This Basis for Conclusions accompanies, but is not part of, the Technical Release.

This Basis for Conclusions summarises the Board’s considerations in reaching the conclusions in TR i-2 Ijarah.

In 2001, a working group was formed with the responsibility for identifying the need for an accounting standard on Ijarah, and ensuring that the proposed standard is consistent with developments in Islamic based transactions and the requirements of current law and regulations. The working group was chaired by a former member of the MASB, and comprised representatives from the accountancy profession, the corporate sector, statutory bodies and other user groups. The working group also consulted the views of BNM's Shariah Advisory Council on Shariah issues that arose.

In July 2004, the MASB issued an exposure draft on Ijarah. Public response to the exposure draft was not limited to accounting for Ijarah, but extended to Islamic accounting standards in general. Most respondents agreed that there is a need to standardise accounting for Islamic financial transactions and events, but among them, there were those who questioned whether this necessarily entailed a need for separate Islamic accounting standards.

In its review of the comments raised, the Board conducted further research, consultations, and surveys to determine how best to proceed with its project of developing Islamic accounting pronouncements. One specific task was to formulate a pronouncement on Ijarah. This pronouncement is the result of such work.

Respondents to MASB ED i-2 Ijarah stated that the explanation of Ijarah given therein may appear to include conventional leases as well. In this Technical Release, the Board has provided clarification as to which transactions fall under its scope.

Ijarah may be arranged in conjunction with another transaction or as part of a series of transactions. This often results in products that are comparable to conventional financial instruments. Some respondents had indicated that an accounting pronouncement on Ijarah would be more valuable if such transactions were addressed.

For example, an entity may Ijarah assets to another entity and Ijarah the same assets back. Alternatively, an entity may legally sell assets and Ijarah the same assets back. The form of each arrangement and its terms and conditions can vary significantly. In the former lease and leaseback example, it may be that the arrangement is designed to achieve a tax advantage for the other entity that is shared with the reporting entity in the form of a fee, and not to convey the right to use an asset.

The proposed accounting treatment for Ijarah in MASB ED i-2 was similar to that of an operating lease. A significant comment raised was that Ijarah is not classified as 'operating' or 'finance'; there should be a single model to account for Ijarah. Another comment was that treating Ijarah as an operating lease ignored the lessee's right to the benefit of the Ijarah item, which should itself be recognised as an asset. The Board conducted further research based on these comments. The Board's findings are laid out in paragraphs BC9 to BC21 below.

The Board identified the following two main alternatives to account for the lessee's ownership of usufruct:

The first view suggests that the lessee does not acquire the entire usufruct outright at the commencement of Ijarah. Rather, it obtains the usufruct through its use of the Ijarah item. However, by using the Ijarah item, it is also simultaneously diminishing that same usufruct. Thus, at any point in time, the asset that arises is immediately amortised. The off-setting effect would lead to an amount recognised in expense. Another standard setter, while not explicitly mentioning its view, prescribe charging Ijarah payments as expenses - suggesting that it is inclined towards this view. As a consequence of not recognising the right to the benefits as an asset, the corresponding obligation to make Ijarah payments is also not recognised as a liability.

The second view makes a distinction between the right to a benefit, and the benefit itself. In Ijarah, the subject matter contracted for is the right to the benefit. The benefit itself is realised as the item is being used. Thus, at the commencement of Ijarah, the lessee has acquired a right which meets the definition of asset and should therefore, be recognised as such. The amortisation of that right represents the benefit realised through the use of the item. This view is derived from the majority of fuqaha that recognise a benefit, manfaat and a right, hak as assets, mal.

The Board is more inclined towards the second view and believes that Ijarah gives rise to an asset and a liability of the lessee even when the contract may be defined as 'operating' by MASB approved accounting standards on leases. By charging Ijarah rental as an expense as and when it is incurred, users of the financial statements may be deprived of information regarding the extent of the lessee's right to the benefit of the item and its obligation to settle outstanding Ijarah payables over the Ijarah period.

Another accounting standard setter has interpreted the lessor's right to the underlying Ijarah item as recognition of its net investment in the Ijarah item as an item of property, plant and equipment subject to depreciation. In its jurisdictions, Ijarah is almost always treated as a rental of the Ijarah item throughout the Ijarah period. Where a purchase option is exercised by the lessee by, or at, the end of the Ijarah period, it is treated as a sale of the lessor's asset to the lessee with the recognition of any gain or loss on disposal.

It is the Board's opinion that the usufruct is transferred to the lessee at the commencement of Ijarah. Accordingly, measurement of the lessor's right to the Ijarah item must take into consideration that it is devoid of the usufruct transferred to the lessee. Where a purchase option is exercised by the lessee by, or at, the end of the Ijarah period, the transaction would be considered a sale of the underlying Ijarah item.

As mentioned before, another standard setter treats Ijarah as either an operating lease, or an operating lease followed by a sale. In either case, the lessee's Ijarah payments are recognised as an expense over the Ijarah term. The Board disagrees with this treatment because there is a transfer of usufruct to the lessee. It is the opinion of the Board that the lessee should recognise the acquisition of usufruct as an asset, and any resultant obligation to pay for the usufruct as a liability.

The model in MASB approved accounting standards on leases is based on a 'whole asset' approach. In a finance lease, the lessee recognises the 'whole asset'. In an operating lease, the lessor recognises the 'whole asset'.

Ijarah does not draw a distinction between 'operating' and 'finance'. Instead, Ijarah focuses on the 'rights and obligations' of the lessor and the lessee. In Islamic accounting thought, there would not arise a situation where either a lessee or a lessor recognises the 'whole asset' because:

Other standard setters have also deliberated on a 'rights and obligations' approach to leases, even though their lease standards may not necessarily reflect this view. For example, as early as 1976 the Financial Accounting Standards Board (FASB) had stated in the Basis for Conclusions of FAS 13, Accounting for Leases (1976):

Some standard setters are actively pursuing research into the 'rights and obligations' approach with a view to improve the existing lease accounting model. The IASB has issued two discussion papers on a new approach to leases 'Accounting for Leases: A New Approach in 1996, and Leases: Implementation of a New Approach in 2000.' The papers posit that the right to use an asset conferred by a lease meets the definition of asset. They assert a lease conveys rights and obligations that should be recognised as assets and liabilities by a lessee. The papers also acknowledge that the nature of the asset that arises under a lease is different from an asset obtained by ownership.

Following the discussion papers, the UK-based Accounting Standards Board (UK ASB) is undertaking research on leases on behalf of the IASB. In its newsletter Inside Track, April 2004, the UK ASB's introductory findings suggest the following approach:

UK ASB's most recent paper, Leases: A Contractual Rights and Obligations Approach, was presented at IASB's World Standard-setters' Meeting in September 2004. The Board will continue to keep abreast of the IASB and UK ASB Project on Leases.

The research on a rights and obligations approach to leases is not likely to yield a workable accounting model in the near future. Even then, the extent of its compatibility with Ijarah, though promising, is uncertain. The Board prescribes that, in the interim, an entity shall apply the requirements and guidance of MASB approved accounting standards on leases and other applicable MASB approved accounting standards in accounting for Ijarah.

In addition, the Board believes that the disclosure of additional information in paragraphs 22-26, and the requirements of applicable MASB approved accounting standards would assist in explaining the conceptual differences between the lease accounting model and Ijarah.