Ijarah Contracts Used by Islamic Financial Institutions - Essay Example

?Islamic Accounting Table of Contents Introduction 2. Types of Ijarah Contracts Used By Islamic Financial s 2 Simple Ijarah (similar to an Operating Lease) 2.2 Ijarah Muntahia Bittamleek (similar to a Financing Lease) 2.3 Ijarah Mausufah Fi Zhimmah (A Forward Lease) 3. Similarities and Differences between Ijarah Contract and Leasing 4. AAOIFI Standards and IFRS Recommended Accounting Treatment of the Ijarah/Leasing Contracts 5. Conclusion 1. Introduction: A sound banking method forms the base for every winning financial system. It assists in strengthening the financial system of the country. The stronger the economy the stronger the country is. There are two kinds of banking systems and they are Islamic banking and the Conventional banking. Islamic banking is significantly different from conventional banking, and some of the differences are discussed in this essay. This report talks about an important feature in banking system i.e. lease. In conventional banks, it is referred to as conventional lease; and in Islamic bank, the lease is known as Ijarah. “Ijarah derives from the root word ajar a – to recompense, compensate or give a consideration and return. Ajr refers to a worker’s wage, and ujra h to rental payment.” (Kamali n.d.). Ijarah is a Shariah compliant alternative to Conventional lease. Through these two kinds of lease, bank performs as a Lessor and the individual to whom the asset is leased acts as a Lessee. The bank insists the lessee to pay an amount monthly for the use of the asset. The rights of the asset remains with the bank, and only the privileges of use are transferred to the lessee. 2. Types of Ijarah Contracts Used By Islamic Financial Institutions: 2.1 Simple Ijarah (similar to an Operating Lease) In a business world marred by financial uncertainties and increasing costs of operations, Ijarah loans are broadly considered as the safest, easiest, and the most efficient means to finance production procedures. Like all the other forms of Islamic financing, Ijarah too is rooted in the sound economic main attitude laid down by the Sharia. There are different types of Ijarah, each matched to the specific needs of the parties involved in the agreement. “The two most popular forms of Ijarah loans are the Simple Ijarah or Ijarah as an operating lease and Ijarah thumma al-bai or Ijarah as a financial lease. The distinguishing feature of Ijarah as an operating lease is that the lease contract is not associated with a purchase agreement.” (All About Ijara as an Operating Lease 2005). The following are some of the features of Ijarah as an operating lease: The whole price of the asset, or the part of property specified in the contract is not amortized through the main leasing tenure. The lessee can get out of the contract, that is, stop the Ijarah as an operating lease agreement anytime the lessee wishes to. On the other hand, the lessee should provide a notice prior to doing so. The real ownership of the piece of property or assets mentioned in the agreement is retained by the lessor. This agreement is executed irrespective of the quantity of payment the lessee has tendered, and that identifies the lessor’s insistence to bear every responsibility and risk connected with the ownership. In Ijarah as an operating lease, permits a part of the property to be returned to the lessor at the end of the leasing tenure. The lessor, which can be a bank or any other financial organization, can again lease the property, if it is a functioning unit, to a different person or business unit. 2.2 Ijarah Muntahia Bittamleek (similar to a Financing Lease) Ijarah Muntahia Bittamleek is an Ijarah dealing, in which the possession of the subject asset can be relocated to the lessee after the lease term. Ijarah and Ijarah Muntahia Bittamleek are by nature mere leasing contracts, in which the subject issue is the usufruct of the property; and not the quantity of cash, as in the case of a finance lease. In other words, it is not a financing deal, and instead, it is an alternative to financing dealings. “Ijarah Muntahia Bittamleek” includes: Ijarah and the relocation of legal title at the end of the lease, for a token deliberation as specified in the lease. Ijarah throughout gift Ijarah through transfer of title prior to the ending of lease, at a cost pre-decided. By applying all these clauses upon consumers, it assures to lease from the Individual Family Service Plan (IFSP), the IFSP buys in its name, the property specified in the consumer’s promise; and then it rents it to the consumer. “The IFSP calculations the total cost of the property on the basis of the original price plus a reasonable mark-up.”(Umar & Ahmad n.d., p. 213). The rent is planned in the aim that the termination of the period of lease, the IFSP’s acquisition price and income is improved and it move the property ownership to the other party for a insignificant sale cost or as a present by a separate sale agreement at the termination of the period of lease. 2.3 Ijarah Mausufah Fi Zhimmah (A Forward Lease): Ijarah Mawsufah Fi Zimmah is one of the Shariah values that can be applied in Islamic economic products. “The Shariah Advisory Council (SAC)” (Sukuk n.d.) of the Securities Commission (SC) has permitted the purpose of Ijarah Mawsufah Fi Zimmah, “(Rohmatunnisa 2008) it is established with the main contract of Ijarah, in a particular arrangement. Its opening has guided to further innovation in the arrangement of sukuk. “The forward lease is a contract whereby the financier will start paying the rent to the contractor/lessor even though the asset is still under construction.” (Ijarah Project Financing via Forward Lease (Ijarah Mawsufah fi Al-Zimmah 2010). The rent paid will be utilized for financing the cost for construction purposes. Any obstacles during the project will be encountered by the lessor or the financier of the contractor. Ijarah Mawsufah Fi Zimmah is the rent of a property that is not yet obtainable or owned by the lessor, at the time of contract. The agreement, on the other hand, is based on the responsibility of the lessor to distribute the asset based on agreed, detailed condition, and cost and time of accessibility. The rental expense under this Ijarah represents the right of the lessee to utilize the assets when they are ready to be utilized. Scholars from various schools of thought have also accepted this Ijarah contract. An Ijarah agreement on a property will survive in future, if it has its detailed stipulation clearly stated in the agreement. Ijarah Mawsufah Fi Zimmah resembles “bai salam” (Definition of Salam 2009) in the following aspects: 1. Subject Matter and Technique of Payment: The subject matter does not survive when the Ijarah Mawsufah Fi Zimmah agreement is completed; the lessee has to decide its stipulations through the agreement, and it reflects Bai Salam. Throughout the agreement period, the lessee determines the detailed condition of the leased property, containing the charge of the lease rental, type of the leased asset, lease time and process of payment, with detailed work conditions. 2. Failure of the lessor to conform to the condition as determined by the lessee : Should the lessor fail to obtain the asset as specified, in spite of constant attempts to deliver, the lessee is entitled to stop the agreement. This condition is reliable with “AAOIFI’s” the condition that the lessee in permitted to refuse the asset distributed by the lessor if the property fails to meet the conditions. 3. Similarities and Differences between Ijarah Contract and Leasing: Ijarah contract is an agreement between two parties; the lessor and the lessee. The agreement is made under the rule that the lessee will hold any benefit against the definite concern regarding the benefit possessed by the lessor. It is a lease contract beneath which a definite asset is rented out by the lessor to a lessee against specific rent for a set phase. An operating lease is a complete rental contract which involves the following conditions: (a) The lessor imparts protection of the asset. (b) The cost of the asset is not fully amortized over the lease period. (c) The asset is generally given back to the lessor. Thus, the lessee has the benefit of acquiring an asset, use for its benefit and returns the same when it has completed its use. In a financing lease, the owner officially possesses the asset. “The risks and rewards incidental to ownership vests with the lessee and it is the lessee who pays taxes etc. in relation to the asset leased” (Lessor not Entitled to Depreciation in Case of Finance Lease 2012). The following are the differences between Ijarah contract and leasing: 1) In Terms of Ownership: In Ijarah contract the lessor is the owner of the property. Whereas in leasing the lessor provides the financial assistance to the lessee for the assets permitting the creditor to hold ownership of the asset all through the period of the contracts. 2) In bearing the Risk: In Ijarah contract, the risks and liabilities of ownership be lying with the lessor of the property throughout the period of contract. If any damage or loss occurs during the period, which is beyond the control of the lessee, the risk will be borne by the lessor. In leasing the risks are managed by the lessor. 3) Responsibility: The responsibility of the rental starts when the lessee handles the asset in Ijarah contract whereas in leasing the rental responsibility, it starts when the lessee accepts the assets. 4) Property Usefulness: In Ijarah contract, the lessee has the right to use the leased property more than once; whereas in leasing, the property can be used by the lessee for unlimited number of times. 5) Recovery of an Asset: In an Ijarah contract, the lessee can avail the use of assets and has the right to purchase the same asset which is not allowed in the contract. In leasing the lessee has no right to purchase the asset at the agreement price. 6) Fine: In Ijarah contract, the fine will be imposed to the lessee by the lessor for the delayed payment of the leased property. In leasing too, fine will be charged to the lessee for the delay in payment. 7) Valuation: In Ijarah contract, the leased property will have an agreed value on the completion of the leased period. It can be re contracted again. In leasing, the property will have only a secondary value after the termination of the contract. 8) Premature Completion of Lease: In Ijarah contract, the contract can be stopped when the lessee has violated the terms of the agreement made in the contract. In leasing, the contract can be terminated, when the lessee fails to meet the responsibility, and also when the lessee any default relating to the payment. In this situation, the lessor can take legal actions against the lessee. 9) Result of Premature Termination: In Ijarah contract, after premature termination, the lessee need not pay the rent for the leased property; whereas in leasing, the lessor and the lessee need to release all the terms and payment before the termination of contract. 10) Sale and Lease Back as One Deal: In Ijarah contract the sale and lease returned are made as two separate entities in the contract. But in leasing, the property is sold from one person to another, and the same property can be leased back to the original seller. 11) Factors of Rent: In Ijarah contract, the rent of the property is influenced by market factors. The rate of interest is influenced by the market rate of interest. But in leasing, the market rate of interest is considered only as a basis for renting property at the time of lease payments. 12) Equal to a Sale: Leasing is different from sale, as it does not change the right of ownership of the property, to the lessee. It always stays with the transferor. In leasing, the dealer doesn’t make out any selling return on entering into an operating lease, as it is not equal to a sale. The lease with guarantee to purchase and sale is dissimilar to the memorandum of sale. The rent paid by the lessee cannot be regarded as part of the cost of the asset; relatively it is the cost of the service of the asset. The leasing transaction signifies the transfer of the property from one person to another for a specified price without changing the ownership of that asset. 4. AAOIFI Standards and IFRS Recommended Accounting Treatment of the Ijarah/Leasing Contracts: The AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) has developed a set of regulations to take care of some of the reporting that is required in the case of Ijarah operations, and most of the Ijarah operators stick to these principles. “The AAOIFI has come up with its own solution whereby it calls such transaction as ‘effective profit rate’ to describe the spreading of income or expense” (Sharbatlya 2011). The AAOIFI is accountable for the formulation and issuance of worldwide Islamic finance principles. “A stand-alone Ijarah contract would probably meet the conditions for an operating lease under existing IFRSs” (Shariah-Compliant Leases – Lessor Issues n.d.). The following are some of the differences between AAOIFI and IFRS: The AAOIFI standards are established only for the Islamic financial industry, whereas the IFRS standards are meant for the social and economic activities. When AAOIFI is made for the industry and to support the Islamic finance practices, the IFRS is not specific in its support to any industry. It is used generally. The AAOIFI includes accounting, ethics, auditing, governance, and Shari’a; whereas the IFRS standards are related only to the accounting. The IFRS standards involve so many agreement issues during leasing and contracting, and it does not include all the section of Islamic finance and banking. To overcome this problem, AAOIFI standards are developed. AAOIFI accounting standards necessitate both Operating Ijarah and Ijarah Muntahia Bittamleek to be considered, related to Operating Lease. On the basis of IFRS, both Operating Ijarah and Ijarah Muntahia would be classified and treated as Finance Lease. AAOIFI accounting standards require clear savings account funds to be presented in financial statement, as a separate item between liabilities and owners equity. Following are the advantages of AAOIFI standards: AAOIFI standards guarantee merging of financial reporting by IFIs. Establish greater simplicity to the financial reports of IFIs. Bring about coordination of Islamic finance practices. Reveal theory and essence of Islamic finance transactions “IFRS often require entities to discount the future cash flows to measure the value of assets and liabilities” (Uddin n.d.). 5. Conclusion Every financial institution requires a sound financial policies and method. This report states the Islamic accounting and the Ijarah contract. It also explains that the Islamic accounting is different from the conventional banking. Two types of lease are explained in this topic- the operating and the financing lease. Operating lease is a lease of property for the entire contract period. The lessor is the owner of the property and the lessee is responsible for paying a fixed rent and also takes the risk when the contract terminates before the lease period in case of the financing lease. The AAOIFI and IFS are the recommended accounting principles used during the contract period. AAOIFI is a set of regulations which take care of some of the reporting that is required in the case of Ijarah operations. It is clear that diverse necessities of the IFIs cannot be efficiently dealt with the IFRS. Therefore, there was a need for the enhancement of Islamic accounting standards spread by AAOIF. But AAOIF standards frequently disagree with IFRS. This significantly persuades the discussion on the peak point of accounting standards. On the other hand, the alterations that occur in the presentation and evaluation of the Islamic transactions could be resolved, if IFRS standards illustrate flexibility. They should also broaden the discussion in increasing applicable accounting standards. Reference List All About Ijara as an Operating Lease (2005). Ijaraloans.com. Available at [Accessed on 04 May 2012] Definition of Salam (2009). Bloomsbury Information Ltd. Available at [Accessed on 04 May 2012] Ijarah Project Financing via Forward Lease (Ijarah Mawsufah fi Al-Zimmah (2010). UAE Laws and Islamic Finance. Available at < http://ilovetheuae.com/2010/12/09/ijarah-project-financing-via-forward-lease-ijarah-mawsufah-fi-al-zimmah/> [Accessed on 04 May 2012] Kamali, MH (n.d.). A Shari‘ah Analysis of Issues in Islamic Leasing. International Islamic University Malaysia (IIUM). Available at [Accessed on 04 May 2012] Lessor not Entitled to Depreciation in Case of Finance Lease (2012). Deloitte. Available at [Accessed on 04 May 2012] Rohmatunnisa, D (2008). Dissertation presented in part consideration for the degree of MA in Finance and Investment. The University of Nottingham. Available at < http://www.kantakji.com/fiqh/files/markets/c44.pdf> [Accessed on 04 May 2012] Sharbatlya (2011). Islamic Financial Contracts and their Accounting Treatment. Islamic Banking. Available at < http://sharbatlya.blog.com/2011/10/25/islamic-financial-contracts-and-their-accounting-treatment/> [Accessed on 04 May 2012] Shariah-Compliant Leases – Lessor Issues (n.d.). IASB/FASB Meeting Week Commencing 16 May 2011. Available at < http://www.ifrs.org/nr/rdonlyres/64c83556-762f-4a0a-9449-026f24a7500b/0/leases0511b02aobs.pdf> [Accessed on 04 May 2012] Sukuk (n.d.). Securities Commission Malaysia. Available at [Accessed on 04 May 2012] Uddin, N. (n.d.). Comparative Analysis of Reporting Practices of Islamic Financial Institutions (IFIs). Available at < http://www.wbiconpro.com/110-Nazim.pdf> [Accessed on 04 May 2012] Umar, A & Ahmad, F (n.d.). Theory and Practice of Modern Islamic Finance: The Case Analysis from Australia. Print. Read More