Islamic Accounting - Case Study Example

Islamic Accounting Ijarah and Lease [Pick the ISLAMIC ACOUNTING – IJARAH The conventional mode of accounting is at times much contrasted as compared to that advised by the Islamic principles known as the Shariah and due to that contrasting nature, the accounting has been redefined by the Muslim scholars in which they have incorporated the Islamic essence to keep it reconciling with the guidance of the Shariah. This has changed the various accounting concepts and has given them a new name and face. For example, the conventional insurance is redefined as Takaful, the partnership is now given the name of Musharika in Shariah based accounting and the conventional leases have been given the identity of Ijarah. All these changes in the traditional accounting, conducted by the Muslims, have been carried out due the prohibition of Riba i.e. Interest in Islam. Other concerns have been due to the substance over legal form of the transaction since when the substance of the transaction differs from that of the legal form, that transaction is deemed to be void within the guidance of Islam. LEASE AND IJARAH Lease and Ijarah are both the alternate names used for each other but the treatment is different as one is the conventional mode of financing which is followed all over the globe and other is the Islamic guidance driven mode of finance which incorporates all the requirements of Islamic finance and keeps it within the guidance of the Shariah. Lease Lease is a mode of finance in which the owner of the asset, who is known as the lessor, gives away the asset to the lessee for use against a charge which is the rental of the asset. There are two types of leases as specified by the International Financial Reporting Standards, i.e. Operating lease and the Finance lease. Finance lease: A finance lease is one in which the property is transferred to the lessee as the lessee become the owner due to the transfer of all the substantial rewards and risks of the asset. He, the lessee, has to pay a rental to the lessor, which includes the interest expense and the cost of the asset. At the end of the lease, the asset may be transferred to the lessee against a small payment of that can be the last rental. However, the lessee will have to charge depreciation of the asset in his books as he is the owner of the asset. Operating Lease: In case of the operating lease, the lessor transfers the property to the lessee but keeps the ownership of the property and in exchange charges a rental for that property. In the light of the IFRS 17, any kind of lease that does not fulfil the criteria for a finance lease falls in the category of operating lease and the income that is generated by the lessor is his rental income while he is required to book the depreciation of the asset as he is still the owner. Ijarah An ijarah is, conversely, the Islamic mode of lease finance and can be used for asset based transactions over which the owner of the asset charges a rental. However, an Ijarah may also be carried out where the ownership of the property can be transferred at the end of the term of the Ijarah as is transferred in the conventional lease. This kind of Ijarah is referred as “Ijarah Muntahia Bittamleek” that indicates an Ijarah which ends with the transfer of the property or an Ijarah which is followed by a sale transaction. An Ijarah transaction can also be used for contracts of hiring of service or even contracts of employment. (Board 2010) Thus, it can be said that an Ijarah is a partially an operating lease as the risks and rewards of the asset remain with the lessor and may be transferred at the end of the term. SIMILARITIES OF LEASE AND IJARAH Even though they both have some distinctions, however there are some similarities between the two types. Ownership: Similar to the operating lease, the risk and rewards of the asset remain with the lessor as he charges depreciation on the asset while the lessee only pays rental and accounts for it in the profit and loss account where he doesn’t charge and depreciation on the asset. Risks and rewards: The risk and rewards of the operating lease as well as the Ijarah lie with the owner of the asset, who is the case of Ijarah is referred to as Muajjir, during the lease period. If the property sustains a loss which is beyond the control of the lessee, the lessor will be held responsible as he bears the risks. Penalty: If the lessee makes a default in the payment or the payment is delayed, the lessor may penalize the lessee which may include the asset being forfeited or a monetary compensation which is decided during the initial phase of the Lease of Ijarah contract. Termination before the end of lease term: The termination of the Ijarah of Lease is possible which takes place before the end of the contract i.e. referred to as the premature termination. This premature termination occurs when the lessee fails to make payments on time or there is another violation of the agreement of the lease. Assets repossession: In the conventional lease contract, an operating lease shall not contain any term in the agreement which allows the lessee to buy the asset by paying a price which is known as a bargain price. Even in the Ijarah, there cannot be two agreements such as that of the rental and another one that of bargain purchase. DIFFERENCES OF LEASE AND IJARAH Apart from the similarities, there are numerous differences among the both out of which few are discussed. Rental obligation: The initiation time of the lease or Ijarah can differ which is based on the payments which are made by the lessee. In case of Lease, the rental of the leased property becomes payable as soon as the property is received by the lessee while in case of Ijarah, the rental can be charged when the property is handed over to the lessee. Use of penalty: The penalty which is charged from the lessee due to the default of payment of any violation of the terms of the agreement, in case of Ijarah, shall go to charity and cannot be held by the lessor while in the conventional lease, the penalty is the income of the lessor. Transactions of Sale and leaseback: In the conventional lease, the IAS provides the lessee and the lessor to arrange a contract which provides the sale and leaseback in such a manner than the owner of the property sells it to another person and the person who has purchased the property can lease that property back to the owner that way the original owner can have money for his purposes and also gets the asset back through lease. In case of Ijarah, such is not possible because it involves two separate contracts and the dual nature of the contract is prohibited in the shariah as the substance differs from the legal form of the contract but such a contract can be carried out if both contracts occur separately. (Fatima, 2006) RANGE OF IJARAH BASED CONTRACTS There is a range of contracts based in Ijarah that are used by the Islamic financial institutions which include: Ijarah Muntahia Bittamleek Ijarah Thumma Al-Bai Ijarah Muntahia Bittamleek: In this type of Ijarah, the ownership of the property is transferred to the lessee at the end of term of the lease and he becomes the owner of the asset. (Ghuddah) Ijarah Thumma Al-Bai: In this Ijarah transaction, which is in common language knows as Ijarah followed by sale, the leased asset is sold to the lessee at a nominal price which is paid by the lessee at the end of the Ijarah tenure of deducted out of security deposits. AAOIFI STANDARDS AND IFRS CONTRADICTORY ACCOUNTING TREATMENTS The accounting treatment of Ijarah and Lease as recommended by AAOIFI standards and the IFRS are different respectively. Nature of contract: In light of FAS 8, the recommended treatment is that a lease contract be treated as an operating lease transaction and it is prohibited in the Islamic Shariah to involve more than two transactions in one contract with opposing results while the conventional lease allows such a transaction. Recognition: The Islamic standards prohibit the treatment of the Ijarah transaction as a finance lease where the asset becomes the property of the lessee where it is mentioned that the subject of a lease shall become a part of the statement of lessor’s balance sheet and shall be recognized at its historical cost less depreciation while the IAS 17 provides a different treatment when it suggests that the leased asset shall form a part of the balance sheet of the lessor and shall be shown as receivable from the lessee, being measured at an equivalent amount of lease’s net investment. Treatment of expense: The FAS 8 recommends that the expense that is incurred from the lease transaction be recorded in the profit and loss account while the IAS 17 suggests that the total instalment paid due to the leased asset shall be bifurcated in two parts i.e. diminution of the remaining liability and financial charge of the asset. Depreciation: As per the IAS, the depreciation on the asset is charged by the lessee for the finance lease as the risks and rewards are transferred to him and he recognized the asset in his book at its book value while the FAS 8’s treatment of a lease is that the lessor keeps the risks and rewards which is why he has to recognize the asset in his book and charges depreciation on it according to the class of assets. Transfer of property: The transfer of property, as per FAS 8, takes place in four methods. These methods are transfer of the asset in form of gift after depreciation, transfer in consideration for a small token in form of a sale transaction, transfer in form of sale which is prior to the end of the lease term at a price which is equivalent to the sum of outstanding payments and transfer of the asset through gradual sale. (Usmani n.d.) On the other hand, IAS 17 recommends the transfer of the asset’s ownership at the end of the term where the purchase option can be implemented at a price which is lower than that of the fair value of the asset. (IASB 2010) RECONCILIATION OF DIFFERENCES The differences in the lease and Ijarha are reconcilable and the accounting can be done in a more similar manner. Some of the ways of reconciliation are as follows: Since the Ijarah produces an asset which is recognized in the books of both the lessor and the lessee, therefore two separate contracts may take place through the same. Since the FAS 8 also treats the asset as an operating lease, therefore the treatment of the asset as per the IAS 17 can be kept consistent with the depreciation be booked in the books of the lessor and income charged in the profit and loss account. Differences can also be settled when the transfer of the asset takes place at the price that is less than the fair value of the asset as is done as per the IAS 17 and transfer condition is mentioned at the initiation of the contract. Bibliography Board, Malaysian Accounting Standards. "Financial Reporting Issues relating to Islamic Finance." 2010. Fatima, Mateeha. DIFFERENCES AND SIMILARITIES BETWEEN IJARA AND CONVENTIONAL OPERATING LEASE. Karachi: College of Management Sciences, 2006. Ghuddah, Dr.Abdul Sattar Abu. Ijarah ( Lease ). Al-Baraka Banking Group (ABG). IASB. "IAS Plus." 2010. http://www.iasplus.com/standard/ias17.htm (accessed April 2011). Usmani, Maulana Taqi. "IJARAH." Accountancy.com.pk. Read More