Key Differences Between IFRS and AAOIFI Research Assignment (Essay Sample)

Differences between AAOIFI and IASB standards
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Islamic Accounting
Part 1
Buy and sell over loan contracts
It is referred as Bai-Inah in Islamic finance. The bank sells an asset to a client and later repurchase it at a discount hence creating debt. It is opposite of a Murabahah contract where a client sells an asset to the bank and repurchases it at cost-plus-profit. Under the Bai-Inah contract, the bank has no intention to sell its assets to the clients, and the conditions are that upon completion of the property transfer to the client the asset is resold back to the bank. There is a debate if it is Hilah as its only economic value is to create debt. One of the features of this type of contract is that it provides a clear flow of buy and sell off an asset emulating an underlying transaction. Another feature provides clear documentation of the transaction to show the sequential order of the sell and buy off the contract. Bai-Inah contract shows clear demarcation between a buyer, seller, offer, value, and asset (Islam, 2015). The selling and purchase price is agreed, and terms cannot be tampered with without consent. Though this type of contract is not allowed, Malaysia has allowed it since the Shariah scholars there consider it as valid.
Form over substance
According to the IFRS, the principle of substance over form is the concept of the reliability of financial statements. A financial statement which is reliable is one that reflects transactions in their true nature rather than in their legal form. However, AAOIFI prefers the principle of form over substance where they emphasis on the legal nature of a financial transaction rather than its economic benefits. The preference of this principle by AAOIFI is seen on their standard on leasing. They recognize the obligations and rights of the contractual parties which are reflected by the legal form of the contract. The legal form of Islamic contracts is considered fully valid even when the contracts do not have economic substance.
An example where the principle of form over substance is used is in the execution of BBA financing. A BBA contract is where a bank acts as a seller to a client and sells the goods at cost price plus a predetermined markup. The client determines the goods he needs from a supplier and the bank purchases the goods from the provider and then sell them to the client at a higher price. The client then repays the bank in installments for a specific period. It enables the bank to evade giving the prohibited interest-based loans. A BBA contract is allowed by AAOIFI since it is considered as a trading activity where the seller is the bank and the purchaser is the customer. The legal form of this financial transaction is given more emphasis than the economic benefits. However, the economic substance and legal form of a BBA contract are the same (Ismail and Sori, 2017).
Time value of money
The AAOIFI rejects the concept of time value of money, as is shown in the Statement of Financial Accounting 2. It is haram for financial institutions to make money out of money since money is considered worthless by itself in Islam. The definition of money in Islam is different from the conventional way of defining money. In Islam, money is only a medium of exchange and is considered capital when combined with other resources. The inability of money to produce itself means that it would be unjust to assign the time value to it as it must be joined with other resources for it to gain value. The concept of time value of money is rejected since no interest is charged (Rosman et al., 2016). However, some critics argue that although interest is prohibited, it would be appropriate to show a financing effect of a financial transaction.
Islam prohibits people from making a profit out of currency they have received before being given its counter-value as valuation is only done when the trade of goods is complete, not when the loans or debts are given. Thus, qard is stated on maturity rather than up front. Any increment in Islamic finance is set by the debtor and is voluntary.
Reconciling the differences
The differences between the AAOIFI and IASB standards are mainly of the time value of money, form over substance and loan contracts. Some of these differences cannot be reconcilable as the conventional way of doing it is haram from an Islamic point of view. The time value of money in the conventional way as applied by the IASB is where the present value of money is always greater than its future value, with the interest rate being the discounting factor. In Islam, interest is prohibited and hence the time value of money cannot be used (Hanif, 2014). However, though interest is prohibited in Islam, use of time value of money can be necessary to show the financing effect of transactions. Presently, time value of money is not acceptable in Islam.
The legal and economic nature of a financial transaction is a point of debate between the AAOIFI and IASB. IASB prefers substance over form principle while the AAOIFI prefers the form over substance principle. An Islamic perspective will emphasis on a legal nature of a transaction rather than the economic benefit. The loan contracts are also handled differently by the two regimes where AAOIFI standards ensure that banks do not charge interest they give their clients. AAOIFI only establishes standards to be applied in situations where the IFRS are contrary to the beliefs of Islam or when IFRS have not set any standards for products unique only to Islamic Finance. The reconciliation process between AAOIFI and IASB is still at the early stages, and a solution will be hard to arrive at due to the different principles being applied by the two regimes.
Part 2
Financing lease
According to IASB, a financing lease is a lease where a lessor buys an asset for a lessee and rents it to the lessee for a specified period. The lessee is in a similar position as if they had bought the asset themselves. The lessor’s reward is the rent they charge the lessee and retains ownership of the asset until the complete payments have been paid. However, the lessee has exclusive use of the asset. For a lease to be considered a financing lease, the following tests have to be met:
• The lessor has to hand over the ownership of the asset to the lessee at the end of the lease period.
• The lease period runs through the bigger part of the economic life of the asset, even if the ownership transfer of the asset is not done.
• At the beginning of the lease, the present value of the present value of all the lease payments has to be at least the fair value of the asset.
• The asset leased have to be specialized in nature such that they can be used without major modifications.
• If the lessee is allowed to cancel the lease, any losses incurred by the lessor are transferred to the lessee.
• Any fluctuations in the fair value of the residual leading to gains or losses fall to the lessee.
• The lessee/ hirer can continue the lease for a subsequent period paying a rent lower than the market rent.
How can a firm using AAOIFI standards mimic economics of financing leasing?
Firms that use AAOIFI standards can gain the economics of financing leasing through Ijarah Muntahia Bittamleek. Ijarah Muntahia Bittamleek literary means to give something on a stream of rental payments. It can also be defined as a process where the usufruct of a property is transferred to the lessee in exchange for rewards in the form of rental payments. It is a contract that has three major elements: form, two parties and subject matter. The form includes an offer and acceptance. The contract has to have two parties, a lessor, and a lessee. The subject matter of Ijarah Muntahia Bittamleek includes the consideration and the benefit from the utilization of the asset leased (Sarea, 2012). In an Ijarah Muntahia Bittamleek contract, the ownership of the leased asset to the lessee at the end of the Ijarah term.
There are five different ways with which the transfer of ownership of the asset can be done. The first is a gift at the end of the period of the lease. The transfer of the ownership of the asset is done under no consideration to the lessee. The second way is through the sale of the asset to the lessee for a token consideration the end of the lease period. The token must be agreed by the two parties. The third way is through the sale of the asset at the end of the period of Ijarah for an amount specified in the lease. There must be a promise to enter into a sale contract which includes the amount to be paid at the end of a lease period. The fourth way is selling the asset any time during the Ijarah period for an amount equal to installments remaining. The fifth way of transferring ownership of the asset is through the gradual transfer of the title. The price has to be determined so that a proportionate share of the asset is transferred at every period.Firms using AAOIFI standards can use the Ijarah Muntahia Bittamleek contract to mimic the economics of a financing lease.
Accounting treatment of Ijarah Muntahia Bittamleek and financing lease
Accounting treatment of Ijarah Muntahia Bittamleek in the books of the lessor
1. Accounting treatment when the bank purchases the asset on behalf of the client.
Dr Advance against Ijarah
Cr Pay order
Dr Cash
Cr Security deposit
2. When the lessee receives the asset
Dr Asset acquired for Ijarah
Cr Advance against Ijarah
3. Accruals of income when due
Dr Rental receivable
Cr Rental income
4. When receiving rental payments
Dr Party Bank A/c
Cr Ijarah rental receivable
5. At maturity of Ijarah contract
Dr Security Deposit
Cr Party Bank A/c
Dr Party Bank A/c
Cr Asset acquired for Ijarah at wdv
Accounting t...