Comparison between FAS 32 - Ijarah, IFRS 16 - Leases and IFAS 2 - Ijarah: Introduction and Basis Lessee Accounting

Introduction

Due to the growth of Islamic Finance, the Shar'iah compliant mode of transactions such as Musharakah partnerships, Murabahah sales and Ijarah Leases are becoming increasingly commonly in Pakistan. This has also been attributed to the recent decision of Federal Shariat Court to eliminate Riba across the country.

On May 27, 2022, the Securities and Exchange Commission of Pakistan (SECP) vide its SRO 437(I)/2007 made Islamic Financial Accounting Standard (IFAS) 2 - Ijarah, issued by Institute of Chartered Accountants of Pakistan (ICAP), applicable on Ijarah contracts entered into across the country.

Moreover, International Financial Reporting Standard (IFRS) 16 - Lease has been applicable on all companies for periods beginning on or after January 1, 2019, with the exception of Banks, Development Finance Institutions (DFIs) and Microfinance Banks (MFBs) whose implementation date had been extended to June 30, 2019.

Therefore, for the purpose of statutory reporting, companies account for their lease contracts in accordance with IFRS 16, except for those entered under an arrangement of Ijarah, which are accounted for in accordance with IFAS 2.

However, some Islamic Banks in Pakistan have their parent companies in Bahrain, which follow Financial Accounting Standards (FAS) issued by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). For the purpose of preparing financial statements for group reporting, these Banks are required to prepare their financial statements in accordance with FAS.

Accordingly, the Ijarah contracts for the purpose of group reporting have to be accounted for according to FAS 32 - Ijarah by these Islamic Banks.

Accounting for Lessees - Overview of IFRS 16 and FAS 32

IFRS 16 requires all the lessees to account for their leases as finance leases. Therefore, it requires the recognition of Right of Use Assets and Lease Liabilities for each lease contract entered, regardless of whether the ownership of the asset will be transferred to the lessee at the end of the contract, or the lease term.

The right of use assets and lease liabilities would be initially measured at the present value of all the lease rentals payable by the lessee over the lease term, discounted using the internal rate of return of the lessor, or alternatively the incremental borrowing rate of the lessee.

The right of use asset would be depreciated over the lease term under a reasonable basis reflective of obtaining economic benefits from the asset. The lease liability would be subject to interest expense at the rate of discounting used initially, and amortised using the rentals paid by the lessee.

However, IFRS 16 provides exemptions for leases with a term of less than 12 months (short-term leases) and leases where the underlying asset has a low value (low value asset).

If at the end of the contract, the asset transfers to the lessee, the amount paid to transfer the asset is included in the estimation of lease liability, and the right of use asset is amortised over its useful life rather than lease term. At the end of contract, the right of use asset is reclassified to property, plant and equipment (fixed assets).

FAS 32 follows a similar treatment for all of its Ijarah contracts. It requires the recognition of right of use (usufruct) asset, gross Ijarah Liability and deferred Ijarah costs for all the Ijarah contracts, except for short-term Ijarah and low value Ijarah, which can be treated similar to operating lease transactions in accordance with IFRS 16.

However, it divides the Ijarah contracts into Operating Ijarah contracts and Ijarah Muntahia Bit Tamlik (MBT) contracts. Ijarah MBT contracts are those where lessee is provided an option of transfer of ownership of the underlying contract to the lessees.

The right of use asset for Ijarah MBT under FAS 32 is initially measured at its prime cost, which is the cost of the underlying asset to lessor or alternatively, the fair value of the asset at commencement date, less the terminal value, which is the promised value at which transfer of the asset would be made to lessee.

The gross ljarah liability comprises of the notional amount of rentals payable under Ijarah. The differential amount of both is recognised as deferred Ijarah cost which is a contra liability amount. This similar to recognising the Gross Investment in Finance Lease and Unearned Finance Income under IFRS 16 by lessors, albeit, on the opposite side of the balance sheet.

For Operating Ijarah Contracts under FAS 32, the right of use asset will be measured similar to IFRS 16 at fair value of all the future rentals payable over the lease term. The rest of the treatment is same as Ijarah MBT contracts.

The depreciation would be recognised according to a systematic basis that is reflective of the pattern of utilisation of benefits from right of use assets. The deferred Ijarah cost would be amortised over effective rate of return method, and taken to income statement, similar to IFRS 16, and the Gross Ijarah Liability would be amortised over the rentals paid.

Therefore, apart from the presentation of Gross Ijarah Liability and Deferred Ijarah Cost separately, the basic treatment of lease contracts under FAS 32 and IFRS 16 are the same.

Introduction and Accounting for Lessees - Differences between IFRS 16 and FAS 32

The following differences are noted in accounting for lease contracts under both standards:

1. FAS 32 also includes Ijarah agreements linked with Diminishing Musharaka agreements. IFRS 16 excludes such agreements since they fall within the scope of IFRS 9.
2. Under FAS 32, the right of use asset would be amortised over the Ijarah term in all the cases, regardless of transfer of ownership at the end of Ijarah term. Under IFRS 16, the right of use asset would be depreciated over the economic life rather than the lease term if ownership transfers at the end of lease term, or lessee is reasonably certain to exercise bargain purchase option.
3. Under FAS 32, the residual value at which the transfer of the asset would be made at the end of the contract is deducted from the right of use asset to restrict the right of use of asset over the lease term and exclude the value of asset after the lease term. In IFRS 16, such residual value is not excluded from right of use asset, if lessee intends to purchase the asset at the end of the contract and residual value is taken in lease liability so as to account for the value of asset even after the conclusion of the lease and subsequent transfer of asset.
4. Under FAS 32, in case of Ijarah MBT where ownership is transferred to lessee gradually, and lessee's ownership and Ijarah co-exist on the same asset (such as Ijarah on lessor's portion under Diminishing Musharaka), the lessee shall account for the combined asset comprising the right of use asset and ownership of tangible asset similar to accounting for right of use asset under FAS 32. No such concept is described by IFRS 16, where the such contracts are treated under IFRS 9 as financings of asset.

Accounting for Ijarah under IFAS 2 for Lessees

IFAS 2 requires the treatment of all Ijarah contracts as operating leases similar to IFRS 16. The Ijarah rentals are recognized as an expense in the income statement on a straight- line basis unless another systematic basis is representative of the time pattern of the user’s benefit.

The transfer of the asset at the end of lease term is treated as a purchase of the asset and recognised as property, plant and equipment (operating fixed asset). Therefore IFAS 2 does not observe any concept of finance lease under IFRS 16.

It can be observed that IFAS 2 is still behind the times in comparison with IFRS 16 and FAS 32, or could be strictly intended to reflect the legal form of the transactions under Shar'iah based structure.

However, the Accounting Standards Board of ICAP could consider bringing IFAS in line with globally acceptable accounting standards issued by AAOIFI to enhance consistency and comparability of information.