WEEK 8

FN 6103
ACCOUNTING FOR ISLAMIC FINANCIAL TRANSACTIONS

PROFESSOR DR ZULKARNAIN MUHAMAD SORI

drzulinceif@gmail.com

PROFESSOR DR ZULKARNAIN MUHAMAD SORI, INCEIF, 2015 Copyright

 FN 5013/6013/6103
ACCOUNTING FOR ISLAMIC FINANCIAL TRANSACTIONS

PROFESSOR DR ZULKARNAIN MUHAMAD SORI, INCEIF, 2015 Copyright

 AGENDA

Accounting for Ijarah Contracts

Fiqh rules on Ijara and comparison with operating
and financial lease
Accounting recognition and measurement of Ijarah
as lessor and lessee.
Various types of IMBT
AITAB differences between AITAB and IMBT and
MASB
PROFESSOR DR ZULKARNAIN MUHAMAD SORI, INCEIF, 2015 Copyright
 TERMS

Ijarah Islamic Rental Contract

Usufruct Legal Right to use an asset
al ijarah (tashghiliyah) Operating Ijarah

al ijarah muntahia Ijarah with an option for transfer of title to lessee

bitamleek
Al ijarah thumma al- Ijarah followed by Sale
bai’
Lessor Who owns and leases or sub-lease the asset from
the owner to the ultimate lessee

Lessee The party who uses the asset and benefits from it.
 IJARAH

The technical meaning in fiqh

=> a contract for hire of persons or services or “usufruct” of a
property.

Islamic banking point of view,

=> al Ijarah usually refers to a Islamic leasing contract of land,
property or equipment which are leased to a client for a stream of
rental payments.
 Types of Ijarah contacts in use

1. al Ijarah (tashghiliyah) - operating Ijarah

2. al Ijarah muntahia Bittamleek – Ijarah with option to transfer
ownership of asset to lessee, and in Malaysia,
3. a composite contract; Al Ijarah thumma al-bai’ (Ijarah
followed by sale) is practiced in Malaysia.

From a conventional banking point of view,

the finance lease is preferred by banks who want to
concentrate on the financing and not on the operational
complexities of leasing; hence, they transfer substantially all
the risks and rewards of ownership of the leased asset to the
client.
SUBSTANCE OVER FORM
Shari’a point of view
There is no such thing as a finance lease.

Anything which separates the physical transaction from its

financial aspect, making the transaction a loan is treated as
ribawi and thus prohibited.

Normally - not possible to transfer all the risks and rewards of

ownership of the asset, although some Fuqaha allow this.

The leased asset should be recognized and depreciated as asset

owned by the Islamic bank and the rentals receivable treated as
income.

Major problem for Islamic banks who want to follow IFRS, IAS17,
which requires all financial leases to be treated as a receivable
with the principal and interest portion separated
 Finance leases
in which all risks and rewards of ownership are
transferred to the lessee, are not recognized in
the Shari’ah.

In an Ijarah contract, the risks and rewards of

ownership is with the lessor i.e. the Islamic bank,
while the risks and rewards of use rests with the
lessee, i.e. the customer.
 OPERATING MECHANISM
Ijarah is the transfer of ownership of a service for an
agreed upon consideration.

Three major elements:

1. a form, which includes an offer and a consent.
2. two parties: a lessor (the owner of the leased asset),
and a lessee (the party who reaps the services of the
leased asset)
3. the object of the (Ijarah) contract, which includes the
rental amount and the service (transferred to the
lessee).
 Operating Ijarah

Ijarah contracts that do not end up with the

transfer of ownership of leased assets to the
lessee.
 Ijarah Muntahia Bittamleek

Ijarah contracts that end up with the transfer of ownership of leased

assets to the lessee.

Ijarah Muntahia Bittamleek may take one of the following forms:

a) Ijarah Muntahia Bittamleek that transfers the ownership of leased

assets to the lessee – for a price represented by the lease payments
made by the lessee, over the lease term.

At the end of the lease term and after the last installment is paid, legal
title of leased assets passes automatically to the lessee on the basis of a
new contract.
 Ijarah Muntahia Bittamleek

b) 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
sales contract for a specified price, which may be a token price.

c) Ijarah agreements that gives the lessee one of three options that he
may exercise at the end of the lease term:
purchasing the leased asset for a price that is determined based on
lease payments made by the lessee,
renewal of Ijarah for another term, or
returning the leased asset to the lessor (owner).
 Ijarah Muntahia Bittamleek
Terminologies in Ijarah/Leasing:

Fair value
=>the amount for which an asset could be exchanged between well
informed, willing parties (seller and buyer) in an arm’s length transaction.

Useful life of leased assets

=>is (a) either the time period over which these assets are expected to
render services, or (b) the number of output units expected to be obtained
from these assets.

Residual value of leased assets

=>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.
Ijarah Muntahia Bittamleek
Ijarah Muntahia Bittamleek

TYPES OF IMBT
 Ownership of the Asset [IMBT]

I. Gift at the end of the period of the Ijarah:

This means the ownership of the asset 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. instalments).

II. Sale for a token consideration at the end of the Ijarah contract:
In this case, initially there is an 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.
Note:
In cases (i) and (ii), 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, and
the asset is not impaired and 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 lessee.
III. 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.

IV. Sale of the asset at any time during the period of the lease, for an
amount, equal to the remaining installments:
Ijarah contract is executed together with a promise to sell 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 instalments.

V. 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 needs 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.
Sale and Leaseback:

This is a common practice.

From a Shari’a perspective,

it is not prohibited provided that the two contracts are not conditional
upon on another. However, one of the parties may make a promise to
lease to or from the other
 ELEMENTS OF IJARAH

Fuqaha - there are 3 general and 6 detailed elements of Ijarah:

The wording: This includes offer and acceptance.
Contracting parties: This includes a lessor, the owner of the asset, and
a lessee, the party that benefits from the use of the asset.
Subject matter of the contract: This includes the consideration (rent)
and the benefit from the use of the asset.

The benefit from use of the asset is the subject matter of the contract,
because it is the element to be satisfied in return for the rent. Hence, it is
the benefit of using the asset which is guaranteed rather than the asset
itself.

For example, it is commonly stated: “I hereby rent out this car to you”
 EXECUTION OF IJARAH

The basic rule of the Ijarah is that it should be executable.

If the commencement of the contract is not stipulated, then the Ijarah will
start from the time of the contract and will be executed as from that time.
An Ijarah contract according to which execution of the contract is deferred
to a future date is valid. However, such a case is considered by the
Hanafis as a non-binding contract.

It is considered permissible to enter into an Ijarah contract to lease an

asset for a second year to the same lessee as the first year before the
expiry of the first year’s contract.

Making Ijarah contingent on a future event or a condition:

The majority of fuqaha have agreed that Ijarah, like sale, cannot be made
contingent on a future event or a condition. But Ibn Taimeyah and Ibn Al-
Jawzeiyah are of the opinion that making Ijarah contingent on any future
event or condition is considered permissible .
 Contracting Parties
To enter into a contract, both contracting parties should be of sound mind and judgment.
There is agreement that Ijarah cannot become valid unless the contracting party is a
competent person who is qualified to dispose of funds. For a contract to be valid, it should
have the mutual consent of both contracting parties. For the purpose of enforceability, the
contracting party to whom the offer is made should have the authority to act in order to
create a contract. This is according to both Hanafis and Malikis who are of the opinion
that the authority to act is a condition for enforceability.

Subject matter
The subject matter of Ijarah is the benefit (the use of the asset) and the rent. These are
discussed below.

Benefit: It consists of two parts

a. The contract should include the use of a benefit of a specified asset, for example,
one person says to another: “I hereby lease you this house”, or the use of a
benefit of an asset whose specification is accepted based on the lessor’s
description, for example, “I hereby lease you a house the specification of which is
so and so”.
b. The contract should include a known act.

Conditions of the Benefit

Benefit should fulfill the following conditions:
a) The benefit of using the asset, not the use of it as such, should be
the subject matter of the Ijarah. This is a matter of agreement
between the fuqaha.
b) The benefit should be subject to valuation and intended to be
fulfilled in the contract because no agreement can be concluded on
what is considered permissible but does not have a price. Spending
money in such a way is considered wasteful.
c) The fulfilment of the benefit should be of a permissible nature.
d) Ability to fulfil the benefit should be real and in accordance with
Shari’a.
e) The benefit should be identified in such a way as to remove lack of
knowledge (Jahala) which leads to dispute. Fuqaha are in
agreement that lack of knowledge which leads to dispute nullifies
the contract.
 Specification of the benefit
The benefit is specified by stating the subject matter or the duration. It
may also be identified by specification or physical identification.

The condition of specifying the subject of benefit has led to the division of
Ijarah into
(a) Ijarah of assets whereby the benefit is fulfilled from a particular asset.
In this type of Ijarah if the asset is impaired, then the Ijarah becomes
nullified, for example, the leasing of a particular house to live in.
(b) Ijarah whose specification is accepted based on the lessor’s
description. In this type of Ijarah the benefit is fulfilled from what is
specified by description. If the benefit of the asset is impaired after it
has been specified and used for some time after the contract became
effective, the lessor will provide a replacement.
 Lease payment.
Rent (Lease payment) is what the lessee is committed to pay as a
consideration for the benefit enjoyed by him.

Everything that is suitable to be considered a price in a sale can be

suitable to be considered as a lease payment in an Ijarah.

The majority of fuqaha have said: “the conditions applicable to price are
also applicable to rent”. Rent should be known.

This is in compliance with the saying of the Prophet, (Allah’s blessings and
peace be upon him): “he who hires a worker should inform him of his
wage”.

If the benefit is fulfilled and the rent was not determined, the rent for a
similar benefit should be paid.
 Paying the rent in the form of services (another benefit).
The majority of fuqaha have permitted the payment of rent in the form of
a benefit of the same kind of the subject of the contract.

Flexibility in determining the rent.

Rent can be determined in terms of time, place and distance. For
example, one person says to another: “if you sew me this dress on this
day, its charge will be one dirham and if you sew it tomorrow, the charge
will be half dirham, and if you live in this house as a blacksmith you will
be charged ten and if you live as a perfumer, you will be charged five,
and so on.
 Entitlement of the rent and its due time.
The Hanafis and Malikis are of the opinion that entitlement to the rent
does not become a right as per the contract itself. Rather, entitlement to
the rent becomes a right by fulfilling the condition in the contract or by
fulfilling the subject matter of the contract. The Hanafis added the
condition of accelerating the actual payment of the rent by the lessee.

Shari’a characterization of the advance payment of rent.

Receipt of an advance payment is not prohibited in Shari’a, but only on
the basis that it is an advance payment on account from the amount of
the rent. It should not, however, be considered (in terms of the
relationship with the lessee) as a profit on the lease, as this is an internal
affair of the lessor. This is because, from the Shari’a point of view, the
rent consideration is an indivisible amount which should not be divided
into a principal and a profit. From a Shari’a perspective, profit is only
viewed as the result of a transaction of purchase and sale of a
commodity for an amount in excess of its cost.
In Ijarah, however, the whole consideration is a rent which can be
accelerated or deferred in whole or in part (provided that it is a portion
of the whole rent). It can also be paid in instalments or deferred until
after consuming the benefit from the leased asset.
 Lessor’s obligations.

a) Making the leased asset available:

The lessor is obliged to enable the lessee to benefit from the leased
asset by making it available throughout the duration of the lease. Making
the asset available includes equipping and preparing the asset in the
manner which – according to normal practice – is considered necessary in
order for the specified benefit to be enjoyed.

Making the asset available also entails enabling the lessee to enjoy the
benefit of the leased asset. However, if anything happens during the
period of the lease that prevents the lessee from enjoying the benefit of
the leased asset, for a reason not attributable to the lessee, then the
lessor is obliged to rectify the situation. For example, repairing the leased
house or removing all matters leading to inconvenient housing.
b) Guarantee in respect of defects:
In Ijarah, the option of defect is treated as in sale. The defect which
entitles a lessee to an option is one which causes an impairment in the
benefits which are the subject of the contract. The same applies if the
defect occurs before fulfilment of the benefit but after the contract is
concluded. In either case, the lessee shall have the option of revoking the
contract or accepting the impaired benefit while being obliged to pay the
full rent. However, there are some fuqaha who are of the opinion that a
portion of the rent should be deducted for the defect.

c) Maintenance of the leased asset:

Lessee’s obligations:

Utilization of the leased asset is determined according to the conditions

of the contract or according to practice. The lessee is also responsible
for keeping the leased asset intact and for payment of the rent.

Fuqaha agree that the leased asset is a trust in the hands of the lessee.
However, if the leased asset is impaired without omission, violation of
what is permitted, or negligence in keeping it intact on the part of the
lessee, then he is not to be liable for such impairment because whilst the
lessee is permitted by the lessor to enjoy the benefit of the leased asset,
he is not to be held as a guarantor for the leased asset.
Maintenance of the leased asset:

In principle, it is not considered permissible to stipulate in the contract

that the maintenance of the leased asset is to be carried out by the
lessee because this would lead to the lessee paying a rent that includes
an unknown element.

According to the schools of fiqh, this condition renders the Ijarah contract
void. If the maintenance condition is included in the contract and the
lessee has benefited from the leased asset, he should pay the fair rental
amount and be reimbursed for what he spends on maintaining the
building. In addition, the lessee is entitled to be paid the equivalent fair
wage and expenses incurred in carrying out the work of maintenance if
that was done by permission of the lessor. If he does the work without the
lessor’s permission, then this will be considered to a be a gift on his part
and he cannot claim any reimbursement.

The lessor should also maintain the asset and carry out all repairs that
would make it suitable for use. If he refuses to do so, according to the
opinion of the majority of fuqaha, the lessee shall be entitled to revoke
the contract unless he leased subject to that condition.
However, the lessee can be asked to carry out the maintenance based
on the following:
a) To carry out the operating maintenance, which is required as a result
of using the leased asset, and is needed in order to ensure its
continuous utilization (for example, oils needed for machines and
equipment).
b) Periodic maintenance which is required to enable the asset to
continue providing the benefit.
c) Maintenance that is specified in description and amount in the
contract or according to practice whether such maintenance is merely
work or involves the use of known materials or spare parts because
this type of work is considered as rent taken into consideration.
 Revocation of Ijarah for a justifiable reason:
Hanafis are of the opinion that it is considered permissible to revoke an
Ijarah contract unilaterally for a reason relating either to a contracting
party or to the asset itself, without the contract remaining binding.

In this case, revocation is valid because it becomes necessary when there

is a reason, otherwise if the contract remains binding, the party having the
reason will be disadvantaged by something he did not agree to in the
contract.

Hence, permitting revocation of the contract in such cases is meant to

prevent any one of the two parties from being forced to suffer a damage to
which he did not agree.
 FORMS OF IMBT

Ijarah Muntahia Bittamleek has many forms that focus on what the two
contracting parties have agreed upon and what they have intended to
achieve from such contracting, for example, lease or sale, Ijarah and a
promise to sell, the rent they have specified in the Ijarah, the cost of the
goods in the sale transaction, and the time at which the legal title is
transferred.
Accounting issues on Ijarah and Ijarah Muntahia Bittamleek
• Recognition of Asset and Liability in the books of lessor and lessee.
• Recognition of Profit/ Income or Loss/ Expense
• Valuation of Asset
• Disclosure
 RECOGNITION & MEASUREMENT OF IJARAH

Financial Accounting Standard No. 8 (FAS 8) sets out the

accounting rules for recognizing, measuring, presenting
and disclosing Ijarah and Ijarah Muntahia Bittamleek
transactions of Islamic Financial Institutions.

The standard covers acquisition of Ijarah assets, leasing

of the assets, Ijarah expenses and revenues, gains and
losses including Balance Sheet presentation
Operating Ijarah In the books of the lessor:

(1) Assets acquired for Ijarah:

Assets acquired are recognized at historical cost. This includes net purchasing
price + all expenses necessary to bring the asset to bring the asset to intended
use.

Examples of expenses are custome duties, taxes, freight, insurance,

installation and testing.

If there is a permanent reduction in the estimated residual value, this reduction is

recognized as a loss in the respective financial period.

Leased assets is depreciated on a basis consistent with lessor’s normal

depreciation policy for similar assets. (This requirement is currently being
reviewed as a result of feedback from industry who wants the depreciation term
to be the economic life of the asset i.e. the lease term.

Leased assets in the financial statements as Investments in Ijarah assets.

(2) Ijarah Revenue:
Ijarah revenue should be allocated propotionately to the financial period
of the lease term. Ijarah revenue is presented in the income statement
as Ijarah revenue.

(3) Direct initial cost:

If not material, should be written off as incurred. If material, should be
allocated over the lease period consistent with lease revenue pattern.
(4) Repairs of leased assets:
Repairs necessary to secure the services of the leased assets, if
immaterial, should be written off in the period, while if repairs are
material and varied, a provision is set up by regular charges to income. If
lessee undertakes repairs with lessor’s consent and they are chargeable
to lessor, then it shall be expenses in the financlal period and a payable
set up for amount owed to lessee.

(5) At the end of the financial period:

Amortization of initial material direct costs, cost of repairs to be charged
against provision, depreciate assets, Ijarah installments receivable to be
at cash equivalent.
 AITAB - al-Ijarah thumma al-Bai`

AITAB - Vehicle financing

AITAB involves two types of contracts, namely leasing contract (ijarah ),

followed by sale contract (al-bai` ).

Initial stage, the Islamic financial institution will conclude an ijarah

agreement with the customer. Under this agreement, the Islamic financial
institution will appoint the customer as an agent to purchase the vehicle
identified by the customer. Subsequently, the Islamic financial institution will
lease the vehicle to the customer for a specified period.

Upon expiry of the lease period, the customer has the option to purchase
the vehicle from the Islamic financial institution. If the customer opts to
purchase the vehicle, the Islamic financial institution and the customer will
conclude a sale contract and the ownership of the vehicle will be transferred
from the Islamic financial institution to the customer.

SAC resolved that the application of the AITAB concept in vehicle financing
is permissible
 Conditions
i) The modus operandi of AITAB shall consist of two independent contracts,
namely ijarah contract and al-bai` contract;
ii) The sale price upon expiry of the lease period may be equivalent to the last
rental amount of ijarah ;
iii) An agency letter to appoint the customer as an agent for the Islamic
financial institution shall be introduced in the modus operandi of AITAB;
iv) The AITAB agreement shall include a clause that specifies “will purchase
the vehicle” at the end of the lease period, as well as a clause on early
redemption by the lessee;
v) The deposit paid to the vehicle dealer does not form a sale contract since it
is deemed as a deposit that has to be paid by the Islamic financial
institution;
vi) In line with the principles of ijarah, the Islamic financial institution as the
owner of the asset shall bear all reasonable risks relating to the ownership;
and
vii)For cases relating to refinancing with a new financier, the lessee shall firstly
terminate the existing AITAB contract before entering into a new AITAB
agreement.
 Illustration 1

On 20th June, 2010, Shumul Bank of Bahrain BSC, brought 10 proton Gen 2
cars from the Malaysian manufacturer at a cost of $10,000 each. The freight
costs from Malaysia to Bahrain was $20,000 and local handling and transport
costs to the Bank’s warehouse $3,000 with another $2,000 registration costs for
the cars. Shumul Bank will lease the cars on various terms to its customers. At
the end of the year, due to newer comparable models of cars coming from
mitsubishi, the value of the cars dropped by 20% of its original cost.

During the year, Shumul bank managed to lease all its cars on operational Ijarah
contract for two years with monthly rental of US$500 per car to Bahrain Islamic
bank BSC payable yearly in advance, starting 1 July 2010. During the year it
received two payments on account, the second one on 31st December 2010. The
legal costs of the Ijarah amounted to $5,000 which Shumul and the customer
agreed to share equally. The bank considered considered the legal costs
immaterial. Under the terms of the Ijarah, Shumul Bank will be responsible for
takaful premiums on the car (theft, fire and collision damage) which amount
US$200 per year per unit, while the customer was responsible for 3rd party
damage takaful, regular maintenance and fuel. The takaful premium for a whole
year on theft was paid by the bank on 1st July, 2010.
 Illustration 1

On 1st of October 2010, the manufacturer recalled the cars for some major
repairs to be undertaken on proton gen 2 cars. Shumul Bank requested the
customer to send in all the cars to the manufactuer for repairs. The cars were
handed back to the customer on 31st October 2010.

Shumul Bank depreciates its Motor vehicles on a straight line basis over five
years with nil residual value and its financial year end is on 31st December.
Assets held for less than a month are not depreciated for the month.

Required in the books of the Shumul Bank.

1. Journalize the necessary entries.
2. Prepare an extract of the balance sheet and income statement of Shumul
bank at 31st December 2010 related to the above transactions.
3. Comment on the profitability of the Ijarah contract.
 Illustration 2

Facts are same as in problem illustration 1, except that the initial direct costs are treated
as material by Bahrain Islamic Bank (BIB) and the BIB paid $100 per car per year on third
party takaful and $600 in 2010 and $1000 in 2011 for maintenance of the cars. Journalize
the required entries and show the financial statements extracts for the year ended 31st
December 2010 and 2011.
 THANK YOU
THIS TEACHING GUIDE WAS PREPARED BASED
ON VARIOUS REFERENCES THAT AVAILABLE
ONLINE & HARDCOPY. SHOULD YOU NEED THE
LIST OF REFERENCES, PLEASE CONTACT:

PROFESSOR DR ZULKARNAIN MUHAMAD SORI

Professor of Accounting at INCEIF, via:
Email: drzulinceif@gmail.com
DL: +603-76514173

PROFESSOR DR ZULKARNAIN MUHAMAD SORI, INCEIF, 2015 Copyright