Most importable, in ijarah contracts the lessee must make unilateral agreement with the lender to buy the product at the end of the period. This is because as has been identified, the ijarah lease arrangement is geared towards helping the lessee to own the product at the end of the lease period lease to own) (Ahmed, 2011). Secondly, the lease arrangement which include a transfer of ownership to the lessee is what helps the bank to be able to gain some profit. If the lesser cannot sell off the product to the lessee, the bank may not be able to realize all its profits. As a result, unlike the conventional leasing which is one fold, the ijarah contra is twofold and looks to make sure that the lessee can gain the product at the end of the lease. Reconciling the IFRS and the AAOFI It is important to understand that there are few big differences between the IFRS and the AAOIFI standards. In fact, many firms operating under sharia law also operate on IFRS. The main difference is with regard to the emphasis of each of the standards. For IFRS, it focuses on the accounting principle and the economic aspect of any business transactions (Hassan & Mahlknecht, 2011). On the other hand, the AAOIFI focuses on the ethical part of it and the social art of it, hoping to make firm to be more open with regard to showing whether their income is halal (permissible) or haram (forbidden). As a result, firms that aim to be sharia compliant can be able to still use the IFRS standards as long as they are able to show that their operations are halal. In this case, what these firms need to do is to make sure that even if they use IFRS, they are able to record the transaction in such a way that they can clearly indicate the validity of their cash flow with regard to sharia requirements. This means that the firm can chose to concentrate on one of the two standards and but still take care of the requirements of both (Askari, et al, 2011). In this regard, it can be argued that there is not significant dichotomy between the two standards. Penalties in ijarah can be reported as outgoing credit and can have their own account in the books of accounts of the firm. It is necessary to note that in both the accounting standards, the firm is expected to transact all its cash flow. In such a case, as (Ariff & Iqbal, 2011)for AAOIFI, there is one trust that is brought forward by the fact that when it penalties its customers for late payment of premiums, they are supposed to take the money to a charity fund and this income therefore ends up in the hands of other the customer or the bank. In such a case, AAOIFI accosting would have to know how to record this transaction of money that transfers between the customer to the philanthropic cause, but through the accounts of the banks. However, it is also importnat to know that even the firms that use the IFRS can also contribute to the humanitarian causes and still can be able to report this in their according books. The only difference is that for a firm that uses the IFRS, the contribution to a humanitarian cause will only be done from its profits. Al-Ijarah Thumma Al-Bai’ (AITAB) This is the Ijarah type of sharia lease arrangement where the lessee ends up owning the product that is being leased to him or her. This is different from the conventional lease arrangement. Because of the nature of this lease agreement, it may not fully be able to comply with the IFRS standards. However, it is crucial to note that in such a lease, the losses and profits of the lease are shared by both the lender and the lessee. With regard to reconciling this with the IFRS, the person doing the accounts must be able to recognize this fact (Kettell, 2010). As a result, instead of reporting a profit during the time the lease had been activated, the profits should only be reported as and when they have been recognized. Consumer protection act also requires that the interest rate that the customer is paying should be clearly stated in a percentage form. However in Al-Ijarah Thumma Al-Bai, there is not direct interest paid to lender. This does not mean however that there is no pay to calculate this. The lender, in most cases a bank, the percentage of gain by the bank can be easily calculate and the customer will be able to know how much the lease will cost him on top of the value of the product being leased to him. By calculating and determining this figure, the accountants will have come up with a way to make sure that he or she can reconcile the Al-Ijarah Thumma Al-Bai with the IFRS standards. In such a case, there is an accounting method that can be used to reconcile the AAOIFI accounting to the IFRS. For instance, as has been identified, in AAOIFI, during a lease, the customer never owns the asset until the lease period ends. However, the bank is the one that fully pays for the asset bought from supplier. In reconciling this to the IFRS accounting standards, what the bank can do is to record the sale to the customer but with a deferred payment for the period of the lease period. When recording the purchase of the asset from the supplier, the bank will record and immediate payment. In other words, in its accounting books, it will have made a payment (credit) and will have made a sale on debt. However, this in itself does not self everything. According to IFRS accounting standards, the firm should prepare its books in such a way that they show an honest account of its income. However, just doing the above to try and reconcile the AAOIFI with the IFRS does not fully reveal the profit making, or what the bank has gained from the transaction. The complex nature of an ijarah contract lease makes it hard. However, to have a clear statement of account that is in line with the IFRS accounting, the income can be split into two. For instance, as has been seen, in an Ijarah lease, the first sort of income comes from two main ways. The first one is the lease payments done by the customer during the first phase of the contract. This income to the firms can be recorded differently. The second income comes from the sale of the product to the customer after the lease period is over. This income can be recorded differently. Furthermore, one more problem arises because the way losses are shared between the customer and the bank is different from the way this is done in conventional accounting methods on which the IFRS are based. In other words, if the transactions end up bringing a loss, the AAOIFI requires the bank to also share the loss with the customer. This means that the accounts have to be reconciled with the IFRS which does not recognize the principle of sharing the loss with the customer incase the lease does not become profitable for the customer. Conclusion The AAOIFI standards are accounting standards developed for Islamic firms that want to be sharia compliant. However, the problem is that the IFRS standards do not give an exception to these firms. If a firm that wishes to be sharia compliant is registered or headquarter in a country that recognizes the IFRS standards, it will still be needed to report its accounts with the IFRS standards. Due to the small differences with regard hot the AAOIFI treats accounts and the way the transaction are done in AAOIFI standards, this can bring a small difference with regard to the accounts of income and losses. In this regard, the firm should be able to know how to reconcile the two standards so that they are compliant to bit standards. There are no particular ways to reconcile the accounts and the accountants have to be come up with ways to make sure that the accounts are in line with the IFRS standards that focuses on the economic outcome of any transaction. It is also necessary to note that at the end of a transaction, whether the firm is using the IFRS or the AAOIFI standards, the results can be either a loss or a profit. However, a major point to remember is that these two standards are not the opposite of each other. In fact, the AAOIFI standards were developed in the light of IRFS standards, but only added the principles of sharia banking. In this case, it could be said that reconciling the two is not a hard task for accountants as long as they know what is required by both standards. Reference list Ahmed, H. (2011). Product Development in Islamic Banks. New York, NY: Oxford University Press. Ariff, M., & Iqbal, M. (2011). The Foundations of Islamic Banking: Theory, Practice and Education. New York, NY: Edward Elgar Publishing. Askari, et al. (2011). The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future. New York, NY: John Wiley & Sons. Essvale Corporation Limited. (2010). Business Knowledge It in Islamic Finance. New York, NY: Essvale Corporation Limited. Greuning, H., & Iqbal, Z. (2008). Risk Analysis for Islamic Banks. Washinton, DC: World Bank Publications. Hassan, K., & Mahlknecht, M. (2011). Islamic Capital Markets: Products and Strategies. Hoboken, NJ: John Wiley & Sons. Ismal, R. (2013). Islamic Banking in Indonesia: New Perspectives on Monetary and Financial Issues. New York, NY: John Wiley & Sons. Karim, S. (2010). The Islamic Moral Economy: A Study of Islamic Money and Financial Instruments. New York, NY: Universal-Publishers. Kettell, B. (2010). Frequently Asked Questions in Islamic Finance. Hoboken, NJ: John Wiley & Sons. Saleem, F. (2012). Islamic Commercial Law. Hoboken, NJ: John Wiley & Sons. Read More