Comparison of Leases IAS-17 Vs. Ijarah FAS-8

1-Introduction

Islamic finance is an emerging area in financial literature. Started with establishment of Islamic development bank in 193-74, it has shown a speedy growth and momentum in first decade of 21t century. Global volume of assets under Islamic finance has crossed the figure of US $ 1,289 billion by the end of December 2011. Islamic finance has shown resilience in global melt down and recorded average annual growth of 21% from 2007 to 2011 [IFSL-2012]. and according to an estimate of Islamic development bank ……………… Islamic banking was emerged as a reaction to Haram (prohibited by Islamic law) practices in financial sector including Riba (interest & usury), Gharar (excessive risk) Myser & Qimar (game of chance) and financing for Haram (prohibited) businesses [Examples of prohibited businesses include liquor, pork, pornography, promotion of adultery etc ]. In Pakistan Islamic finance has shown marvelous overall average annual growth of above 65% from 2004-12. At present June 2013, assets of Islamic banking has reached to PKR 903 Billion, deposits PKR 771 Billions and investment & financing PKR 700 Billions with a branch network of 1,115, covering 9% of market share. Accounting discipline has a deep rooted relationship with modern banking. We see due care and concentration of experts on this area of study. At present efforts are in the way to have a global set of accounting standards to make the accounting results relevant and comparable across the globe. Being a special type of finance based upon Islamic law [obligatory following by Muslims], Islamic finance needs accounting guidelines to execute day to day transactions and determine financial rights

and liabilities of parties involved. With the emergence of Islamic finance a separate set of accounting standards was required primarily justified on following grounds/arguments.
• Accounting standards must confirm with Islamic code of life [e.g. prohibition of interest, present value through discounted cash flows etc], a requirement absent in conventional set of accounting standards.
• New forms of business contracts emerged based upon principles of Islamic finance [Murabaha, Musharaka, Diminishing Musharaka, Ijarah, Takaful and PLS deposits etc], which are not taken into account while setting conventional accounting standards.
• Ensuring Shari’a compliance in business dealings [Halal business, interest free operations etc]; which is a unique requirement of Islamic financial institutions only.
• Determination of zaka based upon results of financial reporting is another requirement from Islamic financial institutions which is not addressed in conventional accounting standards.
Keeping in view the industry needs Accounting & Auditing Organization of Islamic Financial Institutions [AAOIFI] was established in 1991 which has done a great job so for. By the end of Nov 2007, 30 Shari’a standards and by June 2008, 23 accounting standards, 5 auditing standards, 6 governance standards and 2 codes of ethics were issued by AAOIFI for the guidance of Islamic Financial Institutions (IFIs). IFIs and conventional banks are working in the same institutional settings. In many countries of the world including Muslim countries common business, corporate and taxation laws are in practice. In fact in numerous countries including Muslim countries required changes in financial laws have yet to be inserted, hence IFIs have to follow the national business, corporate and tax laws resulting in preparation of financial reports according to conventional accounting standards. There is a need to highlight the financial reporting issues of IFIs prepared under conventional accounting standards. This study is intended to contribute in this regard by comparing Ijarah accounting standard FAS-8 and Leasing accounting standard IAS-17.

2-Leasing Vs Ijarah

Leasing and Ijarah are the synonymous concepts used for a business where earnings are made by renting assets. Under this type of business an investor after purchasing the asset hand over the right of use to another person for an agreed amount of rentals payable in lump sum or in installments for a determined tenure. IAS-17 [conventional accounting] and FAS-8 [Islamic Accounting] address the accounting issues of leasing and Ijarah. Both standards are effective from January 1, 1999. Scope of both standards eliminate the lease agreements for extraction and use of natural resources, and licensing agreements including motion pictures, video recordings, plays, manuscripts , patents and copy rights. Traditionally leasing/Ijarah business is divided into two categories of operating and finance lease. In the following paragraphs we have presented similarities and differences in IAS-17 and FAS-8.

Finance Lease/ Ijarah Muntahia Bittamleek
According to Ijarah FAS-8 if legal title of the leased asset transfers to the lessee as a result of Ijarah agreement, it is called Ijarah Muntahia Bitamleek, while according to Leases IAS-17, “ A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred”. In order to determine whether a lease is a finance lease only ownership transfer is not the sole criteria, rather one has to look into economic substance of underlying transaction. Following tests could be very effective in determining the status of a lease [as per IAS-17]. (a) The lease transfers ownership of the asset to the lessee by the end of the lease term; (b) The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised; (c) The lease term is for the major part of the economic life of the asset even if title is not transferred; [Above 66% or 75%] (d) At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; [Above 90%] and (e) The leased assets are of a specialised nature such that only the lessee can use them without major modifications being made. (f) If the lessee can cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee; (g) Gains or losses from the fluctuation in the fair value of the residual fall to the lessee (for example in the form of a rent rebate equaling most of the sales proceeds at the end of the lease); (h) The lessee has the ability to continue the lease for a secondary period at a rent which is substantially lower than market rent. Under FAS-8 only ownership transfer is the deciding factor between operating Ijarah [operating lease] and Ijarah Muntahia Bittamaleek [finance lease], while under 1AS-17 in addition to ownership there are certain other indications which can change the status of lease from operating lease. At the time of leasing an asset to a customer by financial institution, under Ijarah standard [FAS-8], historical value of asset, acquired by financial institution, remains in the balance sheet arising neither profit, nor loss, however under leasing standard [IAS-17], asset is reported as receivable by assigning value of net investment [which is the difference of MLP plus any residual value and Present value of MLP plus any residual value using implicit interest rate]. Practically it is fair value of asset, hence generally there is no difference in value under both standards as under normal course of business financial institution acquires the asset on request of customer, consequently historical cost and fair value is the same. However in case of an asset purchased earlier, difference might arise in fair value and historical cost, hence using the word of fair value is more appropriate than historical cost. Another difference is under IAS-17 asset is reported as receivables [as if it is sold], while under FAS-8 it still remains Investment in Ijarah Assets. Expenses incurred to negotiate a lease contract can either be expensed out immediately or if material can be spread over Ijarah [Lease] term. Also if there is any reduction in value of asset that is debited to income summary account. [IAS-17, FAS-8]. Ijarah Revenue/Lease Rentals are the periodic payments [lump sum payment] made by lessee under a lease agreement in return for right to use the leased asset. Under FAS-8 whatever received as Ijarah revenue should be recognized over Ijarah term proportionately, however under IAS-17 it should be allocated between return of principal and finance income. Under FAS-8 there could be four ways of transferring title to lessee as under. 1) Through gift; (2) Through Sale for a token amount; (3) Through sales prior completion of Ijarah term; (4) Gradual sale. Under Ijarah FAS-8 depreciation is charged by financial institution, while under Lease IAS-17 no depreciation shall be charged by lessor. In all the cases depreciation is charged by lessor except case 4, where lessor’s charge for depreciation decreases while lessee’s charge for depreciation increases gradually. Under gift scheme residual value is zero, under sales, residual value is agreed sales amount, In case of impairment of asset prior to transfer to lessee in all four cases difference of lease payments received and fair market rental value is returned to lessee by lessor. If asset is not taken over by lessee any of the two situations emerge. Either lessee is not obliged to purchase the asset, then asset is revalued and lower of net book value Vs cash equivalent value is reported in balance sheet, consequently any loss arises is reported in income summary account. However if lessee is obliged to purchase and fails in meeting his obligation, and cash equivalent value is lesser than net book value, consequent loss is to be recovered from lessee.

Operating Lease/Ijarah
A type of lease which is not finance lease or Ijarah Muntaha Bittamleek. It is a short term lease whereby ownership risk and reward rest with lessor and lessee is awarded a right to use the asset for agreed lease rentals. There is no difference in treatment of operating leases between Ijarah standard [FAS-8] and leasing standard [IAS-17]

3-Discussions

Under Ijarah FAS-8 asset is recorded at historical cost at the time of inception of lease while fair value is recommended by IAS-17, Hence IAS-17 provides solid foundation for depiction of economic reality which is absent under Ijarah standard. Under normal course of business where an IFI purchases an asset for its customer historical book value and fair value are the same, however there exists other circumstances where fair values apart from book value. E.g an asset purchased in the past; and/or substantial change in the market price occurred due to demand, supply or technological change. Hence it is conclude that IAS-17 is more helpful in depiction of economic reality than FAS-8. Under IAS-17 physical asset is converted into receivables as if it is sold, which is not the case with FAS-8. Under FAS-8 investment account is maintained and depreciated as per normal policy of lessor. Legal position is more supportive to FAS-8 than IAS-17. In fact it is the nature of contract which changes the whole scenario. Under leasing lessor is not responsible for making good the asset or a portion of asset is not workable, while under Ijarah lessor is responsible for maintaining asset in working condition. As for decision to treat a lease as operating or finance, IAS-17 prefers the economic substance over legal form. However once again it is the nature of the contract which binds lessor under Ijarah to follow the legal form instead of economic substance principal. Furthermore even after declaring a lease as Ijarah Muntahia Bittamleek [Finance lease] nothing changes in financial reporting framework under Ijarah FAS-8. As for earning is concerned the amount received as lease rental is treated as revenue and depreciation is treated as an expense of the period under FAS-8 while lease rental is allocated between principal and interest earnings under IAS-17. In case of FAS-8 earnings are appropriated over lease term equally, while under IAS-17 higher earnings in earlier years and lesser in later years. However if an asset is impaired under FAS-8 adjustment to earnings is made to refund the difference of fair market rentals and Ijarah installment received resulting in higher loss charging in the year of adjustment, consequently undue bad picture to be reported as a cost of prosperity depicted earlier. This is not the case under IAS-17 as substantial risk and reward is already transferred to lessee.