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ACCOUNTING FOR

ISLAMIC BANKS
ACCOUNTING ISSUES ON IJARAH
FINANCING

TYPES OF CONTRACTS
ISLAMIC COMMERCIAL TRANSACTIONS
Gratuitous
Contracts
Gift

Trading
Contracts
Leasing

Sale

Waqf
Loan

Operational
Lease
Operating
Lease +
Transfer of
Ownership

Investment
Contracts

BBA

Musharakah
Mudharabah

Murabahah
Salam
Istisna etc.

Accounting for Ijarah Financing


Compare

and contrast Lease financing


and Ijarah financing
Explain the nature of Ijarah financing
Discuss the AAOIFIs recommendations
on accounting standard for Ijarah
financing

Nature of Leases
A lease is classified as a finance lease if it
transfers substantially all the risks and
rewards incident to ownership.
Otherwise it is an operating lease.
Substance rather than form of the contract
that distinguishes finance from operating
leases.
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Substance over form

an accounting principle used "to ensure that FS give a


complete, relevant & accurate picture of transactions &
events".
If an entity practices the 'substance over form' concept,
then the FS will show the overall financial reality of the
entity (economic substance), rather than the legal form
of transactions (form).
In accounting for business transactions & other events,
the measurement & reporting is for the economic
impact of an event, instead of its legal form.

Example: substance over form

A lease might not transfer ownership of the leased


property to the lessee.
In some circumstances, the lessee might nevertheless
be required to record the leased item as an asset if the
lessee intends to use the asset for a major portion of its
useful life, or where the present value of the future lease
payments is nearly equal to the fair value of the asset.
Although the lessee is not the owner, the lessee may be
required to record the asset as being owned by the
lessee based on the underlying economic reality.

Characteristics of Finance Lease


A Finance Lease includes the following:
ownership transfer at end of period
option to purchase when asset price is lower
than fair value
lease term is major part of economic life of the
asset
at inception PV of lease payments amount to
fair value of leased asset
specialized nature of leased assets

Recognition, Measurement
& Disclosure of Finance Leases
Lessors recognize assets held under finance lease
as receivables at an amount equal to the net
investment in the lease.
Recognition of finance income should be based on a
pattern reflecting a constant periodic rate of return
on the lessors net investment outstanding in respect
of the finance lease.

Ijarah
The

word al Ijarah comes from the word ajr


meaning reward or wages for work done or services
rendered
Technical meaning in fiqh contract for hire of
persons or services or usufruct of a property
From Islamic banking point of view Islamic leasing
contract of land, property or equipment which are
leased to a client for a stream of rental payments

Nature of Ijarah Financing


Ijarah is the ownership of the right to the benefit
of using an asset in return for consideration
(Jurist).
Transfer of ownership of a service for an agreed
upon consideration (operational)
Examples:
- Rental of fixed assets
- Rental of a package of services

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Nature of Ijarah Financing (continued)


3 major Elements :
1.A form which include an Offer & Acceptance/ a
consent,
2.2 parties Lessor a lessor (the owner of the leased
asset) & Lessee (the party who reaps the services of the
leased asser)
3.object of the ijarah contract which include rental
amount and service (transferred to the lessee)Asset Specification? Particular asset or based on
description (replaceable)
Asset Impairment : Termination or Perpetual?
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Nature of Ijarah Financing (continued)


Rent should be contracted (similar to price)
Rental payment can be non-monetary & of the same
kind of benefit.
Flexibility of rental consideration subject to time,
place, distance and usage.
Rental is due upon fulfilling the condition in the
contract
Prepayment and unearned rent is acceptable
No profit in rent (non-divisible)

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Duties of Lessor/Lessee
Lessors Obligations
Making the leased asset available
Guarantee in respect of defects
Maintenance of the Leased Asset
Lessees obligations
Utilization of leased asset according to
contractual conditions
Rental payment and safeguard asset

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Classification of Ijarah
IJARAH FINANCING

OPERATING IJARAH
No transfer of title to lessee

IJARAH MUNTAHIA
BILTAMLEEK
Ownership is transferred to
lessee

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Types of Ijarah
a) Operating Ijarah
Ijarah where the title of assets are not transferred to the lessee.
Ijarah contracts that do not end up with the transfer of ownership
of leased assets to the lessee.

b) Ijarah Muntahia Biltamleek

Ijarah where title of assets are transferred to the lessee by


way of gift, token price, pre-determined price, equivalent
price & gradual transfer of share holding
The agreements that gives the lessee one of three options
that he may exercise at the end of the lease term
- purchasing the leased asset
- renewal of Ijarah for another term
- returning the asset to the lessor
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Classification of Ijarah Muntahia


Bittamleek

IJARAH MUNTAHIA BITTAMLEEK

GIFT
At End of Period

TOKEN PRICE
End Of Period Price

EQUIVALENT
Within Lease Period

GRADUAL TRANSFER
During the lease period

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Gift

Ijarah Muntahia Bittamleek that transfers the


ownership of Ieased assets to the Iessee - if the
lessee so desires - for a price represented by the
rental payments made by the lessee over the lease
term.
At the end of the lease term & after the last instalment
is paid, legal title of leased assets passes
automatically to the lessee on the basis of a new
contract.

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Gift (cont.)

This means the ownership of the assets is transferred


to the lessee for no consideration by entering into a
gift contract in fulfilment of a prior binding promise
(made at the inception of the ijarah contract), upon the
settlement of the last lease rental payment.

The title can also be transferred through a gift deed


which is conditional on the completion of all ijarah
rental payments (i.e. installments).

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Token price
Ijarah Muntahia Bittamleek that gives the lessee the
right of ownership of leased assets at the end of the
lease term on the basis of a new contract for a specified
price, which may be a token price.
Sale for a token consideration at the end of the ijarah
contract.
In this case, initially there is a ijarah contract and a
promise to sell by the lessor if the lessee wishes at a
token consideration.
The consideration can be any agreed amount between
the parties.

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Ethical issues
In

cases gift & token, in substance, the ijarah


rentals would include a portion of the capital cost of
the asset which will result in higher rentals as
opposed to an operating ijarah.

In

this case, if the asset is not transferred at the


end of the ijarah, & the asset is not impaired & the
lessee has fulfilled his other obligations, the fuqaha
agrees that the rent should be adjusted to a fair
amount and the balance refunded to the Iessee.
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At the end of lease term


Ijarah

agreements that gives the lessee one of 3


options that he may exercise at the end of the
lease term:
1.

2.
3.

purchasing the leased asset for a price that is


determined based on rental payments made by the
lessee,
renewal of ljarah for another term, or
returning the leased asset to the lessor (owner).

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Sale at the end of the lease for an


amount specified in the lease
This

is done through an ijarah contract


together with a promise to enter into a sale
contract.
The sale contract will include the amount to be
paid after the expiry of the ijarah period.

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Sale of the asset at any time during the period of the


lease for an amount equal to the remaining installments

In this case, an ijarah contract is executed together


with a promise to sell the the asset to the lessee,
whenever he wishes to buy the asset during the period
of the lease for a price equal to the remaining
installments.

When the lessee exercises the option to buy, the bank


will execute a sale contract.

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Sale through gradual transfer of title

This is executed through an ijarah contract with a


promise to gradually transfer the title of the asset to the
lessee until the asset is fully transferred.
In this case, the price need to be determined so that a
proportionate share is transferred at every period. There
needs to be a sale contract for each transfer and a
reduction in lease rental as the ownership of the bank
decreases.
In case the ijarah contract is revoked prior to complete
transfer, the property will be jointly owned by the bank
and the ex-lessee.
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Sale and Leaseback

This is a common practice.

example is the situation where a company short of cash sells its


machinery to the bank & then leases the same property from the bank
Although the legal ownership has been transferred to the bank, the
underlying economic reality for the company remain the same. Under
the substance-over-form principle, the sale & subsequent leaseback
are considered one transaction.
Similarly, if two companies swap their inventories, then they will not be
allowed to record sales because in substance no sales have occurred,
even if they have entered into valid enforceable contracts.

From a shariah perspective, it is not prohibited provided that the


2 contracts are not conditional upon on another. However, one of
the parties may make a promise to lease to or from the other
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Fair value of leased assets


Fair

value is the amount for which an asset could


be exchanged between well informed, willing
parties (seller & buyer) in the arms length
transaction.

Useful
1.

2.

(service) life of leased asset is :

Either the time period over which these assets are


expected to render the services or
The number of output units expected to be obtain
from these assets.
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Residual value
Residual

value of leased assets is the amount


which is expected to be obtained for these
assets at the end of their useful (service) life,
net of the expected cost of disposal.

Residual

value of leased assets is to be


estimated at the inception of the lease.

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Operating Ijarah : Recognition


Measurement & Disclosure (FAS 8)
Recognition of Ijarah asset upon acquisition:
Measurement of Ijarah Asset at Historical Cost. This
includes net purchasing price + all expenses necessary to
bring the asset to intended use. Examples of expenses are
custom duties, taxes, freight, insurance, installation,
testing.
Permanent reduction in the estimated residual value, this
reduction is recognized as a loss in the respective financial
period.
any impairment loss as well as depreciation is borne by the
lessor.
Presented as Investments in Ijarah Assets.
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Operating Ijarah Recognition


Measurement & Disclosure
Ijarah revenue
should allocated proportionately to the financial periods in
the lease term. Presented in the SOCI as ijarah revenue.

Initial Ijarah direct costs


If immaterial should be written off as incurred.
can be amortized if material. Should be allocated over the
lease period consistent with lease revenue pattern

Repairs of leased asset


If immaterial should be written off as incurred.
if material can be allocated with provision for repairs.
Any repairs undertaken by lessee with lessors consent is
an expense in the lessors books
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Recognition of Ijarah Asset & Income


Dr Equipment
Cr Cash
(Cash purchase of equipment for Ijarah Financing)
Dr Ijarah Financing Asset / Investment in Ijarah Asset
Cr Equipment
(Provides Ijarah financing to lessee)
Dr Cash
Cr P&L
( Repayment received from lessee & income recognition/ Ijarah
rental received)
Dr P&L/ Depreciation expense
Cr Accumulated Depreciation
( Depreciation cost of Ijarah Financing asset)
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Recognition of Ijarah Asset & Income


Dr Ijarah Expense
Cr Cash
(expenses incurred by lessor)
Dr Cash
Cr Investment in Ijarah Asset P&L (if gain)
(disposal or sale of ijarah assets)
Dr Expense
Cr cash
(Immaterial direct costs)
Dr Deferred cost P&L
Cr Cash Deferred Cost
(Material Direct Costs)

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Ijarah Al Muntahia Biltamleek :


Recognition, Measurement & Disclosure
GIFT
Recognition upon acquisition of assets & measured at
historical cost
Presented as Ijarah Muntahia Biltamleek Assets
Impairment prior to end of period, excess to fair rental
amount is due to the lessee

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Ijarah Al Muntahia Biltamleek : Recognition,


Measurement & Disclosure (continued)

END OF PERIOD SALE


Residual value (guaranteed) as token or agreed price is
deducted to determine the depreciable amount.
If the net realizable value > net book value upon
disposal,
IF the lessee does not purchase, the difference is a
receivable due from the lessee.

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Ijarah Al Muntahia Biltamleek : Recognition,


Measurement & Disclosure (continued)

PRIOR TO END OF LEASE PERIOD SALE


price to be paid is equivalent to remaining Installments
any gain or loss arising from the disposal value & net
book value is recognized in the lessors books

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Ijarah Al Muntahia Biltamleek : Recognition,


Measurement & Disclosure (continued)

GRADUAL SALE OF RIGHTS


Ijarah revenue is recognized proportionate to
decrease share of leased asset
Mutual proportionate responsibility for repairs of asset
Upon disposal of share gain or loss from difference
between selling price & net book is recognized.

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Ijarah Muntahia
Bittamleek
Asset reported in the
lessors books &
depreciated
Maintenance costs
borne by the lessor
Ijarah Revenue is not
divisible

Finance Lease
Finance lease is
reported as
receivable
No depreciation &
maintenance costs is
borne by the lessee.

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Conclusions

Conventional accounting adopts the concept of


substance over form on the other hand AAOIFI FAS 8
adopts form over substance (Shariah compliance)
AAOIFI recognized Ijarah asset as Fixed Asset (incident
to legal ownership)
Thus, repair cost is the expense of the lessor (i.e. the
bank) but the conventional practice is borne by the lessee
Ijarah contract offered by Malaysian institutions is AlIjarah Thumma al-bay on the other hand AAOIFI adopted
Ijarah Muntahia Bitamleek

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AL-IJARAH THUMMA AL-BAI (AITAB)

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Definition
Al-Ijarah

means hire, lease or rent


Al-Bai means purchase
AITAB refers to two contracts
undertaken separately which are:

Al-Ijarah Contract (hiring); and


Al-Bai Contract (purchase)

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Operation of AITAB

DEALER/SELLER sells the goods to the finance


company, which becomes the owner, in return
for payment, which is cash price less deposit
paid by HIRER for the goods under AITAB
Agreement

Upon settlement of the hire rentals, the


Purchase Agreement will be executed
automatically, thus transferring the ownership
of the vehicle from the finance company to
the hirer.
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AITAB Car Financing vs


Conventional Hire Purchase Loan
Conventional
Loan

Islamic
Financing

Interest Rate

Profit Rate

Hiring Charges

Mark-up

Late Payment Interest

Late Payment Charges

Two agreements under AITAB whereas Conventional HP uses


only one agreement
Late payment for AITAB is 1% p.a. on the installment due and
for Conventional HP is 8% p.a. on the installment due
Under AITAB, customer has to sign the Aqad Letter whilst
Conventional HP does not have such agreement
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Restriction in applying AITAB Car


Financing scheme
Customers who are selling alcohol, illegal
drugs etc
Customers who are operating a gambling
business
Customers who are involved in immoral
business such as prostitution

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Others
Late payment fee of 1% p.a. of the
installment due charity accounts
Minimum period of financing is 1 year (12
months) & a maximum financing is 7 years
(84 months)
However, period of financing & margin of
financing (normally 90%) used by finance
companies is determined based on various
factors such as: type of cars (new or second
hand), age of vehicle, customer profiles,
income exposure, market condition
Ibra for early settlements

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MASB Technical Release i-2


To provide

guidance on the application of MASB


approved accounting standards to transactions
and events based on Ijarah

Under

this TR i-2, where ijarah transfers


substantially all the usufruct of a tangible item,
an entity shall account for Ijarah as a finance
lease in accordance with MASB approved
accounting standards on lease
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MASB Tr i-2
In

the financial statement of a lessee,


accounting for Ijarah as a finance lease would
confer the lessee rights over an asset as similar
to ownership of the asset. However, it is not the
same as outright ownership as the lessee has
the obligation to return the item at the end of the
Ijarah period additional information to be
disclosed in the financial statement

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MASB Tr i-2
In

the financial statement of a lessor, accounting


for Ijarah as a finance lease would recognise
the lessors right to the Ijarah receivables at an
amount equal to the net investment in the lease

Effective

for annual periods beginning on or


after 1 July 2006

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Illustrative Example 1

ABC Airlines Berhad (ABC) enters into an Ijarah


contract for an aircraft from XYZ Leasing Berhad
(XYZ). The aircraft has an expected useful life of 10
years and XYZs net investment in the aircraft is RM
10,000,000.

ABC agrees to pay XYZ RM 15,000,000 in Ijarah


payments for the right to use the aircraft for 10 years.
At the end of the 10 years, ABC has the right to
exercise an option to purchase the aircraft for RM1.
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Illustrative Example 2

Ahmad enters into an Ijarah-based arrangement


with a bank. The bank purchases a car that Ahmad
wishes to use for RM 50,000. Ahmad will then pay
the bank RM 898 a month for 5 years for the right to
use the car. Ahmad and the bank have undertaken
that Ahmad will purchase and the bank will sell the
car for RM 1 at the end of the 5 year Ijarah period.
The car has an estimated economic life of 5 years.

The mutually agreed terms of the contract stipulate


that Ahmad will bear the costs of maintenance and
insurance of the car.
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Illustrative Example 3
Private

Air Berhad (Private) agrees to pay XYZ


RM 7,000,000 in Ijarah payments for the right to
use an aircraft for 5 years. The aircraft is similar
to the one in Example 1. Private does not have
an option to purchase the aircraft.

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Illustrative Example 4

Abu wishes to use a car from Alif Auto Berhad which


costs RM50,000. Abu enters into an Ijarah-based
arrangement with Alif Bank Berhad, which is a related
party of Alif Auto. Under the arrangement, Abu will pay
the bank RM 932 a month for 5 years for the right to
use the car.
The mutually agreed terms of the contract stipulate that
the bank will bear the costs of maintenance and
insurance and provide 24-hour road assistance. The
bank will provide Abu with a substitute car while the
leased car is undergoing maintenance works. In
addition, Abu can exercise an option to replace the car
with another make or model.
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