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THE IJARAH ACCOUNTING HEADACHES FOR THE AUDITOR IN AAOIFI JURISDICTION FINANCIAL REPORTING STANDARD (FRS) VERSUS ACCOUNTING

G 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, Shariah 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 Shariah 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 2

Course material for Fiqh Muamalah in Banking and Finance, page 64 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 interestbased lending, AITAB is conveniently accepted as a Shariah 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.

Nurdianawati Irwani Abdullah and Asyraf Wajdi Dusuki (2006), Customers 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 Shariah.
6 7

Thesis on Exploratory Study of Ijarah Accounting Practices in Malaysia 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 Shariah 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 Shariah law which specifically regulates the operation of AITAB. The only existing regulatory Shariah rules on the facility can be found in Shariah 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. ii. iii. iv. v. vi. Hire Purchase Act 1967 Road Transport Act 1987 The Income Tax Act 1967 Income Tax Leasing Regulations 1986 Takaful Act 1984 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 Shariah Standard No. 9 on Ijarah and Ijarah Muntahiah Bitamleek. While, in this standard, it discusses the Shariah 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 12

FRS 117 Leases, A Practical Guide to Financial Reporting Standards (Malaysia), page307. 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 lessees 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 15

Para 7, FRS 117, Malaysian Accounting Standards Board 2005. 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, 1417H1996. 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 banks 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 companys 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 Shariah 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 Shariah. 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 lessors statement as asset less depreciation. Therefore, for Shariah 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 lessees 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 (waad) to sell.27 As guided by Shariah, 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 Shariah, 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 Shariah principle. Despite of the advantages features, Hire Purchase Act, like any other law, is not completely perfect and does contain certain loopholes, either in Shariah 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 Shariah regulation providing a Shariah rule for AITAB transaction is highly needed. 32

AITAB Car Financing, Critical Issues on Islamic Banking and Financial Markets. Kuala Lumpur, Dinamas Publishing, page 114. 28 Shariah 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 Shariah Standard No. (9): Ijarah and Ijarah Munatahia Bitamleek, Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), page 147
31 32

27

Legal Protection, A Critical Appraisal of AITAB operation: Issues and Prospects, page 11. Legal Protection, A Critical Appraisal of AITAB operation: Issues and Prospects, page 11.

CONCLUDING REMARKS
From the interview made with the Shariah, 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 Shariah 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 Shariah regulation providing a Shariah rule for Ijarah transactions. It is believed to solve the problem of Ijarah accounting as well as to make the contract in accordance with Shariah 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, Shariah compliant.

APPENDIX
Malaysian Financial Institutions Providing Ijarah Product INSTITUTION DATE PRODUCT

Bank Islam Malaysia Berhad Affin Islamic Bank Berhad

1893

Ijarah Muntahiah Bitamleek (Ijarah Financing)

1999

AITAB

AmIslamic Bank Berhad

1993 1993

Islamic ARIF Hire-Purchase AITAB Industrial Hire Purchase AITAB

Bank Pembangunan EONCAP Islamic Bank Berhad Hong Leong Islamic Bank Berhad HSBC Amanah Maybank Public Bank

1998

1998

Auto AITAB Hong Leong Hire Purchase Financing-i Lease with an option to purchase (IwOP) AITAB AITAB

1997 2000 1994 1996

RHB Islamic Bank Bank Muamalat Bank Rakyat

2006 1 October 1999 October 2001 June 2002 2 August 2004 8 August 2005

Hire Purchase-i AITAB AITAB Car Hire-Purchase Financing-i Islamic Industrial Hire Purchase (IHP-I)/ Ijarah Muntahiah Bitamleek Alliance Hire Purchase-i Ijarah Thumma Al-Bay' TABLE 1

OCBC Alliance Bank Kuwait Finance House (M) Malaysia (Source: Abdullah & Dusuki, n.d.)

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