Differences between Ijara and Conventional Operating Lease Contracts - Assignment Example

Table of Contents Introduction………………………………………………………………………………..2 Meaning of Ijarah………………………………………………………………………….2 Elements of Ijarah…………………………………………………………………………3 Differences between Ijara and conventional operating lease contracts…………………...5 AAOIFI and IFRS standards……………………………………………………………...7 Ways of reconciling any variations in interpretation……………………………………...9 References……………………………………………………………………………….10 Introduction The institutions of financial sphere around the world are in a process of an evolution and they are persistent in their pursuit of better quality of their services to satisfy their clients and customers. Over the ten-decade period of developing within theories of capitalism at the moment it is gaining common language with the theology of Islam in a field of banking and finance in order to create products which are more compliant to Sharia to capture the enormous Islamic communities. It involves players at the international level and the local one as well. The main aim of this research is to give detailed characteristic of conventional leasing system and Ijara, to disclose differences and common features and discuss the variety of options and applications of both(Usmani). Meaning of Ijarah “Ijarah” in the language of banking and finance can have two simple definitions “hiring” and “leasing” which are commonly interchangeable, but the origin of that word comes from Arabic ‘ajara’ which means ‘recompensing’ or ‘rewarding’. From the view of the Islamic banking system Ijarah is referred to Islamic contract of leasing of property and equipment, of land to be leased to a client for rental payments or stream payments. From the view of Islamic banking system Ijarah is referred to a certain leasing contract of property and equipment or land which is leased to a client for rental or stream payment(Open to comparison). Ijarah word is to symbolize a contract between the two sides – the lessee and the lessor where the lessor is presented as an owner of a property of any kind and he gives permission to a lessee to make use of the usufructs of the property in question with terms agreed about the leasing and the rental period. According to the fact that Islamic countries cannot be disconnected with their religion Ijarah contract has gained the permission of the Shari’ah due to several authorities(Nizram): 1. As Allah says in the Quran “and if they suckle your offspring, you should give them recompense” (surah al – Talaq:6). 2. Prophet Muhammad said, “He who hires a worker must inform him about his wages” (Reported by Al-Bayahi). Elements of Ijarah The contract of utilization of the usufruct of Ijarah consists of five essential components: 1. Lessee and lessor The both parts of the contract are to be provided with certain conditions: they must be able to take responsibilities as well as being in sound mind and having reached the age puberty and the majority age. Secondly, the must not be banned to deal with their property, they need to present stability and stay far from being declared bankrupt or wasteful. Both of the sides should not be under pressure re any kind of compulsion. 2. Property There are four conditions set up for property: first and foremost property must be owned by a lessor, it has to be available for immediate use, it is supposed to be delivered to the lessee and specific information as detailed description, address and specification have to be provided. 3. Benefit (usage or usufruct) When talking about the benefits there are five conditions for them: benefits must be permissible, they may be in fixed value, the lessor is empowered and capable of providing the benefit and to give the permission to the lessee to apply property; benefit may be in fixed value; it must be specified. The benefit must not be represented as the material element of the property (Ghuddah). 4. Rental The two necessary conditions are set up in relation with rental: the rental must be in known currency such as US Dollar or other, it is insufficient to state the rental price using only figures without specifying certain currency; the rental must be in absolute amount only. 5. Contract A contract itself presents the important element of any operation and thus it has to be performed the best way possible applying the appropriate procedure and fulfilling certain requirements. There are three essential conditions for the contract: definite and decisive language is the spine of contract of this kind for both offer and acceptance which have to be absolute. It must be non-conditional and it is not to be fixed on a certain day or have limitations within certain period of time; the text must contain past and present tense, but not future or imperative. The offer must be agreed by acceptance and both actions have to be performed at the same meeting. This procedure itself has to possess three major elements(Jangda): a) a contract includes offer and acceptance – ‘ijab’ and ‘qabul’ b) two parties which are presented as lessor – the owner of the property in question and the lessee who is to reap the services of the leased property c) the object of the Ijarah contract – this part includes the information on rental amount as well as the service where this property is transferred directly to the lessee Differences Between Ijara and Conventional Operating Lease Contracts Before outlining the distinctions it is necessary to mention that there are several points of resemblance between the two contracts. Taking into consideration ownership of the property the lessor saves his right to own and this is executed both in conventional and Ijarah contracts. The lessor is the one to bear liabilities and the risks as well along with the maintenance cost and this responsibility is referred to cases where property has undergone some damage due to circumstances that were out of control of the lessee. Also in both types of the contract the rental payment which comes first is executed when the lessee receives property in an appropriate state and in conditions ready to use and is ready to meet the objectives of the hiring process (Fatma). There is practically no economical difference between a conventional leasing contract and an ajarah. But taking into consideration all the aspects in more specific way it is interesting to point out that the operating lease contract differs in some particular features. They are as follows: firs of all it is about the cost of acquiring the asset – it turns to be not amortized within the leasing period. The person responsible for keeping the maintenance costs of the asset is the lessor. At the end of the leasing period the asset is returned to the lessor(Ibrahim). One of the main aims of this research is to point out a very significant statement: there is a lack of legal balance mutual understanding among the parties of profit and loss in conventional leasing system (Ameer 2014). The main distinctions between conventional operating lease contracts and Ijarah are generally based on major elements of this type contracts such as identification of the risk-bearer, ownership, specific details of the payment and the nature of the property under the contract. The paragraph containing terms and conditions of the contract can also serve as grounds for distinctions between two types of contracts(Siddiqi). The Ijarah mode of financing the property to be hired non-replaceable, is it is not to be damaged in the process of usage. While in the conventional operating lease contract it is clearly stated that the leased property must not be object of limited use (Al-Bab 2003). The other specific aspect of the Ijarah leasing is implied in the principles of work itself where the basic tenets of Shari’ah are to be adhered. For example talking about conventional lease contract the lessor is empowered to set a certain penalty in case when lessee delays or even defaults payments. The situation within Ijarah contract is practically the same except the contract is sure to include some conditions for lessor to use the received amount as a penalty but for charitable causes only (Comparison between Ijarah…). As far as ‘sale and lease back’ question is considered in Ijarah contract these two actions are to be executed separately, but they are allowed. Whereas in conventional leasing contract covers the sale of the property by one organization to another and this consequently lets out the property to be hired by the initial seller. Thus, conventional and Ijarah leases are two sides of one phenomena. Their concepts are similar, but the distinctions are sensible. These differences can be summarized in following positions: Ownership: ownership can be transferred anytime in conventional lease, while in Ijarah ownership stays with the lessor. Rental administration: conventional lease contract - rental starts after transfer of payments, when in Ijarah it starts when the lessee begins to use the object of Ijarah contract. Rental determination: under conventional lease contract, rentals of leased property can refer directly to rates of interest. On the contrary, in Ijarah contract, rentals can not be connected to interest rates as the overall volume and timing of payments must be agreed in beforehand. Risks/maintenance expenses: in conventional lease contract, the risks and costs related with the leased assets are limited by the lessee, when in Ijarah contract both parties bear these risks and costs which are to depend on circumstances, origin and level of damages. Penalty in case of default: conventional lease contract often provides for default interest on delayed rental payment, whilst Ijarah lease it is not allowed(Investment&Finance). AAOIFI and IFRS standards One of the key questions of this research is do the Islamic financial institutions need a different record of standards? The top answer to this question is that the IFIs unfortunately are not based on capitalist paradigm which outlines the present IFRS. While conventional accounting is based on a framework of decision usefulness, Islamic accounting is based on an accountability Shari’ah fulfilment framework which pursuits to “determine the obligations and rights of all interested parties, with rights and obligations which result from incomplete transactions and other events, according to the principles of the Islamic Shari’a and its fairness concepts, charity and compliance with Islamic values in business.” (AAOIFI, SFA 1). The reason why the standards issue by AAOIFI appeared is obvious and expected and it includes several major factors, such as: a) IASB or IFRS standards cannot be applied by financial institutions of the Islamic world. In some specific cases IFRS according to Shari’ah fulfilment but mostly all the other cases show absolute incompatibility of conventional model and Islamic financial institutions due to inability to meet the characteristics of Islamic sector of banking and finance. b) AAOIFI standards created specific banking and financial activities for Islamic institutions which are not stated in IFRS(Accounting and auditing). c) Some of the standards of IFRS can be adopted by AAOIFI as long as they do not go in conflict with the principles of Shari’ah. The AAOIFI describes Ijarah as ownership of the rights to gain benefits as a result of using a property in return for consideration ( FAS 8, Paragraph 1/1). Some scientists do include the duration of the benefit gained in the definition. Considering leasing the IAS 17 describes lease as a certain agreement whereby the lessor the right to use the property for a specific period of time in return for the rent. The definition stated by MASB 10 is analogous to the definition given by IAS 17. The MASB 10 described the leasing process as “an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time”. The definitions mentioned above contain the element of usufruct exchange for transactions of money. The definition presented in AAOIFI is provided with specific conditions which distinguish conventional leasing from Ijarah. The AAOIFI FAS 8 standard in Juristic Rule 1/3/3/2 discusses that the compliance of the benefit must be of a permissible origin and the benefit must be in chime with Shari’ah. AAOIFI standards shows more respectful attitude to the lawfulness of the usufruct and te rent as well. This is made to make sure Ijarah implies such disposition where both return and usufruct are permitted by the Shari’ah. On the contrary the MASB 10 and IAS 17 accept the broader issue of return and usufruct since religion is not considered by those who set the standards. Thus, taking into account the above mentioned statements Ijarah cannot be equal to conventional leasing as well as the principles and types of Ijarah and leasing. The AAOIFI standards categorize Ijarah as Operating Ijarah and Ijarah Muntahia Bittamleek. The main classification factor is whether the lease involves the prospect for the legal title in the leased property to be passed directly to the lessee at the end of the term of leasing. Thus the findings of this research showed that significant difference between two types of contracts do exist. Consequently, Ijarah should not be perceived as the replication of conventional leasing taking into consideration the types, definitions, objectives, principles and methods of measurement. Ways of reconciling any variations in interpretation This study is to indicate that in order to reconcile any variations in interpretation that are likely to emerge there has to be a set balance and harmonization between the accounting practices of the Islamic scholars and adepts of the conventional system(Uddin). A sound communication with the exchange of experience would build a bridge between the two different worlds in order to fulfil this difficult task. Enormous efforts are to be considered from the AAOIFI conducted through public negotiations which is to result in legal authority and maturity of the AAOIFI standards drawing away from remaining only as a reference (Abdellatif). Conclusion As a financing model, Ijarah remains in its early development stage and there is huge framework in Asia, Malaysia, and the Middle East to expand the future appliance for project financing. It seems that only small number of Muslim countries has used Ijarah bonds so far and the predominant majority of countries of Muslim world have not yet begun utilizing Ijarah method for conveyance of property in secondary markets. This is described in the latest statement by the Governor of the Central Bank of Malaysia for insertion of an Islamic universal framework, Ijarah-based, with the involvement of developing countries the profit from which could be utilized for project financing in the countries which participate. Ijarah can also be considered as a surrogate to the commonly used bay‘ al-mu‘ajjal and murabahah within bonds market of the Islamic world. References Abdellatif. 2014. Islamic leasing (Ijara) is on the rise. [ONLINE] Available at: http://www.capital-markets-intelligence.com/wp-content/uploads/2014/11/Abdellatif.pdf. [Accessed 21 April 15]. Accounting and Auditing. 2008. Organization for Islamic Financial Institutions. [ONLINE] Available at:http://www.investopedia.com/terms/a/aaoifi.asp. [Accessed 21 April 15]. Al-Bab. 2003. Comparison of IFRS, Indonesian Sharia SFAS and AAOIFI Shariah Standards Against the Application of Sharia Banking. [ONLINE] Available at:https://www.academia.edu/7921354/Comparison_of_IFRS_Indonesian_Sharia_SFAS_and_AAOIFI_Shariah_Standards_Against_the_Application_of_Sharia_Banking. [Accessed 21 April 15]. Ameer. 2014. Islamic Banking: Ijarah and Conventional Leasing. [ONLINE] Available at:http://www.iiste.org/Journals/index.php/DCS/article/viewFile/12847/13179. [Accessed 21 April 15]. Comparison between Ijara and convent.. 2015. Ijara Islamic Financing. [ONLINE] Available at:http://www.ijarausa.com/comparison-between-ijara-and-convent/. [Accessed 21 April 15]. Fatma. 2013. MEANING OF IJARAH. [ONLINE] Available at:https://www.academia.edu/3583126/MEANING_OF_IJARAH. [Accessed 21 April 15]. Ghuddah. 2013. Ijarah (Lease). [ONLINE] Available at: http://www.albaraka.com/ar/media/pdf/Research-Studies/fatwa-ijara.pdf. [Accessed 21 April 15]. Ibrahim. 2010. IFRS vs AAOIFI: The Clash of Standards?” International Centre for Education in Islamic Finance. [ONLINE] Available at: http://mpra.ub.uni-muenchen.de/12539/. [Accessed 21 April 15]. Investment&finance. 2013. What is the Sharia Objection to Conventional Lease. [ONLINE] Available at:http://www.investment-and-finance.net/islamic-finance/questions/what-is-the-sharia-objection-to-conventional-lease.html. [Accessed 21 April 15]. Jangda. 2010. Ijarah – Islamic Leasing. [ONLINE] Available at: http://www.hibamagazine.com/ijarah-islamic-leasing/. [Accessed 21 April 15]. Nizram. 2013. AAOIFI. [ONLINE] Available at: https://www.google.com.ua/url?sa=t&rct=j&q=&esrc=s&source=web&cd=5&cad=rja&uact=8&sqi=2&ved=0CEwQFjAE&url=http://www.assaif.org/ita/content/download/31770/162486/file/Mr%20Khairul%20Nizam%20%28AAOIFI%20-%20Governance%20and%20Auditing%20Standards%29.pdf&ei=Fhs2VcfNEev4ywOZuoGACA&usg=AFQjCNHF6fvlTCyVOfJq2f3haerbqyX5Mg&sig2=MuqzQIsnjCi5qwpkLJt_Aw&bvm=bv.91071109,d.bGQ. [Accessed 21 April 15]. Open to comparison. 2010. Islamic finance and IFRS. [ONLINE] Available at:https://www.pwc.com/en_GX/gx/financial-services/islamic-finance-programme/assets/comparison-Islamic-finance-IFRS.pdf. [Accessed 21 April 15]. Siddiqi. 2010. ECONOMIC BENEFITS of ISLAMIC LEASING. [ONLINE] Available at:http://www.siddiqi.com/mns/Economic_Benefits_of_Islamic_Leasing.htm. [Accessed 21 April 15]. Uddin. 2010. Comparative Analysis of Reporting Practices of Islamic Financial Institutions (IFIs). [ONLINE] Available at: http://wbiconpro.com/110-Nazim.pdf. [Accessed 21 April 15]. Usmani. 2010. Ijarah. [ONLINE] Available at: https://www.google.com.ua/url?sa=t&rct=j&q=&esrc=s&source=web&cd=7&cad=rja&uact=8&ved=0CFAQFjAG&url=http://www.alhudacibe.com/images/Presentations%20on%20Islamic%20Banking%20and%20Finance/Ijarah/Ijara%20%20by%20Zubair%20Usmani.ppt&ei=qRc2VeXdCcj9ygPKrIHICg&usg=AFQjCNF_P4O6qt_Cy2rCLiaAzyZiPCUAOw&sig2=2GCGV0gaupdLORZkg5VCQQ&bvm=bv.91071109,d.bGQ. [Accessed 21 April 15]. Read More