“THE IJARAH ACCOUNTING HEADACHES FOR THE

AUDITOR IN AAOIFI JURISDICTION – FINANCIAL

REPORTING STANDARD (FRS) VERSUS ACCOUNTING

AND AUDITING ORGANIZATION FOR ISLAMIC

FINANCIAL INSTITUTIONS (AAOIFI)”

Ahmad Bin Zainal Abidin, Management Centre, International Islamic University Malaysia,

Jalan Gombak, 53100 Kuala Lumpur, Malaysia. ahmad.zainalabidin@yahoo.com

Abstract

The hire purchase (Ijarah) business in Malaysia has a unique governance structure. There are few government agencies and ministries involved in overseeing and regulating the practice.

Besides, the most common Ijarah product offered in Islamic Banks in Malaysia, Al Ijarah

Thumma Al Bay’ (AITAB), is governed by Hire Purchase Act 1967 and Financial Reporting

Standard (FRS) 117 on Leases. It is good to mention that the ultimate goal of this paper is to investigate on the issues of Ijarah accounting, together with the issues related to Ijarah

product which affect the auditors in completing their everyday tasks. In achieving the

objectives, this paper will be divided into four parts which in sequence, Part I will discuss on

the basic principles of AITAB and Ijarah Muntahiah Bitamleek which then will be brought

into discussion, Part II, about the different accounting implications between them which

headaches the auditor in Islamic Financial Institutions. All the discussion are very much

related and referred to FRS 117 on Leases, Shari’ah Standard, and Accounting, Auditing and

Governance Standard issued by Accounting and Auditing Organization for Islamic Financial

Institutions (AAOIFI) in Bahrain. Furthermore, this paper also not restricted to provide the

theoretical part of study only, thus practical part also been included for discussion, where

applicable. In addition to that, the concept of „substance over form‟ and „form over substance‟ as well as the vital elements of AITAB under Hire Purchase Act 1967 will be included, in

Part III and Part IV, respectively. In every part of the paper, the analysis and findings will

straight away be discussed in order to get clearer picture on every issue. It is noted at the end

(in Conclusion Part), that the Standard and the Act that govern the Ijarah product in Malaysia

are among the main causes that bring headache to the auditors.

The author would like to acknowledge the comments and insightful information made by

Associate Professor Dr Muhammad Akhyar Adnan, the lecturer in Department of Accounting,

Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia.

INTRODUCTION

Definition

Ijarah comes from the root word ajr, which means compensation and at the same time, it

means the sale of usufruct.1 Meanwhile, according to Hanafi School it is a contract that

enables possession of a particular intended usufruct of the leased asset (Ayn) for a consideration. Some jurists stipulated that the usufruct from the leased asset should be

intended while others explained that what are meant by it are considerable intentions in light

of Shari’ah and reasoning and not mere intentions.

Maliki School of Fiqh defined it as a contract which relates to permissible usufructs for a particular period and a particular consideration not arising from usufruct and Shafie School of

Fiqh defines it as a contract for a defined intended usufruct liable to utilization and

accessibility for a particular recompense. While, Hanbali School of Fiqh defines it as a

contract for a particular permissible usufruct which is taken gradually for a particular period

and a particular consideration.2

Though there are various definitions of Al-Ijarah given by the scholars of jurisprudence via

their school of thoughts, it is agreed that this is a contract on using the benefits or services in

return for compensation.

The definition of Ijarah according to AAOIFI (FAS 8) is “the ownership of the right to the

benefit of using an asset in return for consideration”. While in Financial Reporting Standard

117 (“FRS 117”), a lease is “an agreement whereby the lessor conveys to the lessee in return

for a payment or series of payments the right to use an asset for an agreed period of time”.

In addition to the given definition above, Justice Muhammad Taqi Usmani considering Ijarah

into two types of situation, which in this case of discussion is more relevant for the second

situation whereby, Ijarah can be said as relates to the usufruct of assets and properties, not to

the services of human being like in the first situation mentioned in the book entitled Islamic

Finance. Ijarah means „to transfer the usufruct of a particular property to another person in

exchange for rent revenue claimed from him‟.3 In this case, the word Ijarah is more or less is the same with the English word of „Leasing‟.

In summarizing all the definitions, Ijarah is a leasing of property pursuant to a contract under

which a specified permissible benefit in the form of a usufruct is obtained for a specified

period in return for a specified permissible consideration.

The Development of Ijarah in Malaysia

The hire purchase business in Malaysia has a unique governance structure. There are few

government agencies and ministries involved in overseeing and regulating the practice. The

most significant role is played by Ministry of Domestic Trade and Consumerism which has

exclusive jurisdiction over hire-purchase businesses. Any substantial issue should be referred

to this ministry4.

Almost all banks provide Al Ijarah Thumma Al Bay’ (AITAB) for vehicle financing, except

Bank Pembangunan and HSBC which utilize AITAB for financing of machinery and

industrial goods. Banks like Maybank Islamic Bank, AmIslamic Bank, Affin Islamic Bank

1 Course material for Fiqh Muamalah in Banking and Finance, page 64 2 Dr Abdul Sattar Abu Ghuddah, Ijarah (Lease), Al-Baraka Banking Group (ABG),

Department of Research and Development. 3 Chapter on Ijarah, An Introduction to Islamic Finance, page 157 4 Dr. Nurdianawati Irwani Abdullah and Dr. Asyraf Wajdi Dusuki, A Critical Appraisal of

Ijarah Thumma Al-Bai’‟ (AITAB) operation: Issues and Prospects, 4th International Islamic

Banking and Finance Conference, Monash University, Malaysia.

and Bank Muamalat offers AITAB for individual and corporate customers. Other banks like

Affin Islamic Bank, Bank Rakyat, EONCAP Islamic Bank, Hong Leong Islamic Bank, Public

Bank and RHB Islamic Bank put sole concentration on vehicle financing due to increasing

demand from the public and corporate customers. On the other hand, Bank Islam and OCBC

tend to offer a rather different hire purchase mechanism to corporate customer which is known

as Ijarah Muntahiah Bitamleek. This development is summarized in a simple picture in

TABLE 1 (please refer to APPENDIX).

AITAB appeals to many Islamic financial institutions partly due to its favorable features based

on asset-backed transactions and its relative liquidity5. This is particularly true especially

when the value of the capital goods r equipment itself is grounded in tangible property and

hence, promoting a sense of security. Furthermore, as it does not involve debt or interest-

based lending, AITAB is conveniently accepted as a Shari’ah compliant instrument. One of

the advantages of being an asset-backed transaction is that, if the asset is of high quality, the

bank may not have to rely so much on the creditworthiness of the customer. This allows a

relatively weaker creditworthiness customer to obtain Ijarah financing.

Types of Ijarah

Islamic banks use the lease for the usufruct as an instrument of financing. The bank purchases

the asset and rents it out to the customer in return for rental. The bank uses two models of Ijarah namely Operational Lease and Finance Lease.

Operational Lease

The bank 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 will be returned to the bank. The bank then,

leases the same asset to a new lessee and at the same time bears the risk of recession or

diminishing demand for these assets. After all, the bank may choose to scrap or dispose the

asset.

Operational lease is suitable for assets which are expensive and the purchases require a significant amount of money such as aeroplanes, ships, industrial equipments and agricultural

machineries. In addition, it takes longer time to manufacture it. This is due to the fact that

there is increasing demand for leasing these assets. The bank benefits from the transaction by

retaining the ownership of the asset while at the same time gets a return by leasing it. The

lessee also benefits from the transaction as it meets his immediate need and saves him from

buying the asset at a much higher cost.

Finance Lease

It refers to a type of Ijarah that ends with ownership. Here the bank purchases the asset based

on a promise from a customer. The customer promises to own the asset and hence, the asset

will not be returned to the bank at the end of the lease period, like in the case of operational

lease, and will be bought by the lessee. The rental is calculated based on the value of the asset which is financed, amount of profit, and the period of financing.

Operational lease is different from financial lease in a way that the former does not offer an

option to the customer to buy the leased asset at the end of the lease period while in the latter

the option is offered. If a lessee chooses to buy the asset a new contract will be concluded. All

the lease rentals previously paid will constitute part of the price.

5 Nurdianawati Irwani Abdullah and Asyraf Wajdi Dusuki (2006), Customer‟s Perception of

Islamic Hire Purchase Facility in Malaysia, IIUM Journal of Economics and Management,

IIUM.

PART I: IJARAH MUNTAHIAH BITAMLEEK AND AL IJARAH THUMMA AL BAY’

(AITAB)

Ijarah Muntahiah Bitamleek

Ijarah Muntahiah Bitamleek can best define as a lease that concludes with the legal title in the

leased asset passing to the lessee.6 In other words, Ijarah Muntahiah Bitamleek involves a lease with an expected transfer of ownership at the end of the lease period 7 with few methods

of transferring of ownership by means of token or the remaining amount, or by giving it as a

gift, or by gift contingent on a particular event like upon the payment of the remaining

installments.8

In better illustrating and understanding the structure of Ijarah Muntahiah Bitamleek, the below

illustration can best refer to: -

Diagram 1

Al Ijarah Thumma Al Bay’ (AITAB)

Al Ijarah Thumma Al Bay’ (AITAB) is the innovation of Islamic hire purchase mode of

financing. Islamic hire purchase is a unique contract involving a combination of leasing

(Ijarah) and sale at different stages of transactions, thus invoking a number of jurists, legal

and practical issues.

AITAB combines a lease contract and sale contract in one trading document, but the contract

of leasing and sales works separately. First the contract of leasing will operate, whereby the

lessee will pay monthly rental to the lessor within a fixed period. Upon the end of the leasing

period, the hirer (lessee) has the option to enter into a second contract to purchase the goods

from the owner (lessor) at an agreed-upon price. The price is based on market condition, goods and necessary profit to the bank.9 The purchase price cannot be predetermined at the

beginning of hire purchase agreement, because a predetermined contract is clearly prohibited

by Shari’ah.

6 Thesis on Exploratory Study of Ijarah Accounting Practices in Malaysia 7 Thesis on Reporting of Lease Asset from an Islamic Perspective 8 Chapter 11: Ijarah - Leasing, Understanding Islamic Finance, page292 9 Issues of Implementing Islamic Hire Purchase in Dual Banking Systems: Malaysia

Experience, Thunderbird International Business Review, page 228

The validity of the arrangement of AITAB, as agreed and allowed by a large number of

contemporary scholars and is widely acted upon by the Islamic banks and financial institutions,

is basically underlying upon these two basic conditions:10

Firstly, the agreement of Ijarah in AITAB itself should not be subjected to signing the

promise of sale or gift (at the end of the lease period), but the promise should be recorded in a separate document. In other words, there must be two different agreements or contracts in

AITAB whereby the initial one is a lease (Ijarah) contract and the next is a sales (Bay’’)

contract. Thus, that is the best reason why it is called as Al-Ijarah Thumma Al-Bay’’.

Secondly, the promise should be unilateral and binding on the promisor only. It should not be

a bilateral promise, whereby the promise is binding on both parties because in this case, it will

be a full contract affected to a future date which is not allowed in the case of sales (Bay’’) or

gift (Hibah). As the second contract in AITAB involves the contract of sales (Bay’’), it is not

allowed in Shari’ah to make the promise binding on both parties or unilateral because it will

affect the validity of the contract and at the same time, giving harm to the promisee to abide to

the promise.

Diagram 2

Ijarah Muntahiah Bitamleek and Al Ijarah Thumma Al Bay’ (AITAB): Similarities and

Differences The mechanisms that are almost similar to operating leases and finance leases in daily

practices are Ijarah and Al Ijarah Thumma Al Bay’ (AITAB), respectively. Other terms used

for finance lease are Ijarah Wa Iqtina’ and Ijarah Muntahiah Bitamleek.

The basis of finance lease is similar to AITAB. This mechanism is a development of the

principle of Ijarah which is in the nominee contract as it is more of a feature of financing.

Unlike the first instrument, it gives a choice to the musta'jir (lessee) at the end of the Ijarah period whether to buy the asset or to dispose of it. If the musta'jir chooses to buy the asset, a

new contract will be drawn up.

10 Chapter on Ijarah, An Introduction to Islamic Finance, page 176

The differences between AITAB and Ijarah Muntahiah Bitamleek can be looked at the mode

of transferring the ownership at the end of the period and the basic regulations governing these

two. In AITAB, the transfer of ownership to the customer at the end of the AITAB facility

will be done by the way of sales. Both parties, the financier as the owner of the asset and the

customer as the hirer, will enter into a sale contract to execute the transfer.

While, Ijarah Muntahiah Bitamleek is a lease that concludes with the legal title in the leased

asset passing to the lessee at the end of the contract period. Ijarah Muntahiah Bitamleek has

different kind of transferring the asset, as mentioned by AAOIFI FAS 8.

It includes:

a) Ijarah Muntahiah Bitamleek through gift (transfer of legal title for no consideration).

b) Ijarah Muntahiah Bitamleek through transfer of legal title (sale) at the end of a lease for

a token consideration or other amount as specified in the lease.

c) Ijarah Muntahiah Bitamleek through transfer of legal title (sale) prior to the end of the

lease term for a price that is equivalent to the remaining Ijarah installments.

d) Ijarah Muntahiah Bitamleek through gradual transfer of legal title (sale) of the leased

asset.

AITAB is operated on the basis of conventional concepts because presently, there is no

written Shari’ah law which specifically regulates the operation of AITAB. The only existing

regulatory Shari’ah rules on the facility can be found in Shari’ah Rules for Investment and

Financing Instruments, Accounting and Auditing Organization for Islamic Financial

Institution (AAOIFI). In Malaysia, because there is no specific regulations governing AITAB,

institutions offering this facility tend to impose rules in the spirit of Hire-Purchase Act 1967

and Contract Act 1950. For the accounting standard, AITAB is following the Financial

Reporting Standard 117 on Leases. The following legislation may have effect on certain terms

of the AITAB Agreement.

i. Hire Purchase Act 1967

ii. Road Transport Act 1987

iii. The Income Tax Act 1967

iv. Income Tax Leasing Regulations 1986

v. Takaful Act 1984

vi. Factories and Machinery Act 1967

The bearing of these legislations on the agreement will depend on the nature and type of the

goods, their usage and etc (Ramli and Onn, 2007).

AAOIFI has issued a Financial Accounting Standard No. 8 on Ijarah and Ijarah Muntahiah Bitamleek. It discussed the accounting treatments from the book of lessor and lessee.

Furthermore, AAOIFI has also issued a Shari’ah Standard No. 9 on Ijarah and Ijarah

Muntahiah Bitamleek. While, in this standard, it discusses the Shari’ah issues related to Ijarah

and Ijarah Muntahiah Bitamleek. Hence, all Ijarah Muntahiah Bitamleek products are

governed by both standards issued by AAOIFI.

PART II: THE IJARAH ACCOUNTING ISSUES, ANALYSIS AND

FINDINGS

Overview

When Bank Islam Malaysia Berhad (BIMB), first opened its door to public, it adopted the

cash accounting concept. However, when Bank Negara Malaysia (BNM) allowed the

conventional banks to participate and offered Islamic banking facilities as part of their

business, the accounting policy slowly changed from cash accounting to accrual accounting concept. This is due to the conventional banks that are adopting accrual concept in all of the

products. Similar to conventional practice, the Islamic Banking accounts must also be

prepared in accordance with the approved accounting standards.

Malaysian Accounting Standards Board (MASB) has come out with FRSi-1 on Presentation of

Financial Statements of Islamic Financial Institutions, which states that all companies

practicing Islamic banking must disclose the Islamic banking activities separately from the

conventional activities. This has become effective since January 2004. However, conventional

methods of accounting should be followed in the absence of any specific standards in the

Islamic Accounting Standards. Currently, MASB is actively looking for the best practice of

accounting methods to suit all the Islamic Banking operations.

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has also

issued an accounting standard, Financial Accounting Standard No. 8 on Ijarah and Ijarah

Muntahiah Bitamleek. It discussed the treatments of an Ijarah transaction from the book of

lessor as well as the lessee. Unlike the MASB or FRS standard which is mandatory to be

followed, the AAOIFI standards are merely a voluntary action by the Islamic Financial

Institutions.

The Treatment under FRS 117 – Leases

In Malaysia, the accounting standard that prescribes accounting treatments for leases is FRS

117.11 FRS 117 should be applied for annual periods beginning on or after 1 October 2006.

However, early adoption is encouraged and an entity that applies FRS 117 for a period before the commencement date, it should disclose that fact. In addition, the accounting treatments for

Islamic Hire Purchase (HP-i) or AITAB will be treating similar and following the general

guidelines of FRS 117.

FRS 117 is applicable to all leases except the following:12

Lease agreement for exploration of natural resources; and

Lease agreement for such items as motion picture films, plays and copyrights;

FRS 117 is also not applicable to the measurement issue in relation to the following:

Lease agreement for investment property (which is to be covered under FRS 140

(Investment Property), and

Lease agreement for biological assets (covered under IAS 41 Agriculture)

Classification and Recognition of Leases under FRS 117

FRS 117 classifies all leases, for accounting purposes, into two broad categories:13

1. Operating leases, and

2. Finance leases.

The criterion used in the classification is the extent to which risks and rewards incident to the

ownership of a leased asset lie with the lessor or the lessee.14 Risk incident to ownership

11 FRS 117 Leases, A Practical Guide to Financial Reporting Standards (Malaysia), page307. 12 Para 2, FRS 117, Malaysian Accounting Standards Board 2005. 13 Para 8, FRS 117, Malaysian Accounting Standards Board 2005.

include the possibility of losses from idle capacity or technological obsolescence and that of

variations in return due to changing economic conditions. Rewards incident to ownership may

be represented by the exception in value.

Under FRS 117, a lease is classified as finance lease if, regardless of its legal form, it transfers

substantially all the risks and rewards incident to ownership from the lessor to the lessee.15 A lease that does not transfer substantially all the risks and rewards incident to ownership from

the lessor to the lessee is classified as an operating lease.

FRS 117 does not operationally the concept of „transfer of substantially all risks and rewards

incident to ownership‟. However, it does provide examples of situations where a lease would

normally be classified as a finance lease, as follows: 16

The lease transfers ownership of the asset to the lessee by the end of the lease

term;

The lease contains a bargain purchase option;

The lease term is for the major part of the useful life of the asset;

The present value of the minimum lease payments (excluding executory costs) is greater than or equal to substantially all of the fair value of the asset; and

The leased assets are not of a specialized nature such that only the lessee can use

them without major modification being made.

FRS 117 further lists indicators of situations which individually or in combination could lead

to a lease being classified as a finance lease, as follows: 17

If the lessee can cancel the lease, the lessee‟s losses associated with the

cancellation are borne by the lessee;

Gains or losses from the fluctuation in the fair value of the residual value fall to

the lessee; and

The lessee has the ability to continue the lease for a secondary period at a rent which is substantially lower than market rent.

The journal entries to record the lease in the lessee book for the period would be as follows:

Beginning of the transactions:

Dr Leased equipment

Cr Leased payable

(Record the finance lease)

At the end of the accounting period:

Dr Lease payable Dr Interest expense

Cr Cash

(Record lease payment)

Dr Depreciation expense

Cr Accumulated depreciation

(Record depreciation expense)

The journal entries to record the lease in the lessor book for the period would be as follows:

Beginning of the transactions:

14 Para 7, FRS 117, Malaysian Accounting Standards Board 2005. 15 Para 8, FRS 117, Malaysian Accounting Standards Board 2005. 16 Para 10, FRS 117, Malaysian Accounting Standards Board 2005. 17 Para 10, FRS 117, Malaysian Accounting Standards Board 2005.

Dr Lease receivable

Cr Unearned interest income

Cr Machinery

(Record the finance lease)

At the end of the accounting period:

Dr Cash

Cr Executory expenses payable

(Record receipt of executory costs)

Dr Cash

Cr Lease receivable

(Record receipt of lease payment)

Dr Unearned interest income

Cr Interest income

(Recognize interest income)

The Treatment under AAOIFI

The Accounting Standards Committee has reviewed a number of alternatives and in particular

the alternatives proposed in the preliminary study18 to be adopted in the accounting treatments

of Ijarah and Ijarah Muntahiah Bitamleek. The Accounting Standards Committee

recommended the adoption of the alternatives which were considered to be in compliance with

the provisions of Statement of Financial Accounting No. 1: Statement of Objectives and No 2:

Statement of Concepts.19

Classification and Recognition of Ijarah under AAOIFI20

Operating Ijarah is an operating lease that does not include a promise that the legal title in the leased asset will pass to the lessee at the end of the lease. While, Ijarah Muntahiah Bitamleek

(Ijarah Wa Iqtina) is a lease that concludes with the legal title in the leased asset passing to the

lessee at the end of the contract period. Ijarah Muntahiah Bitamleek has different kinds of

transferring the asset. It includes:

a) Ijarah Muntahiah Bitamleek through gift (transfer of legal title for no

consideration).

b) Ijarah Muntahiah Bitamleek through transfer of legal title (sale) at the end of a

lease for a token consideration or other amount as specified in the lease.

c) Ijarah Muntahiah Bitamleek through transfer of legal title (sale) prior to the

end of the lease term for a price that is equivalent to the remaining Ijarah

installments. d) Ijarah Muntahiah Bitamleek through gradual transfer of legal title (sale) of the

leased asset.21

The journal entries to record the lease in the lessor book in the AAOIFI for the period would

be as follows:

Dr Equipment

18 Mohamed El-Said Abul-Ezz, A Study of the Accounting Aspects of Ijarah and Ijarah Wa

Iqtina, Accounting and Auditing Organization for Islamic Financial Institutions, 1417H-

1996. 19 Financial Accounting Standard No. 8, Ijarah and Ijarah Muntahiah Bitamleek, Accounting

and Auditing Organization for Islamic Financial Institutions AAOIIFI, page 275 20 Financial Accounting Standard No. 8, Ijarah and Ijarah Muntahiah Bitamleek, Accounting

and Auditing Organization for Islamic Financial Institutions AAOIIFI, page 249 21 Para 4, FRS 117, Malaysian Accounting Standards Board, 2005.

Cr Cash

(Cash purchase of equipment for Ijarah financing)

Dr Ijarah Financing Asset

Cr Equipment

(Provides Ijarah financing to lessee)

Dr Cash

Cr Profit & Loss

(Repayment received from lessee & income recognition)

Dr Profit & Loss

Cr Depreciation

(Depreciation cost of Ijarah Financing asset)

The findings

The issue of accounting treatment of Ijarah between the Financial Reporting Standard (FRS)

and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is an interesting topic to be discussed on.

FRS 117 clarifies that leases in the Financial Statements of Lessee in the initial recognition

shall recognize finance leases as assets and liabilities in their balance sheets at amounts equal

to the fair value of the leased property or, if lower, the present value of the minimum lease

payments, each determined at the inception of the lease. Any initial direct cost of the lessee is

added to the amount recognized as an asset. A finance lease gives rise to depreciation expense

for depreciable assets as well as finance expense for each accounting period.

While in the Financial Statements of Lessors, during the initial recognition, the lessors shall

recognize assets held under a finance lease in their balance sheets and present them as a receivable at an amount equal to the net investment in the lease. Costs incurred by

manufacturer or dealer in connection with negotiating and arranging a lease shall be

recognized as an expense when the selling profit is recognized.

Under the AAOIFI, in the case of initial direct cost, there are two alternative treatments were

proposed for the Islamic bank‟s share of the initial direct cost (as a lessor or a lessee);

1. charging these costs as a period expense to the period in which they occur; or

2. recording these costs as a deferred cost to be allocated (equally) over the lease term.

Alternative two has been chosen because it is consistent with the concept of matching

revenues and expenses which is stated in the Statement of Concepts. However, if the initial

direct costs were immaterial, the entire amount is charged to the period in which it occurred. This is consistent with the materiality concept. Unlike materiality concept in conventional

accounting, materiality concept in Islamic Accounting is not subject to any minimum amount

that can materially affect the company‟s transaction. Materiality in Islamic Accounting must

disclose even small or insignificant amount received or related to non-halal income or

expenditure.

PART III: THE ISSUE OF SUBSTANCE OVER FORM, ANALYSIS

AND FINDINGS

In discussing these Ijarah contracts, the concept of substance over form remains a matter of

concern. Substance over form is the principle that transaction and other event are accounted

for and presented in accordance with their substance and economic reality, and not merely

their legal form. It is to ensure that the financial statement or any transaction reflects the

complete, relevant and accurate picture of the transactions and events. When an entity practices the substance over form, it means that the financial statements reflect the financial

reality of the entity (substance) rather than the legal form of the transactions and events (form)

in which underlying them.

Specifically in the Ijarah contract, the legal form of the contract is related to the determination

of the owner of the asset. In relation to that it is definitely clear that the owner and the

responsibilities of the asset are still lying on the lessor and it is not been transferred to the

lessee, as lessee is only the beneficial owner. Meanwhile, the substance of the contract is

related to the maintenance expenses. With regard to that, either party needs to be responsible

for the expenses. Thus, in the issue of determining whether the substance is in the control of

the form or otherwise, it is a need to determine who is responsible for incurring the expenses

for the asset that underlies the Ijarah contract.

Under Ijarah Muntahiah Bitamleek contract, as discussed earlier, ownership of the asset is still

with the lessor, who would then be able to recognize the leased asset as an asset in its book

and to charge depreciation on the same asset. Moreover, the lessor would also be responsible

for major repairs and upkeep of the leased asset. The cost of such repairs could not be passed

on to the lessee. The contract may specify the maintenance regime that the lessee should

follow to ensure that no major unscheduled breakdowns occur, but other than that the primary

responsibility for major repairs rests with the lessor. The above argument is simply to put

forward the idea that in substance, the asset has been physically transferred to the lessee, but

in form, the asset is still owned by the lessor. It is the legal form as defined by the contract

undertaken that determines the relationship. Question of substance is in this instance, a moot one as it is the form that matters22.

Under Al Ijarah Thumma Al Bay’ (AITAB), same like Ijarah Muntahiah Bitamleek, the legal

form of the contract is still with the lessor. Hence, the lessor is still the absolute owner of the

asset. This is only the usufruct that has been transferred to the lessee, who becomes the

beneficial owner of the asset. In this sense, as following the Shari‟ah ruling and teaching, the

maintenance cost is still lie beneath with the lessor. In other words, the owner (lessor) is

responsible to ensure that the asset is always in good condition to render to the lessee, while

on the counterpart, the lessee shall be accountable for its proper and continuous use on regular

basis.

In Malaysia context, again it is highlighted that AITAB is governed by an act called Hire

Purchase Act 1967 and an accounting standard, FRS 117 on leases. Both, the standard and the

Act are conventional in nature. Obviously, it follows the concept of substance over form.

Hence, it reflects the recording of the asset which underlies the Ijarah contract.

The findings

The issue of reporting transactions based on substance or form needs to be addressed. Under

the conventional framework, it is perhaps a non-issue for a number of reasons. There is no

religious or general moral underpinning in departure of the substance from the form. In

Islamic framework, the legal form or the contractual form of transaction is based on Shari’ah.

For example, under Ijarah, the basic contractual relationship is a hiring, one as explained

22 Hamzah Ismail and Radziah Abdul Latiff (1999), Reporting Islamic Based Transactions:

Question of Substance, The Malaysian Accountant.

earlier. The lessor owns the asset and this need to be presented in the lessor‟s statement as

asset less depreciation.

Therefore, for Shari’ah based transactions, departure from the form may suggest that there has

been a manipulation or a deceitful conduct.

However, in Malaysia, Al-Ijarah Thumma Al-Bay’ (AITAB) is recorded according to Hire

Purchase Act and FRS 117 on Lease, which presents the asset that being leased as the asset of

the lessee, rather than the asset of the lessor. In FRS 117, a lease is classified as a finance lease

if it transfers substantially all the risks and rewards incident to ownership of the asset from the

lessor to the lessee. Title may or may not eventually be transferred. All other leases which do

not meet this criterion are to be classified as operating lease. A hire purchase contract for the

hire of an asset would also fall within the definition of a finance lease. Hire purchase contracts

in Malaysia contain provisions, which transfer the title of the asset to the hirer upon payment

of all the hire purchase installments.

In the case of AITAB, similar to conventional hire purchase, it requires the lessor to disclose

the items leased as receivables rather than as property, plant and equipment, since, even if the lessor still holds the legal title, the substance of the transaction implies that the lessee is the

one who is responsible for the item and should disclose it in the financial statements as the

lessee‟s asset. By doing so, the substance as perceived by preparers of account is presented

rather than the form, which contradicts with Ijarah Muntahiah Bitamleek, where the legal

form i.e. ownership is more important than the substance (reality). However, Islamic

principles require the legal form of any contract to be consistent with its substance. The one

who has possession of an asset is responsible for it (Gambling and Karim, 199123; Ismail and

Latiff, 1999).

23

Gambling, T. and Karim R. (1991). Business and Accounting Ethics in Islam. London:

Mansell Publishing Limited.

PART IV: THE ELEMENTS OF AITAB UNDER HIRE PURCHASE

ACT 1967 AND FINDINGS

In Malaysia, Al Ijarah Thumma Al Bay’ (AITAB) has to operate in accordance with, besides

FRS 117 on Leases for Accounting Standard, Hire Purchase Act 1967, legally. Thus, it is

necessary to understand some features of this Act. Back to the history in 1968, specifically on

April 11, this Hire Purchase Act 1967 was come into force. Previous to this date, there was no

specific legislation to control and regulate Hire Purchase in Malaysia, and Hire Purchase agreements came under the ambit of the ordinary laws of contract, and were covered by the

Sale of Goods Ordinance 1957 as “agreement to sell”.24

However, it must be highlighted that Hire Purchase Act 1967 remains as a tool to govern the

conventional Hire Purchase and definitely suite for an interest-bearing term loan, which the

relationship between the bank and the customer is still as the lender and the borrower. In this

way, AITAB assumes identical structure, as does by conventional hire-purchase.25 In this

sense, if the customer (or the lessee), defaults in payment, the bank has the right to sell the

asset. This is due to the fact that the bank is the sole owner of the asset. However, in actual

sense, the bank does not fulfill its obligation as the „sole owner‟ of the asset. Supposedly, as

the owner, the bank has an obligation to bear the maintenance costs of the asset to ensure that

the asset is always in good condition to render to the lessee. But ironically, all the responsibilities are seem to be transferred to the lessee since the lessee is responsible to

maintain the property and pay tax and insurance for the asset.

Listed below are the vital elements of AITAB that must be known, under the Hire Purchase

Act 1967:

The bank will purchase the asset from the car dealer.

The bank as an owner of the asset will lease the asset to the customer according to the agreed upon terms and conditions, specifying market rental values and leasing

period.

The customer or hirer can return the goods at any time before the option to buy is

exercised, and hence terminate the agreement. The customer is not obliged to pay all

the rentals.

The customer or hirer elects to purchase the good when all the rentals specified in the

agreement have been paid.

The bank will receive the lease payments. The bank ensures that the option to

purchase the car is made at a nominal value. The price of the car is equal to the total

lease payments received by the bank during the leasing period.

The transfer of ownership from the bank to the customer will take place at the end of

the leasing period as soon as the customer exercises the option to purchase the car.26

The findings

Based on the elements listed in the analysis part earlier, AITAB under HP Act 1967 has put

the contract of sale together with the contract of leasing. The former is granted on the basis of the option clause. This however, does not conform to the standard rules by the Accounting and

AAOIFI which rules that Al Ijarah Thumma Al Bay’ (AITAB) or Ijarah Muntahiah Bitamleek

24 AITAB Car Financing, Critical Issues on Islamic Banking and Financial Markets. Kuala Lumpur,

Dinamas Publishing, page 115. 25 AITAB Car Financing, Critical Issues on Islamic Banking and Financial Markets. Kuala Lumpur,

Dinamas Publishing, page 115. 26 AITAB Car Financing, Critical Issues on Islamic Banking and Financial Markets. Kuala Lumpur,

Dinamas Publishing, page 115 – 116.

is a contract of leasing with a promise (wa’ad) to sell.27 As guided by Shari’ah, there must not

be any mixture or combination of two contracts stipulated in a contract. Specifically in the

case of AITAB or Ijarah Muntahiah Bitamleek, the customer or the bank (cannot be both or

bilateral promise)28, makes a promise to sell or buy the asset at the end of the lease period.

Though the promise may come from the customer and customer may pay for earnest money

(„urbun), still the asset remains under the risk and ownership of the bank (lessor) throughout the leasing period because the ownership has not yet been transferred.29 That is another reason

as to why there is a need for two separate contracts for Ijarah and later, the transfer of the

ownership. The transfer of the ownership in the leased property cannot be made by executing,

along with the Ijarah, a sale contract that will become effective on a future date.30

Apart from that, Hire Purchase Act 1967 maintains its strength by providing clear procedures

and formalities of a hire purchase transaction, mentioning clearly the rights and liabilities of

the owner and the hirer (lessor and lessee). These rules are in line with the spirits of Shari’ah,

which to promote justice and forbid oppression while dealing in any transaction. Therefore,

AITAB facilities should not be prevented from adopting these rules and incorporating them in

the agreement,31 as long as the practices rules are not against the Shari’ah principle.

Despite of the advantages features, Hire Purchase Act, like any other law, is not completely

perfect and does contain certain loopholes, either in Shari’ah or legal requirements of Islamic

transactions, for instance, unclear documentation in respect of Ijarah and sale contract, limited

application to certain goods only, and involvement in elements of interest in calculation of

term charges. These examples indeed prove that this Act is not adequate and not perfectly

suited to be used to regulate AITAB transaction. Thus, a specific Shari’ah regulation

providing a Shari’ah rule for AITAB transaction is highly needed.32

27 AITAB Car Financing, Critical Issues on Islamic Banking and Financial Markets. Kuala Lumpur,

Dinamas Publishing, page 114. 28 Shari’ah Standard No. (9): Ijarah and Ijarah Munatahia Bitamleek, Accounting and Auditing

Organization for Islamic Financial Institutions (AAOIFI), page 146 29 Chapter on Ijarah, An Introduction to Islamic Finance, page 167 30 Shari’ah Standard No. (9): Ijarah and Ijarah Munatahia Bitamleek, Accounting and Auditing

Organization for Islamic Financial Institutions (AAOIFI), page 147 31 Legal Protection, A Critical Appraisal of AITAB operation: Issues and Prospects, page 11. 32 Legal Protection, A Critical Appraisal of AITAB operation: Issues and Prospects, page 11.

CONCLUDING REMARKS

From the interview made with the Shari’ah, internal and external auditors in Malaysia, as well

as from the analysis and findings of the study, it is agreed and can be concluded that the major

cause of Ijarah accounting problem in Malaysia is the governance of the contract. It is a big

headache for the auditors in doing their job and task when the standard and act, FRS 117 on

Leases and Hire Purchase Act 1967, is conventional in nature. Moreover, it is hard for the

auditors to raise any issue related to Shari’ah when the Islamic Banks are complied with the

standard and act governed to the particular Ijarah contracts and transactions. Hence, as

mentioned, the regulatory body in Malaysia needs to set a specific Shari’ah regulation

providing a Shari’ah rule for Ijarah transactions. It is believed to solve the problem of Ijarah

accounting as well as to make the contract in accordance with Shari’ah principles. At the same

time, despite being the main players in this Islamic Finance Industry, there are still rooms of improvements for Malaysia. Hence, it is important that the governance, implementation and

operational side being well managed, monitored and most importantly, Shari’ah compliant.

APPENDIX

Malaysian Financial Institutions Providing Ijarah Product

INSTITUTION DATE PRODUCT

Bank Islam Malaysia

Berhad 1893 Ijarah Muntahiah Bitamleek (Ijarah Financing)

Affin Islamic Bank

Berhad 1999 AITAB

AmIslamic Bank

Berhad

1993 Islamic ARIF Hire-Purchase

1993 AITAB Industrial Hire Purchase

Bank Pembangunan 1998 AITAB

EONCAP Islamic

Bank Berhad 1998 Auto AITAB

Hong Leong Islamic

Bank Berhad 1997

Hong Leong Hire Purchase

Financing-i

HSBC Amanah 2000 Lease with an option to purchase (IwOP)

Maybank 1994 AITAB

Public Bank 1996 AITAB

RHB Islamic Bank 2006 Hire Purchase-i

Bank Muamalat 1 October

1999 AITAB

Bank Rakyat October

2001

AITAB Car Hire-Purchase

Financing-i

OCBC June 2002 Islamic Industrial Hire Purchase (IHP-I)/ Ijarah

Muntahiah Bitamleek

Alliance Bank 2 August

2004 Alliance Hire Purchase-i

Kuwait Finance House

(M) Malaysia

8 August

2005 Ijarah Thumma Al-Bay’'

TABLE 1

(Source: Abdullah & Dusuki, n.d.)

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