IJARA OR LEASE IN AN ISLAMIC PERSPECTIVE

by Suntou Touray
Islamic Banking and Finance: This topic explains the Islamic accounting standards explanations of Ijara. The deconstruction and analysis is made by me.
Topic: Part 1
The AAOIFI standard relevant to Ijara mode of Islamic financing:
Leases is dealt under IAS17.
Introductions:
Ijara or lease is an interesting financing mechanism. The conventional or mainstream understanding of leases is taken from the international accounting standard which define a lease as “an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the rights to use an asset for an agreed period of time”. (Alfredson, Leo, Picker Et al: 596-597)
Furthermore, “under a lease agreement the lessee acquires, not the asset itself, but the right to use the asset for a set time.” The International finance standards require that leases be classified as either finance lease or operating lease. A finance lease is defined as “a lease that transfers substantially all the risk and rewards incidental to ownership of an asset.” In short a finance lease gives the lessee the right to the risk and reward of usage of the asset without assuming outright ownership. In many cases ownership ends up with the lessee.
Ijara is a widely use trade mode of financing by many Islamic Financial Institutions. For that being the case, the regulatory body which prepare and oversee the Shariah standards requires careful understanding.
I have analysed key features of the AAOIFI standards relevant to Ijara. The standard on Ijara is quiet wide and bulky, the word restriction makes it impossible to analyse in detail all the relevant aspect of the standard. Ijara is covered under AAOIFI standard number Nine (9). I labour to explain concepts such as definitions of Ijara, revenue recognition process, asset valuations, some examples of Ijara financing etc. Ijara according to salman Syed Ali, “constitute 5% of total Islamic Finance revenue”. This figures one would expect to grow significantly over the years. (2008: 1)
Definition of Ijara:
Dr M Ashraf Usmani defines Ijara as “transferring the usufruct not the ownership” of a “valuable, identified and quantified” property to the lessee. The corpus of the transaction is base on one party allowing another the lessee to utilise a tangible property for an agreed term set. This above definition entails that non-valuable or intangible valuable items cannot be leased. For instance consumables cannot be leased as these are not durable goods or the usufruct will end with the consumption. (2002: 147)
AAOIFI itself defines Ijara in broad terms to mean “leasing of property pursuant to a contract under which a specified permissible benefit in the form of usufruct is obtain for a specified period in return for a specified permissible consideration”. The key words in this definition are:
Property, pursuant, contract, permissible benefit, specified period and permissible considerations. This means for an Ijara contract to actualise, it should fulfilled all the above mention criteria for it to be valid. (AAOIFI, 2008, 158)
Tag eldin enumerated that “lease value must be precisely determined at the time of contract to avoid Jahala and Gharar”. This gave further support to the key mention conditions stated above.
Muhammad Ayub explain Ijara to mean only the corpus of the commodity stays with the owner (lessor), the utility or usufruct is what the benefactor or lessee is entitle to. He further clarify that any consumable product is not acceptable as a lease item. (Ayub, 2002: 96)
The Malike School defines Ijara as “possession of usufruct for a consideration”. The school uses kira and Ijara to mean lease, although Ijara is for mainly human labour. The possession of the usufruct is the contractual relationship between the lessor and lessee. (Ghuddah, 2007)
The general theme of the Ijara standard:
The AAOIFI standard first explains the scope of Ijara rules. Ijarah is divided into operating Ijarah, Ijarah muntahi Bittamleek and related to that is Ijarah wa Iqtina. Furthermore, the main “criterion used in the classification is whether the lease includes a promise that the legal title in the leased asset will pass to the lessee at the end of the lease term”. (Sharrif and Abdul Rahman,

The standard states that, operating Ijarah doesn’t result in ownership transfer at the end of the leased period. This is similar with conventional operating lease. The standard further addresses the recognition method in the books of the lessor. That is relevant as the income recognition and the frequency of revenue receivable will ascertain only through that process. Section 3 sub-section 1/1/1 asset acquired for Ijarah, indicates that, “asset acquired shall be recognised at historical cost”. This tells us that, the original cost of acquisition is the basis for valuations. The cost includes “net purchasing price plus expenditure necessary to bring the asset to its intended use”. The values that the tangible asset is value at will include every associated cost that enables the lessor to bring the asset to his possession. (AAOIFI 2008: 244)
Also, the requirement to recognise deterioration and fall in the asset value must be undertaken to avoid over valuations. The depreciation methods should be uniform and consistent. The lessor should finally present the asset under “investment in ijarah asset”.
AAOIFI FAS 8 Juristic Rule 1/5/2 outlines that “the lessee must use the leased asset in a suitable manner or in conformity with common practice and comply with conditions which are acceptable in the Shari’ah. He must also avoid causing damage to the leased asset by misuse through misconduct or negligence”. This clearly stipulates the contractual duties or responsibilities of the lessee. (Sharrif and Abdul Rahman)
The AAOIFI standard stipulates clearly the basis an institution like an Islamic bank can acquire an asset for Ijara contracts. The shariah standard number nine (9) states that, the lessor must own the asset before entering into Ijara contract. But an institution can request an Islamic bank to acquire an asset for Ijara contract, this is promise to lease. (AAOIFI, 2008: 139)
This condition of ownership is the general rule in Islamic finance; Taqi Usmani described Ijara as another form of sale. The only difference the retaining by the lessor the corpus of the asset whilst in trade the buyer acquires ownership. He give an example of A the lessor leased his property to B the lessee, for any tax expenses to be paid, A has to pay tax due on the property whilst B takes care of the expenditure associated with the use of the property. (Usmani, 2005:160)

The lessor enters into a contract with lessee signing a “master agreement”. This document contains all the contractual terms and conditions in the Ijara agreement. The standard however does allow a direct Ijara contract to be entered into without any prior master agreement. The lessee can be obligated to pay a guarantee sum towards a lease relationship, this is to avoid last minutes pull out by the lessee whilst the Islamic bank or institution incur cost which may not be recoverable. (AAOIFI, 2008: 139)
The standard further allows an institution or Islamic bank to acquire an asset from a third party and then lease the asset to that third party. The restriction here is that, the acquisition shouldn’t be conducted on the condition that the third party entered into an Ijara contract. (AAOIFI, 2008: 139) The purpose that the asset is to be use for in the Ijara contract should be known to both parties. Also the asset should be use for a shariah complaint purpose only. (Omar and Abdel-Haq, 1996: 14)). To be continued