Islamic Accounting: Ijarah Contract - Literature review Example

Islamic Accounting - Ijarah contract Introduction and Concept Ijarah can simply be understood as an “Islamic leasing” under Islamic banking and finance. The term Ijarah is derived from an Arabic word known as “ajara” which means compensating against the use of a particular item (Nazir, 2013, p94). From a technical point of view Ijarah refers to a contractual agreement between two independent parties namely, the owner and the hirer whereby the owner transfers the possession of an item for utilization to the hirer over a particular period in exchange for some consideration usually inform of money. The owner of the property is referred to as the lessor in a conventional contract and “Muajjir” in Ijarah contract while the hirer is referred to as the lessee in a conventional contract and “Mstajir” in an Ijarah contract. An Ijarah contract involves transfer of the right to utilize a property but not its ownership right (Boumediene, 2011, p105). This means that the lessee will only be claiming the usufruct of the property while the lesser will retain the ownership of the leased property for the mutually agreed period. Range of Ijarah-based contracts used by Islamic Financial Institutions Ijarah contracts just like the conventional lease contracts can be categories into two namely the operating lease and finance lease specifically referred to as Ijarah Muntahia Bittemleek (Greuning & Iqbal, 2008, p23). Operating lease This is a short-term lease agreement whereby the lessee is awarded the right to enjoy usufruct of property and returns the property after a mutually agreed period. This is purely a contract of hire considering that the risks associated with ownership of the property is borne by the lessor (Islamic bank), the cost of the leased property is not fully amortised and above the lessee should return the property upon the expiry of the lease period (Fatima, 2006). In other words, the ownership of the property cannot be transferred to the lessee at the end of the lease period. It is noteworthy that all Islamic financial institutions often execute Ijarah contracts under operating lease. Finance lease (Ijarah Muntahia Bittemleek) This is a lease contract with an option to transfer the ownership rights to the lessee at the end of the lease period (Messick, 2003, p721). The rental that the lessee is expected to pay under Ijarah Muntahia Bittemleek is usually higher than the normal rental value of the property. This is meant to induce the lessor into surrendering the ownership of the leased property to the lessee. However, the lessee must have paid all the stipulated instalments in full by the end of the lease period in order to gain ownership right over the leased property. It is noteworthy that contract authorizing transfer of ownership of leased property at the end of the lease period should be different from the Ijarah contract as they are considered different and separate transactions as per the requirements of the Islamic leasing principles (Serdaneh & Atmeh, 2012; p52). The document should also specify the manner of transfer of ownership considering that there are distinctive methods of executing a transfer for example through ordinary gift, or sale. Similarities between Ijarah and conventional lease contracts The fact that Islamic Ijarah contract has been designed based on the basic tenets of conventional lease contracts makes both the contracts shares a significant number of common features. The most fundamental features common to both Ijarah and conventional lease contract is the fact that they both involve two contracting parties. One party is the owner (lessor) of the property and the other party represents the hirer (lessee) of a property. According to Boumediene (2011, p105).The lessor and the lessee must mutually agree on a particular amount of money over a particular period, which the lessee is going to use the leased property. The fact that both the Ijarah contract and conventional lease contract support the need for payment of money by the lessee for transfer of usufruct of the leased property brings out an important similarity between the two contracts. Conventional contract refers to the money paid by the lessee in exchange of right to use the hired property as consideration while it is referred to as rent in Ijarah contract. It is important to note the both the lease contracts emphasizes on monetary exchange as consideration/rent. The ownership of the property under the operation lease in both Ijarah and convention lease contract is the same considering that the leased property rightfully owned by the lessor. The premature termination of a lease contract is a common feature between the Ijarah and the conventional lease contracts (Fatima, 2006). A lease contract can be terminated for a number of reason in both Ijarah and convention lease agreement. For instance, parties may mutually agree to terminate a contract. Other reasons for discontinuing a lease contract may include failure by one party to execute terms and conditions stipulated in the contract, and to prevent injustice or harm to the other party. Another similarity is evident in recognition of revenue arising from the lease contract. In both Ijarah and conventional contracts, the lessor often treats the instalments remitted by the lessee as revenue. Both the AAOIFI and IFRS standards states that revenue received from the leased property should be spread proportionately on a straight-line basis over the lease period (Shariff & Rahman, 2002, p206). Additionally, revenue received should be presented in the income statement during financial reporting by the lessor in both the Ijarah and convention lease contracts. Differences between Ijarah and conventional lease contract Notable differences between the Ijarah and conventional lease agreements can be understood form two dimensions that is the accounting the accounting treatment and the structure of the contract (Serdaneh & Atmeh, 2012, p56). The structure of the Ijarah contracts both operating lease and Ijarah Muntahia Bittamaleek have been designed with religious principles in mind. The need to comply with Shari’ah law was one of the key guiding principles behind the structure of the Ijarah contract and perhaps the major line of distinction between Ijarah and conventional lease lies with religious consideration. The conventional lease agreements overlook religious inclination and this can be justified based on the fact that it is open to all institutions and individuals without any consideration for religious background or teaching (Karim, 2010). In the contrary, Ijarah contract is very categorical about religion based on Islamic Shari’ah as it stipulates that nature, purpose and benefits of the Ijarah should adhere to Islamic Shari’ah principles. Obligation of the parties to a lease is also another area of contradiction between the Ijarah and the conventional lease contracts. Jamaldeen (2012, p86) assert that in a conventional lease all the risks and benefits subject to ownership of the leased property is often transferred to the lessee in a finance lease. This is not the case with Ijarah Muntahia Bittamaleek as the lessor is presumed to be the owner of the property and therefore should bear all the risks incidental to the ownership of the property. This means that the lessor (Muajjir) in an Ijarah will undertake all major repairs as well as maintenance expenses relating to the leased property. Ijarah contracts allow the lessee to usufruct of the asset but bear the risk arising from the asset unlike conventional lease where the lessee manages both the risk and benefits (Iqbal, 2011, p130). However, in an operating lease the Maujjir in both the Ijarah and conventional lease is expected to take all the risks and liabilities arising from the property. Transfer of the leased property forms another area of contradiction between the Ijarah and conventional lease contracts. In a conventional finance lease, the leased property is often transferred to the lessee upon the expiry of the lease period and both parties must have explicitly fulfilled their contractual obligation (Ahmad, 2010; p283). However, this is contrary to the Ijarah Muntahia Bittamaleek considering that the process of transferring leased property is considered a separate transaction independent from the Ijarah contract. In order to carryout transfer of ownership of the leased property under Ijarah finance lease then a different contract stipulating the nature of the transaction at the end of the lease term with no conditions attached. AAOIFI (FAS 8) has recommended four acceptable ways that transfer of ownership can be executed under Ijarah Muntahia Bittamaleek. The first one is through gift, second through sale for a specified amount of money, third through sale before the expiry of the lease period and finally through gradual sale of the leased property (Serdaneh & Atmeh, 2012, p50). Accounting treatment of lease contract is also another vital area of distinction between the Ijarah and the conventional lease. The lessor in a conventional finance lease often recognises the leased property as a receivables asset in the books of account while the lessee treats the leased property as an asset while the lease instalments as a liability in the company books of account as per IAS 17 (Serdaneh & Atmeh, 2012, p53). This is contrary to the AAOIFI standards, which requires that the lessor record the leased property as an asset in the company books of account and consequently charge depreciation as appropriate. All the lease instalments subject to the leased property shall be recorded as income in the lessor’s books of account in a Ijarah Muntahia Bittamaleek as the lessor is considered the owner of the property until the end of the lease period. This means that the lessee will only consider the leased property as an asset in the company books of account only when the legal title to the property is transferred under the Ijarah stipulated ownership transfer procedures. There is also significant difference in how penalties are treated in case of breach of lease terms under Ijarah and conventional lease. Ijarah unlike conventional leases often treat penalties as income but later expend it on charitable operations or else it will be treated illegal as per the Shari’ah law (AAOIFI, 2013). Penalties earned from the conventional lease contracts are often recognised as income and the IFRS (IAS 17) is silent on how the company should expend it. AAOIFI standards and IFRS recommended accounting treatment of the Ijarah/leasing contracts It is vital to start by noting that most of the Islamic Financial Accounting Standards (IFAS) as governed by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) are guided by most of the principles of the International Accounting Standard (IAS) as per the International Financial Reporting Standards (IFRS) (Vicary & Chee, 2013, p79). AAOIFI is an important institution to the Islamic faithful considering it is responsible for developing accounting standards that are Shari’ah compliant for Islamic banks and institutions. FAS 8 is the AAOIFI standard that oversee the accounting treatment of Ijarah contracts while the IAS 17 is the IFRS standard that governs accounting treatment of conventional lease agreements (AAOIFI, 2013). Key distinctions between IAS 17 and FAS 8 reporting and accounting standards are evident on the conditions the Ijarah have to abide by. Most of these conditions can be observed in the treatment of the item leased, the lease agreement and most importantly maintenance of the leased item. There are significant difference in the two standards but the ultimate unifying factor is the fact that both standards recognizes lease agreements as a transfer of benefits accrued from a property from the owner to another party in exchange for some consideration spread over specified period of time (Shariff & Rahman, 2002, p188). For instance, both the AAOIFI and IFRS standards require that the lessee pay some consideration in exchange of usufruct arising from the use of property. Just like IFRS, AAOIFI appreciates the needs for accounting standards that can provide users of financial statements with accounting information that are easy to understand, compare and cuts across regional boundaries. However, the need for Shari’ah compliance, which is based on the Quran, has brought about significant structural differences between the IFRS (IAS 17) and AAOIFI (FAS 8) standards. For instance, in a traditional finance lease the lessee as governed by the IAS 17 assumes ownership of the property at the end of the lease (Shariff & Rahman, 2002, p189). This means that when the lessee has settled the last consideration he/she will assume rightful ownership of the property initially leased . This is not the case with the Shari’ah requirements of FAS 8, which assumes that all Ijarah are operating lease (Al-ijarah ‘ain) and in case of transfer of property to the lessee under financial lease (Ijarah Muntahia Bittamaleek) then the transfer agreement must be drafted afresh in different document. The transfer document proposing Ijarah Muntahia Bittamaleek should be attached to the initially drafted lease agreement. In other words, finance lease under conventional accounting standards is considered as a single transaction while Ijarah, which seeks to transfer both usufructs and ownership of property, are perceived to a different and separate transaction consisting of operating lease and sale. Additional differences in the accounting standards between the IFRS and the AAOIFI are also evident in the obligations of the contractual parties (Bellalah & Ellouz, 2004, p538). For instance, IFRS standards in the case of finance lease assume that the lessee is the bearer of all the risks and rewards arising from the property. This is not the case with Ijarah Muntahia Bittamaleek under AAOIFI (FAS 8), which requires that the lesser takes care of all the major responsibilities incidental to the property leased such as maintenance and repairs as well as other related risks considering that AAOIFI treats both the operation and finance lease as an operation lease (Esmael, 2009). One of the key principles of Shari’ah law called Riba (usury) guides this standard. This principle seeks to ensure that no one is exploited in a financial transaction. For instance, AAOIFI standards assumes that passing the burden of carrying out major maintenance and repair costs to the lessee which is the case with traditional leases may be tantamount to exploitation as the lessee may end up incurring unknown payments over and above the required consideration for usufruct and ownership. Other significant differences in accounting treatment of the Ijarah and conventional lease between the AAOIFI (FAS 8) and the IFRS (IAS 17) can be seen in areas of revenue recognition, disclosure and matters concerning residual value. Shariff and Rahman (2002; p188) elucidate that the IFRS standards require that the lessor maintain records relating to the uncertainties of rental income as well as the impending interest rates levels. Unlike IAS 17, FAS 8 does not propose issue of provision for uncertainty on interest rates as this is against the Shari’ah principle of gharar (uncertainty) which prohibits Islamic faithful from engaging in uncertain events. This is evident in Ijarah contract as terms of payment are often set before execution of the lease and a fixed rental in exchange for usufruct is often spread over the lease period, considering that it is not expected to fluctuate. The AAOIFI (FAS 8) standard is silent about the provision for doubtful debts in Ijarah contracts. No disclosure is required in case of Ijarah considering that this type of contract acknowledge only a single method of income recognition (AAOIFI, 2013). As for IFRS (IAS 17), disclosure of revenue is a mandatory requirement particularly for the minimum consideration to be collected for a specified future period as well as method for income recognition. How differences in contract lead to differing accounting treatment in Ijarah/conventional lease Significant differences in relation to the accounting treatment between Ijarah and conventional lease are experienced due to the need to preserve and exercise Shari’ah financial operations. Unlike conventional lease according to IFRS (IAS 17) which is broad and open with no religious conditions, the expression of Ijarah as per AAOIFI (FAS 8) comes with an extra condition requiring that the nature and benefits enjoyed from Ijarah must be compliant with Shari’ah (Shariff & Rahman, 2002, p188). The religious condition forced the Muslim scholars designing the AAOIFI standards to fine-tune the general accounting treatment principles to comply with Shari’ah (Karim, 2010). The first significant difference in the accounting treatment is experienced in the recording of leased property in the company books. In a conventional finance lease, the leased property is often capitalised in the lessee’s books as an asset in addition to the respective lease payments considered as a liability in company books of account. The asset is to be recorded at its fair market value at the time of commencement of the lease contract as recommended by IAS 17. This is not the case with Ijarah contracts where the leased asset under the Ijarah Muntahia Bittamaleek are recorded as assets in the books of the lessor and a depreciation charge is effected on the books of the lessor. Additionally, all transactions involving Ijarah contract should be recorded as “Ijarah Assets’’ in the company books at a sum total cost borne by the bank to acquire the asset. However, Paragraph 43 and 53 of the IAS 17 requires that assets under operating leases be recorded according to their nature in company books and that is plant, property and equipment (Shariff & Rahman, 2002, p207). This difference in accounting treatment arises from the fact that all Ijarah contracts are treated as operating lease considering that the lessor claims the rightful ownership of the leased property and therefore bears all the material risks and costs relating to the property. During financial reporting, the lessor under conventional lease will recognize the leased property in their financial statement but present it as receivables based on the total amount invested in the lease and therefore they do not need to charge depreciation (Serdaneh & Atmeh, 2012, p52). Contrary to this treatment the lessor in the Ijarah Muntahia Bittamaleek often present leased property as an asset in their statement of financial position. Additionally, an Ijarah contract with an option to transfer ownership will treat all the instalments remitted by the lessee in as income on accrual basis and later spread throughout the lease period. Any additional expenditure accrued by the lessor in earning the Ijarah Muntahia Bittamaleek revenue will be treated as expenses and later charged on the income statement. Focusing the accounting treatment during termination of a lease or Ijarah Muntahia Bittamaleek especially when the fault is on the side of the lessee, the consideration will be divided into two items namely for ownership and usufruct (Serdaneh & Atmeh, 2012, p50). Consideration for ownership should be returned to the lessee or charged as expenditure in the income account whereby it will be used for charity. This is not the case with conventional accounting treatment where rent received from the lessee is considered as profits in case the contract is rescinded due to lessee’s fault. However in case of permanent impairment to the property and the lessee is not responsible for the fault , then the monies paid in respect to the Ijarah instalment in excess of the fair rental value shall be treated by treated are receivables due to the lessee and thus credited in the income account of the lessee’s books. On the lessor books of account, the excess of the instalments paid by the lessee shall be treated as a liability. This transaction is only permissible if the damage happens before the right of ownership is transferred to the lessee. Ways of reconciling any variations in interpretation This research has highlighted significant disagreement of accounting practices between conventional lease and Ijara contracts that if not harmonised then it would be virtually impossible to make effective comparison of financial data between financial institutions especially for users of financial statements. The most effective way to reconcile the vibrations in interpretation is through robust consultations between Islamic scholars and conventional banking operators on lease contracts. This will only ensure that the Islamic banks do not only adopt Shari’ah complaint lease contracts but also universally accepted accounting treatment for similar transaction between Islamic financial institutions. References Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), 2013, Accounting Standards, Retrieved April 25 2014 from < http://www.aaoifi.com/en/standards-and-definitions/shari%E2%80%99a-standards/accounting-standards.html> Ahmad, A. F. 2010. Theory and practice of modern Islamic finance: the case analysis from Australia. Boca Raton: BrownWalker Press. Bellalah & Ellouz, S. 2004. Islamic Finance, Interest Rates and Islamic Banking : A Survey of the Literature. Finance India, vol. 18, pp. 533-546. Boumediene, A . 2011. 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