LECTURE NOTES ON

ISLAMIC ACCOUNTING APPLICATIONS

Compiled By:
Bashir Abdisamad Hared
(PhD, CPA, CIPA)

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 CHAPTER EIGHT

ACCOUNTING FOR IJARAH FINANCING

8.1 Principles of Ijarah Financing

Literally, Ijarah means to give something on rent. As a term of Islamic fiqh, Ijarah can also refer
to wages paid to a person in consideration of the services rendered by him. In the context of Islamic
banking, Ijarah can be defined as a process by which the “the use of a particular property is
transferred to another person in exchange for a rent claimed from him/her”. The basic feature of
the Ijarah is where one party is given the right to use the services of a person or of a given asset
from another party for a consideration. This contract has not involved the transfer of ownership to
the other party as there has been no intention to purchase or to own the Ijarah object by the
interested party (operating Ijarah).
Normally, Ijarah is resorted to financing the acquisition of assets, whereby, the bank acquires
a relevant asset or assets and subsequently leases the asset to the customers for a fixed period on a
lease rental basis. The distinguishing feature of this mode is that assets remain the property of the
Islamic bank to put them up for rent every time the lease period terminates so that they do not
remain unutilized for long periods of time. Furthermore, there are some conditions that Ijarah
transactions need to follow in order to be in consonance with the principles of Islamic finance.
Basically, the lease contract must state the lease period clearly. Renewal terms must also be
stated clearly, and things like the rentals for all subsequent years, after the first year, should not
contain clauses like “left to the sole discretion of the lessor” and the like. It is also a condition that
the subject of the contract must actually and legally be attainable. It is not permissible to lease
something that cannot be delivered. Furthermore, it is permissible for the two parties to agree
during the lease period to review the lease period or the rental or both. Part of the conditions also
state that the lessor bears the liabilities when leasing the asset such as damage, payment of
premium cost and basic maintenance. There is no objection to authorizing the lessee to undertake
all the above but the costs thereof must be borne by the lessor or owner.

In 1990, the Dubai-based Emirates Airline asked the Al Rajhi Banking and Investment Corporation
(ARBIC), which operates on Islamic principles, to raise US$60 million lease financing for an
A310-300 Airbus. This was the first aircraft leasing deal to be handled by an Islamic bank and it
attracted support from Islamic commercial banks.
In the same year, Gulf Air asked the Faisal Islamic Bank of Bahrain (FIBB) to raise US$365
million for the purchase of six Boeing 767s. The FIBB offered an Islamic lease maturing in 12
years, but this fell through owing to the Gulf crisis and, at the end of the war, the contract was
given to conventional banks. The ARBIC mandate, however, proved that Islamic lease financing
could compete strongly with conventional aircraft leasing. This method was used by The Albaraka
International Bank in London to finance the purchase of a new minicab fleet for Pakistani taxi
drivers in Sheffield. Figure 7.1 illustrates the steps involved in Ijara.

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8.2 Accounting forIjarahFinancing (AAOIFI FAS 8)
AAOIFI defines Ijarah as “ownership of the right to the benefit of using an asset in return for
consideration”. As for leasing, the IAS 17 defined a lease as “an agreement whereby the lessor
conveys to the lessee in return for rent the right to use an asset for an agreed period of time”.
Nevertheless, the definition given by the AAOIFI is furnished with extra conditions, which will
distinguish Ijarah from conventional leasing. AAOIFI FAS 8 states that the fulfillment of the
benefit should be of a permissible nature and the benefit should be in accordance with the Shari’ah.
AAOIFI’s classifies Ijarah financing into at least two types i.e. Operating Ijarah and
Financing Ijarah (Ijarah MuntahiaBittamleek).The AAOIFI’s standard on Ijarah states that when
a lease does not include a promise that a legal title will pass to the lessee, it is classified as
Operating Ijarah and if there is a promise it is Ijarah muntahia bittamleek.
AAOIFI recognized that Operating Ijarah is where the title of assets is not transferred to the
lessee. However, IjarahMuntahia Bitamleek (finance lease) involves two contracts i.e. a lease
contract and the transfer of ownership at the end of the contract. In this case, the title of the leased
asset is transferred to the lessee based on one of the following methods:
a. by way of gift,
b. token price or pre-determined price,
c. equivalent price, or
d. Gradual transfer of share holding.

In Ijarah, the lessor holds the ownership rights and obligations from the very beginning till
the end of the contract. In other words, “the lease property is the responsibility of the lessor
throughout the duration of the Ijarah, unless the lessee commits misconduct and negligence.”
AAOIFI FAS 8 provides 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.”

8.2.1 Assets acquired for Ijarah:

Assets acquired for Ijarah shall be recognized upon acquisition at historical cost, including all
direct costs incurred to make the asset ready for its intended use, such as custom duties, taxes,
freight, insurance, installation, testing, etc. And at the end of each reporting period, assets are
carried at cost less accumulated depreciation and impairment allowances, if any.

8.2.2 Recognition of Ijarah Revenue:

Ijarah Revenue is allocated proportionately to the financial periods in the lease term.In case of
Ijarah Muntahia bittamlik, the Ijarah revenue is recognized progressively as the lessee acquires a
greater share of the asset.

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8.2.3 Recognitions of Ijarah Expenses:
Repairs and maintenance of the leased asset undertaken by the lessee with the Bank’s consent, the
cost of the repair if immaterial shall be recognized as an expense in the financial period in which
they occur. And if the cost is material and differ from one period to another over the lease term,
then a provision for repairs shall be recognized by regular charges against income.
A depreciation expense is charged and recognized and calculated using the Straight line
method to write off the depreciation amount of the asset over the estimated useful lives. The
method shall be reviewed annually and changed if conditions make a new method appropriate.
Similarly, Ijarah Muntahia Bittamleek asset is calculated based on the method of final transfer of
the legal title of the leased assets.

8.2.4 Ijarah Receivables and Provision:

Rentals are recognized as Ijarah Receivables when due as the terms of the contract. And they are
carried at their cash equivalent value.Ijarah Receivables are impaired if the carrying value is
greater than the estimated recoverable amount (i.e. cash equivalent value).Impairment losses on
Ijarah receivables may also be assessed on a portfolio basis. However if Bank assesses that an
individual receivable is impaired, then; the impairment of that particular asset is recognized
immediately.

8.2.5 Sale of lease Asset:

Gain or loss from the sale, disposal or transfer of leased assets is recognized in the period of sale.
At time of sale of a leased asset, the book value of the sold portion of the asset is removed from
the leased asset account. Any gain or loss resulting from the difference between the selling price
and the net book value is recognized in profit and loss account.

8.2.6 End of Ijarah term:

In case of Operating Ijarah assets for which legal title does not pass to the lessee at the end of the
Ijarah term, the assets are acquired back by Bank and carried in the books as “Leased assets”, and
valued at their cash equivalent value or net book value, whichever is low. And in case of Ijarah
Munathia Bittamlik, where title has to pass to the buyer at the end of the Ijarah, the legal title of
the asset is transferred to the lessee at the end of the Ijarah term once the lessee fulfils all his
obligations and commits to his arrangements.
If the lessee is obligated to fulfill his promise to purchase the leased asset and decides not to do
so, and the cash equivalent value of the asset is lower than the net book value, the difference
between the two amounts is recognized as a receivable due from the lessee.

8.2.7 Accounting procedures for Ijarah Financing:

Usually Islamic Banks use Automated Banking System that automatically generates accounting
transactions for the following stages of Ijarah financing:
a. Application of the customer to the Bank
b. Banks purchases the asset for Ijarah Financing
c. The Bank processes Ijarah Financing contract

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 d. Ijarah revenue, profit and installments are calculated and finalized
e. Installments payment starts by the Customer
f. Settlement of Ijarah Financing at the end of Ijarah term.

The following are the accounting treatments for both Operating Ijarah and Ijarah Muntahia Bit
Tamleek (IMBT) as follow:
a) Accounting entries for Operating Ijarah

Operating Ijarah Accounting entries

Transactions
Purchase of Ijarah Asset Debit: Ijarah Asset – Operating lease,
Credit: Accounts Payable A/C
Purchase of Ijarah Asset by the Bank
Payment to supplier Debit: Accounts Payable,
Credit: Cash A/C
Payment made to the supplier by the Bank
Recognition of operating lease Debit: Operating Ijarah Revenue A/C
rental income Credit: Operating Ijarah rental income
To recognize the deliverable rental income
Receipt of Operating Lease Debit: Cash A/C
Rental Income on due date Credit: Operating Ijarah Revenue
Receipt of Ijarah rental amount
Receipt of Advance Operating Debit: Cash A/C
Lease Rental Credit: Unearned Rental income– Operating Ijarah Rev.
To receive advanced rental income from operating ijaraha
Receipt of Advance Finance Debit:Unearned Rental income– Operating Ijarah Rev.
Lease Rental Credit: Profit & Loss A/C

b) Accounting entries for Ijarah Muntahia Bittamlik (IMBT)

IMBT Transaction Accounting entries

Purchase of Ijarah Debit: Asset for Ijarah Finance
Muntahia Bittamleek Credit: Accounts Payable or Customer A/C (if amount deposited
Asset in his/her A/C)
Purchase of Ijarah Asset by the Bank
Payment to suppliers Debit: Accounts Payable
Credit: Cash A/C
Payment made for the purchase of Ijarah Asset
Recording of Ijarah Debit: Ijarah Financing (IMTB)
financing assets (transfer Credit: Asset for Ijarah Finance
of asset to the client) Credit: Unearned Ijarah income
To recognize the ijarah finance lease made by the Bank

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 Receipt of customer’s
share in leased Asset (if
down payment is
collected)
Recognition of operational
expenses, insurance, legal
expenses, etc.
Recognition of deprecition
expenses at the end of the
year
Recognition of Finance
Lease rental Income at the
end of each year
Late Payment Charges
Payment of Charity (as per
approved policy by the
Shariah Board)
The disposal of the asset,
sale of asset, or asset is
given in a gift
Debit: Cash A/C
Credit: Ijarah Financing (IMTB)
To record the reciept of the down payment or advances
Debit : Profit & Loss A/C
Credit : Cash A/C or Payable A/C
To record operational expenses paid
Debit : Profit & Loss A/C
Credit : Ijaraha Financing Asset A/C (net of depreciation)
To record depreciation expenses recognized at the end of the year
Debit: Unearned Ijarah income.
Credit: Profit & Loss A/C or Income Summary A/C
To recognize the Ijaraha income of the year
Debit: Ijarah Receivable
Credit: Charity Payable or Profit & Loss (if apporved by
Shariah Board)
Debit: Charity Payable (if recognized as profit this entry is not
required)
Credit: Cash A/C
If sold at gain (more than the book value)
Debit : Cash A/C or Ijaraha Recievables A/C
Credit: Asset for Ijarah Finance (net of depreciation)
Credit : Profit & Loss A/C (extra from book value)

If sold at loss (less than the book value)

Debit: Cash A/C or Ijaraha Recievables A/C
Debit: Profit & Loss A/C
Credit: Asset for Ijarah Finance (net of depreciation)

8.2.8 Note on Ijarah Cash payment

Usually in the normal banking practices, the client of Ijarah financing contract (lessee) has an
account at the financing bank (lessor), and based on the agreement, the Ijarah Rentral amounts
are deducted from the client’s “Bank Account” at the financing bank (lessor). So, the Ijarah
Rentral amount is automatically deducted from the lessee’s account which makes the journal
entry of the cash receipt as follow:
Debit: Client Account (decrease) xxx
Credit: Ijarah Rentral Income (receivable) xxx

8.2.9 Other Accounting Implications of Ijarah Treatment

Conventional accounting on leasing adopts “Substance Over Form” approach, thus in the case of
accounting for leasing must reflect economic substance rather than legal form. Since, the lessee

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benefits from the asset (substance) and the asset belongs legally to the lessor (form), thus the asset
will be recognized in the lessee’s book. In the lessor’s book, it will not be recognized as his asset
but only as receivable to represent the rights of the lessor (bank). Many Islamic jurists however
prefer “Form Over Substance”. Similarly, AAOIFI in its standard on Ijarah (FAS 8) has preferred
the legal form rather than the substance for accounting and financial reporting of Ijarah muntahia
bittamleek (finance lease).
There are several implications if the legal form over substance is adopted. First, the bank
will have to bear all the costs incidents to the ownership. Thus, the bank will assume much greater
costs and risks since as the lessor, they have to bear the maintenance costs of the Ijarah asset.
Secondly, since the transactions reflect two transactions, it may lead to higher costs such as double
taxation, stricter regulatory requirements, legal implications etc. Thirdly, as far as accounting is
concerned, the balance sheet of an Islamic bank will carry more fixed assets and may expose them
to greater risks and capital requirements. All these issues are among many of the outstanding issues
that need to be resolved by the researchers in Islamic finance as well as the relevant authorities.

8.2.10 Presentation and disclosures:

According to AAOIFI, there are a number of disclosure requirements in the financial statement of
the Islamic Bank on Ijarah transactions. Among the disclosure requirements are:
1. The amount of Ijarah assets by each major class, net of accumulated depreciation, if any,
shall be disclosed in the notes accompanying the financial statements.Leased assets shall
be presented in the lessor’s statement of financial position under Investments in Ijarah
Assets. Similarly, the policy of the depreciationexpenses should be reported.
2. The Bank shall recognize assets held under Ijarah Muntahia Bittamleek in their balance
sheets and present them as a receivable at an amount equal to the net investment in the
Ijarah.
3. Ijarah installments shall be presented in the lessor’s income statement as Ijarah revenue
and shall be recognized in the accounting period in which these installments are due. Initial
direct costs incurred by the lessor for arranging the lease agreement shall, if material, be
allocated to periods in the lease term in a pattern consistent with that used for allocating
Ijarah revenues. If these costs are immaterial, then they shall be charged directly in the
income statements as an expense to the financial period in which the lease agreement is
made.
4. Repair expenses, if material, shall be recognized in the financial periods in which they
occur. If the repairs are material and differ in amount from year to year over the lease term,
then a provision for repairs shall be established by regular charges against income and be
disclosed. If the lessee undertakes repairs of a leased asset with the lessor’s consent and
the cost of the repairs are chargeable to the lessor, then the lessor shall recognize these
repairs as an expense in the financial period in which they are incurred.

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 5. In addition to the above, the following should be disclosed with respect to Ijarah Muntahia
Bittamleek financing:
a. Reconciliation between the gross investment in the Ijarah at the balance sheet date,
and the present value of minimum Ijarah payments receivable at the balance sheet
date.
b. Unearned Ijarah income
c. The accumulated allowance for uncollectible minimum Ijarah payments receivable
d. A general description of Bank’s material Ijarah arrangements

PRACTICAL ILLUSTRATIONS

Practical Question 8.1

Bank Ummah entered into an Ijarah contract with Takaful Ltd to lease equipment for a period of
3 years. Bank Ummah purchased equipment from a local trader on 1 of January 2010 for $60,000.
The Bank also incurred legal fees of $500 relating to the Ijarah contract, which the bank considered
to be material.
Other details on the Ijarah are as follows:
1. Fair value of equipment: At the beginning of 2010 60,000
At the end of the lease i.e. 31 Dec. 2012 2,000
2. Number of installments on quarterly basis 12
3. Rentals at the end of each quarter 6,000
4. Estimated useful life 3 years
5. Estimated residual value at the end of useful life 4,000
6. Estimated expenditure incurred in the second year 1,200

Required:
Prepare journal entries to record the above Ijarah contract in the books of Bank Ummah assuming
the lease was treated as Ijarah Muntahia Bittamleek through sale for a token consideration (agreed
to be equivalent to 50% of the estimated residual value) at the end of useful life) for the following
periods:
a. At the beginning of Ijarah financing,
b. On receipt of rental installments,
c. At the end of each year; and,
d. At the end of Ijarah term.

Possible Solutions for Practical Questions 8.1

a) Depreciation = (Historical cost - Residual value) / useful life
= (60,000 - 4,000)/3 years = $18,666 per year

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At the beginning of Ijarah

Period Transaction Debit Credit

Year1 Dr. Fixed Asset (Equipment) Account 60,000
1/1/ Cr. Cash Account 60,000
(Being purchase of equipment)
Dr. Ijarah MTB Asset A/C 60,000
Cr. Asset for Ijarah Financing 60,000
To recognize the Ijarah asset by the Bank
Dr. Initial Ijarah Direct Expense Account 500
Cr. Cash Account 500
(Being Ijarah initial direct cost)
Year On receipt of 1st, 2nd& 3rd rental installments
1,2&3 Dr. Cash Account 6,000
Cr. Ijarah Revenue Account 6,000
To receipt the rental income by cash
On receipt of December rental rental installment
end of (each year)
all Dr. Ijarah Receivable/Cash Account 6,000
years Cr. Ijarah Revenue/Profit and Loss account 6,000
To recognize ijarah rental revenue of the year
End of At the end of 1st, 2nd& 3rd Years
each Dr. Profit and Loss Account 18,666
year Cr. Prov. for Depr. on Ijarah Asset Account 18,666
(Being depreciation for the year)
Dr. Profit and Loss Account 167
Cr. Initial Ijarah Direct Expense account 167
(Being amortisation of initial Ijarah expense)
End of At the end of Ijarah term (31/12/2012)
year 3 Dr. Cash Account 6,000
Cr. Ijarah Revenue Account 6,000
(Being receipt of rental income)
Dr. Profit and Loss Account 18,666
Cr. Prov. for Depr. on Ijarah Asset A/C 18,666
To record the depreciation of the year
Dr. Profit and Loss Account 167
Cr. Initial Ijarah Direct Expense account
(Being amortisation of initial Ijarah expense) 167

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 Dr. Cash Account 2,000
Dr. Profit and Loss account 2,000
Cr. Ijarah Asset Account (residual value) 4,000
(Being token disposal at 50% of residual value)

Practice Question 8.2

Bank Islam entered into an Ijarah contract with xalaal Inc. to lease an equipment for a period of 4
years. The Bank purchased equipment from a local trader on the 1 st of January 2010 for $260,000.
The Bank also incurred legal fees of $3,000 relating to the Ijarah contract, which the bank considered
to be material. Other details about the Ijarah are as follows:
1. Fair value of equipment:
a. At the beginning of 2010 $260,000
2. At the end of the lease i.e. 31 December 2013 $30,000
3. Number of installments on bi-monthly basis 24
4. Rentals at the end of every two months $15,000
5. Estimated useful life 4 years
6. Estimated residual value at the end of useful life $20,000
7. Estimated expenditure incurred in the second year $15,000

Required:
Prepare journal entries to record the above Ijarah contract in the books of Bank Islam assuming the
lease was treated as Ijarah Muntahia Biltamleek through sale for a token consideration (agreed to be
equivalent to 50% of the estimated residual value at the end of useful life) at the end of useful life)
for the following periods:
a. At the beginning of Ijarah financing,
b. On receipt of first rental installment,
c. At the end of second year; and,
d. At the end of Ijarah terms.

Practice Question 8.3

Bank Somalia Islamic entered into an Ijarah contract with Mahabbah Inc. to lease equipment for a
period of 3 years. The Bank purchased equipment from a local trader on the 1 st of January 2000 for
$160,000. The Bank also incurred legal fees of $1500 relating to the Ijarah contract, which the bank
considered to be material.
Other details about the Ijarah are as follows:
Fair value of equipment:
At the beginning of 2000 $160,000
At the end of the lease i.e. 31 December 2002 $20,000

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 Number of instalments on bi-monthly basis 18
Rentals at the end of every two months $12,000
Estimated useful life 3 years
Estimated residual value at the end of useful life $16,000
Estimated expenditure incurred in the second year $12000

Required:
1. Prepare journal entries to record the above Ijarah contract in the books of Bank Somalia
Islamic assuming the lease was treated as Ijarah Muntahia Bittamleek through sale for a
token consideration (agreed to be equivalent to 50% of the estimated residual value at the
end of useful life)
2. Explain the differences between Operating Ijarah and Financing Ijarah.

Practice Question 8.4

Islamic leasing or Ijarah is a flexible mode of financing. However not all assets are suitable for
leasing. Industrial equipment worth $ 50,000 with a useful life of 10 years was purchased by an
Islamic bank and leased to an enterprise 2 years ago for a period of 5 years. At the end of year 3 the
client decided not to continue with the lease and returned the asset to the bank.

Required:

a) Distinguish the characteristics of Ijarah and finance lease.

b) State the journal entries that will be recorded for the purchase, lease and the recovery of the
asset in accordance to AAOIFI FAS No.8.

Practice Question 8.5

Bank Haramein entered into an Ijarah contract with Barakah Inc. to lease equipment for a period of
5 years. Bank Haramein purchased the equipment from a local trader on the 1 st of January 2000 for
$100,000. The Bank also incurred legal fees of $1,000 relating to the Ijarah contract, which the bank
considered to be material.
Other details about the Ijarah are as follows:

Fair value of equipment:

At the beginning of 2000 $100,000
At the end of the lease i.e. 31 December 2004 $6,000
Number of instalments on quarterly basis 20
Rentals at the end of each quarter $6,000
Estimated useful life 5 years

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 Estimated residual value at the end of useful life $3,000
Estimated expenditure incurred in the fourth year $1,200

Required:
a) Prepare journal entries to record the above Ijarah contract in the books of Bank Haramein
assuming the lease was treated as Ijarah Muntahia Biltamleek through pre-determined value
(agreed to be equivalent to the lower of the fair value at the end of the year or $4000) for the
following periods:
i. At the beginning of Ijarah;
ii. On receipt of first rental;
iii. At the end of first year;
iv. At the end of fourth year; and,
v. At the end of Ijarah term.

b) Explain the similarities and differences between the Islamic concept of Ijarah and the
conventional concept of leasing.

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