Question 4 (a): Discuss the financial reporting problems of accounting for ijarah muntahia bittamleek, where the transaction

in substance is a financial lease, due to the clash between International Financial Reporting Standards and AAOIFI accounting standards. (10 marks) The study found that there are major differences as to the nature of leasing and Ijarah, and as a result accounting principles that have driven all the three standards as well as accounting techniques developed for leasing and Ijarah are significantly different. Ijarah Muntahia Bittamleek is one that ends with ownership. In this type the financial institution purchases the asset base on a promise to a customer. Because the customer promises to have the asset, the asset will not be go back to the financial institution at the end of the lease period, like it is in the case of an operational lease, but as a substitute will be bought by the lessee. According to the AAOIFIs standard on Ijarah states that when a lease does not include a promise that a legal title will pass to the lessee, it is classified as Operating Ijarah and if there is a promise it is Ijarah Muntahia Bittamleek. The promise of the lessor to transfer the ownership of the leased asset to the lessee in the Ijarah Muntahia Bittamleek is not the same as the substance over form rule as in the IAS 17 and the MASB 10.

In the conventional lease, the referred component relates to the risk and reward incidental to ownership of the leased asset. In Ijarah, the lessor holds the ownership rights and obligations from the very beginning till the end of the contract. The lessor must accept responsibility for any defects of the leased asset, which impair the intended use of the asset, and may not exclude his liability for any impairment that the leased property may sustain. But the impairment caused by the lessees misconduct is not borne by the lessor but by the lessee himself. However, maintenance costs should be taken from the lessors pocket since it is his duty to maintain the asset. Juristic Rules 1/6 sums up the above principles where it states, the lease property is the responsibility of the lessor throughout the duration of the Ijarah, unless the lessee commits misconduct or negligence.

As for the right of the lessor, 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 Shariah. He must also avoid causing damage to the leased asset by misuse through misconduct or negligence.

Therefore, in the Ijarah agreement, the ownership rights and usufructary rights are treated differently as they are detachable according to Islamic commercial law. In contrast, there seems to be no distinction made between ownership rights and usufructary rights by the IAS 17 and the MASB 10. In other words, there can never be a transfer of ownership risk in the Ijarah contract as it deals only with the transfer of usufruct. In the case of Ijarah Muntahia Bittamleek, transfer of ownership only takes place when both parties enter into a contract separate from the Ijarah contract (see AAOIFI FAS 8 Juristic Rule 2/3). The second contract is drawn up when the promise is fulfilled.

Between the AAOIFI FAS 8, the IAS 17 and the MASB 10, the major differences are the revenue recognition and the effect of residual value since the contracts of Ijarah and lease are different in their substance. In addition, the IAS 17 reminds the lessor to record the uncertainties of collectability of lease rentals income and the future level of interest rates. As for the AAOIFI, no provision is recorded on interest rate uncertainty because the rental is fixed throughout the Ijarah term or the terms of payment are determined up front and the lessor cannot increase the rent unilaterally.

Furthermore, the AAOIFI does not mention the provision for doubtful debt in the case of Ijarah, as it might be understood that the provision is commonly practiced but the AAOIFI recommends the financial institutions to establish a provision for the repair of leased assets if the repair expenses differ from year to year over the lease term. This provision is significant under the Ijarah contract because ownership risk is borne by the lessor. Not recording the provision would underestimate the lessors obligation.

Nevertheless, the AAOIFI is also concerned about the recording of the transaction of permanent impairment of the leased asset before the legal title is passed to the lessee. If that was due to the lessees actions and the installment paid was more than

the fair rental amount, then the lessor has to record the transaction as his liability and recognize it as a loss, which will be posted to the income statement. No such emphasis was given in the IAS 17 or the MASB 10.

On the issue of disclosure, all standards require the major class of assets of accumulated depreciation to be stated. In the IAS 17 as well as in the MASB 10, the method for income recognition and future minimum lease payment to be received for specified future payment must be disclosed. However, in the AAOIFI, since only one method of income recognition is recommended, no such disclosure is needed. In addition, a unique requirement in the AAOIFI disclosure is that lease assets for operating Ijarah and Ijarah Muntahia Bittamleek are to be distinguishable whereby assets for operating Ijarah are recorded as investment in Ijarah assets while assets for Ijarah Muntahia Bittamleek are recorded as Ijarah Muntahia Bittamleek assets.

According to FAS 8 formulated by AAOIFI requires that both assets rented on the basis of Ijarah and IMB to be recorded in the books of the lessor. The two categories of assets should be shown in the Statement of Financial position under the heading investments in Ijarah assets and Ijarah Muntahia Bittamleek Assets respectively on initial recognition at cost and at book value there after depreciation expense is recorded by the lessee under conventional leasing bt in Ijarah it is done by the lessor. It shall be on the basis of the depreciation policy of the lessor, in calculating the depreciation of Ijarah Bittamleek Assets residual value is taken as zero, if the lessee acquisition of ownership at the end of the period is through gift. On the other hand if the transfer to the lessee is at a token or amount specified in contract, the said amount should be subtracted in determining the depreciable cost.

Installments of forms, i.e. Ijarah and IBM should be presented in the income stateme nt of the lessor as Ijarah Revenue on accrual basis allocated proportionately according to the term of the lease recognized in the period in which they are due. Where the lessee acquires title through gradual sale the revenue decreases progressively. The Ijarah installment paid is presented in the lessees income statement as Ijarah expense allocated over the lease period recognized when due under both form of Islamic leases IAS 17.