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IJARAH AND THE ACCOUNTING


TREATMENT

SECTION 2

GROUP MEMBERS :
RASHIDAH BT JAMAIN
0725480
ZUREEN SHAHIZAN BT ZULKIFLI
0727854

INSTRUCTOR :
DR. SHERLIZA PUAT NELSON
INTRODUCTION

Ijarah means to give something on rent. In Islamic jurisprudence, ijarah is used in 2

different situations. In first situation, it means to employ services of a person on wages given to

him as a consideration for his hired services. The employer is called musta’jir while the

employee is called ajir. The second situation in ijarah is related to the usufruct of assets and

properties, and not the services of human beings. Ijarah in this sense means to transfer the

usufruct of a particular property to another person in exchange for a rent claimed from him. In

this case, the term ijarah also called leasing. Here the lessor is called mu’jir, the lessee is called

musta’jir. The rules of ijarah are very analogous to the rules of sale because in both cases,

something is transferred to another person for a valuable consideration. The only different

between ijarah and sale is that in sale, the right of the property is transferred to the purchaser,

while in the case of ijarah, the rights of the property remains in the ownership of the lessor, but

only the right to use it is transferred to the lessee. Ijarah can be divided into two types which are

first is finance lease and another one is operating lease.


Al-Ijarah Muntahia Bi Tamleek

In finance Ijarah, it provides the lessor with full recovery of its investment and a

reasonable profit over the initial non-cancellable lease term. The lessor retains ownership of the

equipment but transfers to the lessee substantially all of the risks and rewards of ownership of the

asset. The lessee is responsible for the insurance, registration and maintenance of the equipment.

Financial leases have some similar feature to secured loans. Both allow a business to use an

asset, such as equipment, over a fixed period, in return for regular payments. The business client

chooses the equipment it requires and the bank buys it on behalf of the business. After all the

payments have been made, the business client becomes the owner of the equipment. The lessor's

rate of return is fixed and is not dependent upon the asset-value, performance, or any other

extraneous costs. The fixed lease rentals give rise to an ascertainable rate of return on

investment. Therefore, by spreading payments out over the lifecycle of the asset, the business is

able to align the cost with the benefit derived from the use of the leased asset. The lessor

generally would not provide any services relating to operation of the asset. In addition, financial

leases are non-cancellable; in fact, the lessee cannot return the asset and not pay the whole of the

lessor's investment.

Accounting Treatment for Ijarah Muntahia Bi- Tamleek


Accounting treatment of finance Ijarah by the lessee is when a lessee enters into a finance

lease it is getting access to the risks and rewards of the asset and accordingly the lessee reflects

substance by recognizing the asset in its own accounts. When a lessee enters into a finance lease

it is obliged to make the lease rental payments for the duration of the lease, and accordingly the

lessee reflects the substance by recognising a liability. The lessee strictly capitalises the present

value of the minimum lease payments as the fixed asset and this is the amount also recorded as

the liability. The asset has to be depreciated over the shorter of the period of the lease and the

useful life of the asset. The loan accrued interest which should be recognized to give a constant

periodic return on the balance of the outstanding loan. The rental payment is not therefore simply

a revenue expense but represents partly the repayment of the capital element of the loan and

partly the finance charge on the loan. The total finance charge is the difference between the

minimum lease payments and the present value of the minimum lease payments. On the balance

sheet the finance lease creditor obligation under finance leases will have to be split between

current and long-term creditors. In the notes to the balance sheet a separate listing in the fixed

asset schedule is required to distinguish assets legally owned and those held subject to finance

leases. In the notes to the profit and loss account the amount of the interest charged that was in

respect of finance leases must be disclosed.

Accounting treatment for lessor is when entering into a finance lease the lessor is in

substance making a loan which will be repaid with interest. Despite having legal title to the asset

subject to the lease, the lessor does not recognize this as an asset on its balance sheet, as it does

not control the asset and does not have access to the future economic benefits. The lessor does

however have the asset of a future income stream and accordingly recognizes a debtor ‘net

investment in finance leases.


Al Ijarah Tashghiliyah

Al Ijarah Tasghiliyah also known as operating Ijarah. This type of ijarah does not include

the promise that the legal title in the leased asset will pass to the lessee at the end of the lease. In

the situation where the bank will purchases and maintains assets which have a high degree of

marketability. The bank rents these assets to other parties on terms and conditions agreed upon

for a specific time. After the termination of the period the asset is returned to the bank. The bank

then leases the same asset to a new lessee. The bank bears the risk of recession or diminishing

demand for these assets. At the end the bank may choose to scrap or dispose the asset.

The standard states that, operating Ijarah doesn’t result in ownership transfer at the end of

the leased period. This is similar with conventional operating lease. The standard further

addresses the recognition method in the books of the lessor. That is relevant as the income

recognition and the frequency of revenue receivable will ascertain only through that process.

Section 3 sub-section 1/1/1 asset acquired for Ijarah, indicates that, “asset acquired shall be

recognised at historical cost”. This tells us that, the original cost of acquisition is the basis for

valuations. The cost includes “net purchasing price plus expenditure necessary to bring the asset

to its intended use”. The values that the tangible asset is value at will include every associated

cost that enables the lessor to bring the asset to his possession. (AAOIFI 2008: 244)
AAOIFI FAS 8 Juristic Rule 1/5/2 outlines that “the lessee must use the leased asset in a

suitable manner or in conformity with common practice and comply with conditions which are

acceptable in the Shari’ah. He must also avoid causing damage to the leased asset by misuse

through misconduct or negligence”. This clearly stipulates the contractual duties or

responsibilities of the lessee. (Sharrif and Abdul Rahman)

This condition of ownership is the general rule in Islamic finance. The only difference the

retaining by the lessor the corpus of the asset whilst in trade the buyer acquires ownership.

Given an example of A the lessor leased his property to B the lessee, for any tax expenses to be

paid, A has to pay tax due on the property whilst B takes care of the expenditure associated with

the use of the property.

Accounting Treatment for Operating Ijarah

i) Book of lessor

The IFAS-2 issued by ICAP, as well as, the AAOIFI standard suggest the accounting

treatment of ijarah tasghiliyah is similar to an operating expenses with certain exception. On the

other hand, conventional banks, as well as, Islamic banks currently operating in Pakistan are

accounting are accounting for ijarah as financing transaction, just like finance lease, in

accordance with ISA-17.

Asset is recognized as historical cost and depreciated as per normal depreciation policy

with an expected realizable value at the end. According to AAOIFI standard, these are presented

as Investments in Ijarah Assets, while as per IFAS – 2, these are included in property, plant and

equipment with separate disclosure.


Depreciation has to be calculated in line with the methods allowed by IAS – 16. Most

suitable method is generally the straight line method because the rentals are generally also

accounted for on a straight line basis. Depreciation term shall generally be equal to the lease

term, except where it is expected that the asset will be given on Ijarah again, to same or some

other customer, in which case, the depreciable life shall be equal to the asset’s useful economic

life.

Lease rentals including other associated charges and Ijarah related expenses are

allocated proportionately in financial periods over the lease term. Initial direct cost is

amortized over the lease term. However, IFAS-2 allows that the same may be charged to

income as and when incurred. Repairs undertaken are recognized as expense. According

to AAOIFI Standard, a provision for repairs is established if repairs are material and

differ in amount from year to year.

ii) Book of lessee

The lessee treated the lease asset as the lease rental or lease payment over the lease

period. They did not responsible in any expenditure incurred for the leased asset.

Sale and lease back resulting into ijarah;

• If the sale price is same as that of its fair value any gain or loss shall be

recognized in period in which such transaction occurs; and

• If the sale price is different from its fair value any gain or loss shall be

amortized / allocated as an adjustment to Ijarah expenses over the lease

term.
CONCLUSION

Ijarah is the kind of leasing in Islamic way. Ijarah is not very different from conventional

lease. However it has some differences. First is the rental rate decided at the time of the

agreement and cannot be fluctuate. Secondly, some expenses under ijarah is different between

lessor and lessee. Other than that, for the lessor it is an expenses relating to the corpus of the

asset i.e. insurance, accidental repairs etc. will be borne by the lessor. Actual operating/overhead

expenses related to running the asset will be borne by the lessee. Two contracts into one contract

is not permissible in shariah therefore, we cannot have the agreement of hire and purchase into

one agreement, only we can undertake/promise to purchase the leased asset. Lastly, Ijara rental

can only be charged after possession of asset to the lessee.