ACCOUNTING ISSUES ON IJARAH CONTRACTACCOUNTING ISSUES ON IJARAH CONTRACT

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Topic 4SPRING 2012/2013

UNIVERSITY COLLEGE OF BAHRAIN

FAS 8 (AAOIFI)FAS 8 (AAOIFI)FAS 8 (AAOIFI)FAS 8 (AAOIFI)

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Nature of Ijarah FinancingNature of Ijarah FinancingNature of Ijarah FinancingNature of Ijarah Financing

Ijarah is the ownership of the right to the benefit of using an asset in return for the consideration

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 FinancingNature of Ijarah FinancingNature of Ijarah FinancingNature of Ijarah Financing

ELEMENTS : Offer & Acceptance, Lessor, Lessee Object of the contract rental amount and service

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- continued-- continued-- continued-- continued-

Rent should be contracted (similar to price)Rental payment can be non-monetary and of the same

kind of benefitFlexibility of rental consideration subject to time, place,

distance and usageRental is due upon fulfilling the condition in the contractPrepayment and unearned rent is acceptable

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Duties of Lessor/ LesseeDuties of Lessor/ LesseeDuties of Lessor/ LesseeDuties of Lessor/ Lessee

A. Lessor’s Obligations- Making the leased asset available- Guarantee in respect of defects- Maintenance of the Leased assetB. Lessee’s Obligations- Utilization of leased asset according to contractual

conditions- Rental payment and safeguard asset

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Classification of IjarahClassification of IjarahClassification of IjarahClassification of Ijarah

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IJARAH FINANCING

Operating Ijarah

No transfer of title to lessee

Ijarah Muntahia Bittamleek

Ownership is transferred to

lessee

Types of IjarahTypes of IjarahTypes of IjarahTypes of Ijarah

Operating Ijarah-- Ijarah where the title of assets are not transferred to the

lesseeIjarah Muntahia Biltamleek- Ijarah where title of assets are transferred to the lessee by

way of gift, token price, pre- determined price, equivalent price and gradual transfer of share holding

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Methods of Transfer of Ownership in Methods of Transfer of Ownership in Ijarah Muntahia BiltamleekIjarah Muntahia BiltamleekMethods of Transfer of Ownership in Methods of Transfer of Ownership in Ijarah Muntahia BiltamleekIjarah Muntahia Biltamleek

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Ijarah Muntahia Bil Tamleek

Gift

At the end

Of period

Token price at

End of period price

Equally

Within lease

period

Gradual transfer during lease period

Operating Ijarah: Recognition Operating Ijarah: Recognition Measurement & DisclosureMeasurement & DisclosureOperating Ijarah: Recognition Operating Ijarah: Recognition Measurement & DisclosureMeasurement & Disclosure

Recognition of Ijarah asset upon acquisitionMeasurement of Ijarah asset at historical cost

and any impairment loss as well as depreciation is borne by the lessor

Assets, inclusive of all expenses to acquire, recognised at historical cost

Recognise any permanent reduction in value Presented as Investments in Ijarah assets

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Operating Ijarah recognition , Operating Ijarah recognition , measurement & disclosuremeasurement & disclosureOperating Ijarah recognition , Operating Ijarah recognition , measurement & disclosuremeasurement & disclosure

Ijarah revenue should be allocated proportionately to the financial periods in the lease term

Initial Ijarah direct costs can be amortized if material

Repairs if material can be allocated with provision for repairs

Any repairs undertaken by lessee with lessors consent is an expense in the lessor’s books.

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Recognition of Ijarah Asset & Recognition of Ijarah Asset & IncomeIncomeRecognition of Ijarah Asset & Recognition of Ijarah Asset & IncomeIncome

Dr EquipmentCr Cash

(Cash purchase of equipment for Ijarah Financing)

Dr Ijarah Financing AssetCr Equipment

(Provides Ijarah financing to lessee)

Dr CashCr P&L

( Repayment received from lessee & income recognition)

Dr Depreciation ExpenseCr Accumulated Depreciation – Ijarah Financing asset

( Depreciation cost of Ijarah Financing asset)

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Ijarah Muntahia Biltamleek: Ijarah Muntahia Biltamleek: Recognition, Measurement & Recognition, Measurement & DisclosureDisclosure

Ijarah Muntahia Biltamleek: Ijarah Muntahia Biltamleek: Recognition, Measurement & Recognition, Measurement & DisclosureDisclosure

Ijarah Muntahia Bittamleek Lease payments are usually higher in this form

compared to operating ijarah Revenue, initial cost and repairs expense rules remain

the same as operating ijarah

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Acquiring Ownership through Acquiring Ownership through Gift:Gift:Acquiring Ownership through Acquiring Ownership through Gift:Gift:

Assets acquired for ijara shall be recognized & measured as treated in operating lease above.

At beginning of period:Leased assets shall be presented in Statement of Financial

Position under heading “ Ijara Muntahia Bitamleek Assets”.Leased assets shall be measured at Book Value. Initial direct cost shall be accounted for as same as its

treatment in operating lease.

Cont.Cont.Cont.Cont.

Ijara Revenue:

To be accounted for as treatment in operating Lease.

Repairs of Leased Assets:

To be accounted for as the treatment in operating lease.

At end of Financial Period:At end of Financial Period:At end of Financial Period:At end of Financial Period:

Same treatment as above for Amortized Initial Direct Cost, Provision for Repairs & Ijara Installments Receivable.

However, in calculating depreciation of leased assets Residual Value shall be zero.

Acquiring Ownership For Token Acquiring Ownership For Token or amount specified in Contract:or amount specified in Contract:Acquiring Ownership For Token Acquiring Ownership For Token or amount specified in Contract:or amount specified in Contract:

Same accounting treatment as operating lease regarding:Recognition & measurement of assets acquired for

lease. Initial Direct Cost, Repairs & Revenues.

Leased assets shall be presented in Statement of Financial Position under “Ijara Muntahia Bitamleek Assets”.

At end of Financial Period:At end of Financial Period:At end of Financial Period:At end of Financial Period:

Same accounting treatments as the operating lease regarding:

Recognition of Amortized Initial Direct Cost, Provision for repairs, and measurement of Ijara Installments Receivable.

At end of Ijara Term:At end of Ijara Term:At end of Ijara Term:At end of Ijara Term:

Legal title passes to lessee after paying all Installments and Purchase price.

If lessee refuses to buy & he is not obliged to fulfill his promise, then:

Asset shall be presented in Statement of Financial Position under, “Assets Acquired for Ijara”.

Shall be valued at “Cash Equivalent Value” or “Net Book Value” whichever is lower.

Difference between two amounts shall be recognized as loss in period in which it occurs.

Cont.Cont.Cont.Cont.

If lessee is obliged to fulfill his promise and he decided not to do so and Cash Equivalent Value is lower than Net Book Value, the difference shall be recognized as Receivable Due from lessee.

Acquiring Ownership for Acquiring Ownership for Remaining Installments:Remaining Installments:Acquiring Ownership for Acquiring Ownership for Remaining Installments:Remaining Installments:

Same Accounting treatment as operating jjarah regarding:

Assets acquired for Ijara (Recognition, Measurement & Presentation).

Ijara Revenue, Repairs of asset, Depreciation, Initial cost & permanent material reduction in value of asset.

Cont.Cont.Cont.Cont.

Sale of Leased Asset:

Title shall pass when lessee pays remaining installments prior to end of lease term.

Remaining Installments shall be the Price to acquire leased asset.

Lessor (bank) shall recognize any Gain or Loss resulting from difference between Selling Price & Net Book Value.

Acquiring Ownership through Acquiring Ownership through Gradual Sale:Gradual Sale:Acquiring Ownership through Acquiring Ownership through Gradual Sale:Gradual Sale:

Same Accounting Treatments as above for:

Assets acquired for Ijara (Recognition, Measurement & Presentation).

Leased Assets (presentation & Measurement).

Ijarah Muntahia Biltamleek Vs Ijarah Muntahia Biltamleek Vs Finance LeaseFinance LeaseIjarah Muntahia Biltamleek Vs Ijarah Muntahia Biltamleek Vs Finance LeaseFinance Lease

Ijarah Muntahia Biltamleek Asset reported in the lessor’s

books depreciated Maintenance costs borne by the

lessor Ijarah revenue is not divisible

Finance leaseFinance lease is reported

as receivablesNo depreciation &

maintenance costs is borne by the lessee

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Some remarks……Some remarks……Some remarks……Some remarks……

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 (incidental 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 in Al-Ijara Thumma al-bay’ , on the other hand AAOIFI adopted Ijarah Muntahia Bitamleek

•04/21/23

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• Bank Muamalat entered into an ijarah muntahia bit tamleek with Ali & Co to finance the purchase of factory machinery which runs on gas at $400,000. The terms are as follows:

– Rental payment is $50,000 semi-anually for 5 years

– The salvage value at the end will be $50,000

– Ownership is to be transferred at $20,000

• During the ijarah period, Ali & co paid the following expenses related to the machine:

– Takaful Insurance in year 3 and 4 for fire and theft, respectively $4,000 and $6,000

– Machine broke down for 6 months & was repaired for $25,000

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• Bank Muamalat also had to pay certain expenses:

– Legal expenses of $10,000 before signing the contract, which is considered material

– Takaful expenses for year 1, 2 and 5 for fire and theft for $5,000

• Make the journal entries for Bank Muamalat!

• Make and extract of the balance sheet and income statement

04/21/2328

Dr. Machinery 400,000

Cr. Cash 400,000

Dr. Ijarah Muntahia bittamleek 400,000 Cr. Machinery 400,000

Dr. Deferred cost 10,000

Cr. Cash 10,000

04/21/2329

Dr. Cash 100,000

Cr. Ijarah revenue 100,000

Dr. Takaful Expense 5,000 Cr. Cash 5,000

Dr. Depreciation Exp 70,000 Cr. Acc Depreciation 70,000

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Dr. Amortization exp 2,000

Cr. Deferred Cost 2,000

04/21/2331

Dr. Cash 100,000

Cr. Ijarah revenue 100,000

Dr. Takaful expense 5,000 Cr. Cash 5,000

Dr. Depriciation expense 70,000 Cr. Accumulated Dep 70,000

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Dr. Amortization exp 2,000

Cr. Deferred cost 2,000

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Dr. Amortization Exp 2,000

Cr. Deferred Cost 2,000

Dr. Deprication expense 70,000 Cr. Accumulated Dep 70,000

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Dr. Cash 96,000Dr.Takaful Expense 4,000

Cr. Ijarah Revenue 100,000

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Dr. Cash 94,000

Dr.Takaful Expense 6,000 Cr. Ijarah revenue 100,000

Dr. Deprication expense 70,000 Cr. Accumulated Dep 70,000

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Dr. Amortization Expense 2,000

Cr. Deferred Cost 2,000

04/21/2337

Dr. Amortization Exp 2,000

Cr. Deferred Cost 2,000

Dr. Takaful expense 5,000 Cr. Cash 5,000

Dr. Depreciation expense 70,000 Cr. Accumulated Dep 70,000

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Dr. Acc depreciation 350,000Dr. Cash 20,000Dr. Loss on disposal 30,000 Cr. Ijarah muntahia bittamleek 400,000

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Dr. Cash 25,000Dr. Repair Exp 25,000 Cr. Ijarah Revenue 50,000

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1 2 3 4 5Ijarah muntahia Bittamleek 400 400 400 400 400

( Acc Depreciation ) 70 140 210 280 350

Net 330 260 190 120 50

Deffered Cost 10 8 6 4 2

( Amortization ) 2 2 2 2 2

Net 8 6 4 2 0

Extract of Balance Sheet

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1 2 3 4 5

Ijarah revenue 140 100 100 100 50

( Takaful expense ) 5 5 4 6 5

( Amortization ) 2 2 2 2 2

( Depreciation ) 70 70 70 70 70

( Repair expense) 25

Loss on Sale ( 30 )

Net Revenue 62 23 24 22 ( 82 )

Extract of Income Statement

•ACCOUNTING QUESTIONS &

ANSWERS ON IJARAH

Ijarah Accounting Question 2Ijarah Accounting Question 2Ijarah Accounting Question 2Ijarah Accounting Question 2

Bank Sharia Malaysia Berhad has entered into and ijarah contract with Ummah Shd.Bhd. To lease an equipment for a period of 5 years. Bank Sharia purchased the equipment from a trader on the 1st of January for RM180,000 and incurred custom duty of RM20,000. The bank also incurred legal fees of RM5,000 which is considered to be material.

Both parties agree installments should be paid every quarter, of RM5,000 per month. The net realizable value of the equipment at the end is expected to be RM20,000

In year one Ummah found technical default in the equipment and incurred RM10,000 to retain its full working order. Every year, routine maintenance costs were RM500.

Ijarah Accounting Question 2 Ijarah Accounting Question 2 continuedcontinuedIjarah Accounting Question 2 Ijarah Accounting Question 2 continuedcontinued

The transaction is an ijarah muntahia bit tamleek through sale for a token consideration, agreed to 50% of the estimated residual value at the end of the useful life

Prepare the journal entries only for the following periods: At the beginning On receipt of the 1st rental At the end of a 1st year At the end of the ijarah term

Compute the profit of the ijarah financing from throughout the period!

Journal Entry – Beginning Journal Entry – Beginning Journal Entry – Beginning Journal Entry – Beginning

Dr. Equipment 200,000Cr. Cash

200,000

• Dr. Ijarah Muntahia bittamleek 200,000• Cr. Equipment

200,000

• Dr. Deferred Cost 5,000• Cr. Cash 5,000

Journal Entry – On receipt of the 1st Journal Entry – On receipt of the 1st paymentpayment

Journal Entry – On receipt of the 1st Journal Entry – On receipt of the 1st paymentpayment

Dr. Cash 15,000Cr. Ijarah Revenue 15,000

Journal Entry – The end of Year 1Journal Entry – The end of Year 1Journal Entry – The end of Year 1Journal Entry – The end of Year 1

Dr. Cash 5,000Dr. repair expense 10,000Cr. Ijarah revenue 15,000

• Dr. Amortization Exp 1,000• Cr. Deferred Cost

1,000

• Dr. Depreciation Expense36,000• Cr. Acc Depreciation 36,000

Journal Entry - End of Journal Entry - End of IjarahIjarah term termJournal Entry - End of Journal Entry - End of IjarahIjarah term term

Dr. Amortization exp 1,000Cr. Deferred Cost 1,000

• Dr. Deprication exp 36,000• Cr. Acc Depreciation 36,000

Journal Entry - End of Journal Entry - End of Ijarah Ijarah term term continuedcontinued

Journal Entry - End of Journal Entry - End of Ijarah Ijarah term term continuedcontinued

• Dr. Cash 15,000• Cr. Ijarah Revenue 15,000

• Dr. Acc Depreciation 180,000• Dr. Cash 10,000• Dr. Loss of Sale 10,000• Cr. Ijarah muntahia bittamleek

200,000

•Extract of Income statement

Profit for year 1Ijarah revenue 60,000Less : Cost

Initial direct cost (1,000)Repair cost (10,000)Depreciation (36,000)

4,000

•Extract of Income Statement continued

Year 2-4 (annual)Ijarah revenue 60,000Less : Cost

Initial direct cost (1,000)Depreciation (36,000)

23,000

•Extract of Income Statement continued

Year 5Ijarah revenue 60,000Less : Cost

Initial direct cost (1,000)Loss on Sale (10,000)Depreciation (36,000)

13,000

Thank YouThank YouThank YouThank You

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