The amount of capital required by the companies operating in the market is one of the major concerning issues for them. It is required by the companies that they should maintain a significant amount of funds with them in order to carry out the operations of the business in the suitable manner. Therefore, in such a case, in Islamic finance one of the methods used is Ijarah or leasing. Ijarah is defined as an ownership of the right to get the benefit of using an asset for a specific period of time in return for a consideration. This method is considered by companies as it enables them to make use of an asset without buying it and having the ownership. It is good for the companies as this can be used by them to make use of those assets that can get obsolete within a short period of time like that of machines and equipments (Islamic accounting, 2013).
This report will explain about the Islamic accounting and the contacts based on Ijaraor leasing. Then, differences and similarities between that of Ijarah and leasing will also be explained. The different types of accounting systems which are recommended by (AAOIFI) Accounting and Auditing Organization for Islamic Financial Institutions and (IFRS) The International Financial Reporting Standards will be given in the latter part of the report.
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Ijarah can be defined as the process in which a contract is signed between two parties and one party transfer an asset to another one for a specific period of time. According to Islamic finance a contract of ijarah will be valid only if acquisition of an asset is done. Acquisition of an asset is said to be usufruct in Islamic terms (Usufruct, 2013). This term means a legal right in order to make use of someone else’s property in whatever way on likes during the life period of that asset. The condition with this is that the return of the asset to the owner shall be in a reasonable condition (Ijarah (leasing), 2013). The party which gives the asset on a lease is known as lessor and the one who takes it is lessee. Ijarah is also known to be Ijarah Ain which signifies to give an order on rent to be able to enjoy the usufruct.
Another one is Ijarah Muntahia Bittamleek according to which means that it allows the transfer of ownership of an asset to the lessee by the end of the contract of the lease. The duration of ijarah contract needs to be specified in the contract and it comes into operation on the date on which the contract has to be executed unless any future date has been specified or agreed upon by the both the parties (Ijarah, 2013).
There are different types of contracts that are based on ijarah which are similar to financial or operating leases in one way or the other. Following are the types of ijarah
Ijarah Muntahia Bittamleek is a modern type of ijarah which is used by Islamic financial institutions. In this type the underlying asset which is given on lease does not belong to the bank after the lease contract comes to an end. It is used by those businesses that have an interest in buying an asset but do not have the required funds. Therefore they can use this type of ijarah which accounts for less leverage in their financial position and they do not need to borrow the cost of the asset from any other financial institution (Finance Lease, 2013).
In this type of ijarah the lessor purchases an asset that is being demanded by a customer and then gives the purchased asset on lease. At the end of the contract or lease the ownership of the asset is being transferred to the customer. The transfer of ownership from the lessor to the customer or lessee is done according to the agreement which states that lessor transfer the ownership by employing one of the following methods-
Islamic financial institutions make use of simple ijarah or an operating lease in financial terms. Simple ijarah is used on those assets which are marketable and companies require huge amount of capital in investing in them. The assets which are expensive can be utilized to help of ijarah. An operating lease is one in which ownership of the asset is maintained with that of lessor or the owner. Therefore, it is the responsibility of the owner to maintain the costs and depreciation of the asset. This lease is usually for a short duration of time. Here, the lessee can cancel the contract any time before the expiry of date of contract by giving proper notice to the lessor. At the end of the contract the asset is transferred back to the lessor (Toumi, Viviani and Belkacem, 2011).
Ijarah Mausufah Fi Zhimmah is used for that type of a lease contract on an asset which is not owned by the lessor or it is not available during the signing up of the contract. During the agreement it is kept in mind to prevent any kind of conflict between lessee and lessor. In addition to this the time period and the value of the asset has to be made clear and should be specified. It is up to the lessee that he can decide to make varied or fixed payments and this decision is based on the agreement. This also represents the right of lessee such that the asset can be used when it is ready (Ahmad and Luo, 2010).
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In this agreement if the underlying asset does not confirm according to the set standards then it is the right of the lessee that it can reject the asset. A claim can also be made by him for replacement of a new one. In addition to this, if the lessor is not able to provide the asset at the time specified in the contract then also he has the right that he can cancel the contract and the payments that are done earlier can be refunded (Mac Kee, Mac Kee and Garner, 1999).
For example, with an ijarah Mausufah Fi Zhimmah, a company has the ability that it can make an agreement with a bank for taking a building on lease in London. For this, the company can identify the building and lease the property for a fixed period of time in exchange for a fixed amount. The bank can agree to grant the building at a later time after the start of the contract. In this way, the payments which are made prior and between the time of the contract and when the building is granted are the advanced payments.
The two methods are similar to one another is the respect that payment on an asset has to be made when it is received and used by the lessee. A major difference between the two types of contracts is that in ijarah, in case of late payment the bank or lessor can only charge only that much amount which is able to cover for the losses that are incurred by the lessor in case if payments are not made on time. On the other side, according to an operating lease if the late payment penalty is mentioned in the notice then lessor can claim penalty in case if a payment gets late. For example, the penalty can be charged at 1% of the payment of the lease (Comparisons between Ijarah and Conventional Operating Lease Contracts, 2011).
The main range of ijarah contracts is either financial or operating lease. Now, the use of these Islamic contracts according to the (IFRS) The International Financial Reporting Standards and (AAOIFI) Accounting and Auditing Organization for Islamic Financial Institutions can be explained.
In the case of Ijarah Muntahia Bittamleek or financial lease, the document 17 leases of International Accounting Standards (IAS) or IAS Plus consider the substance that is being transacted rather than considering its form. According to it, a lease is considered to be a financial one in the case if all the rewards as well as the risks or costs associated with the asset is transferred to the lease and if this part of the risk is being shared by the lessor then this will be categorized as an operating lease (IAS 17 — Leases, 2013). In financial lease, the IAS Plus suggests that lessor will show the lease agreement as receivables in its balance sheet and the amount mentioned will be equal to that of net investment that is done on the lease. The payments received on the lease will be shown as revenue in the income statement of the lessor. In the financial statements of lessee the lease is shown under the assets and liabilities in the balance sheet. The amount will be equal to the fair value of the asset and the present value of the minimum payments of a lease. Moreover, the lessee should depreciate the asset by making use of depreciation method followed by the firm (Choudhury, 2011).
Moreover, if the lessee acquires the asset as a gift at the end of the contract the lessor needs to calculate the depreciation which has to be equal to the amount of the lease so that the residual value will be zero at the end of the contract. But, if the asset on the lease will get transferred in exchange for an amount that is already determined in the contract then for calculating the depreciation this amount will be subtracted. Then the instalments will be shown in the income statement as revenue and lessee will show it as an ijarah expense (Garas and Pierce, 2010).
The difference in the ijarah or lease contracts can sometimes lead to variation in the treatments of accounting standards. Like for example, if two business firms have entered into a financial lease for the same kind of an asset but one of them with an Islamic bank and the other one with a conventional one. After a year of the contract both the firms decide to cancel the contract of lease and return the asset. In such a scenario, the Islamic bank will calculate the depreciation on an asset which is consistent with the life of the asset instead of the period of lease contract (Choudhury, 2011). The difference between both the methods will be recorded in the income statement of the bank as profit or loss. The lessee would only lose the cost of installements that were made prior. On the other side, the firm which enters into the contract with conventional bank cannot cancel the contract because the asset is legally owned by it and according to the contract it will be a financial lease.
In the above report, different types of ijarah or lease were discussed and emphasis was put on their similarities and differences. The main types of ijarah were Ijarah Muntahia Bittamleek or financial lease and simple Ijarah or Operating lease. The way in which the lease or ijarah functions according to the Islamic laws is explained in the report. Finally, comparison was made between AAOIFI and IFRS with respect to the accounting treatments in the field of ijarah or leases (Napier, 2011).
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