In an Islamic hire purchase scheme, suppose an Islamic bank is required to purchase a car before leasing it to the customer. Discuss how this could affect the bank’s profit and loss?

Accounting and Auditing Organisation For Islamic Financial Institutions (AAOIFI) was formed to undertake responsibility for issuing accounting standards that adhere to the requirements of Shariah. In Shariah, it recognises the application concept of ‘substance’ and the ‘form’ and does not particularly endorsed to the concept of ‘substance over form’. 

This is evident in the treatment of leased assets and sales based transactions. In view of the primacy of contract in transactions in Islam, the emerging reality must be constructed or appear to be as the form. AAOIFI defines asset as that which the enterprise has acquired rights to hold, use or dispose and does not recognise asset based on ability to control through other than legal ownership. On the other hand, liabilities are strictly contractual obligations. AAOIFI Financial Accounting Standard No.8 (FAS8) (Amended) address the issue of Islamic leasing. For operating lease, it is called simply ijarah (leasing). However, in the issue of Islamic hire purchase, it is called ijarah thumma al bay’ or ijarah muntahiah bi al-tamlik whereby the lease contract is concluded with the legal title passed to the lessee at the end of period. The distinction between both leases is that the latter is awarded ownership title at the end of maturity period to the lessee provided all the lease payments are settled.

Taqi Usmani (2005) demonstrated that in the case of ijarah, the corpus of the property remains in the ownership of the transferor (lessor), but only the its usufruct i.e. the right to use it, is transferred to the lessee. In conventional hire purchase, the legal title is passed to the lessee simultaneously from the start of the contract. However, the beneficial ownership remains to the lessor until all hire purchase instalments have been paid. The different applications and definitions of assets and liabilities between conventional and Islamic definitely will effect the bottom line of bank’s profit and loss account when the bank being the lessor in hire purchase arrangement.

Whenever the banks employ ijarah, the instalments received will be debited to the bank account in the Balance Sheet. Simultaneously, the profit and loss account will be credited with the amount of instalments paid together with a portion of income in suspense as revenue to the banks in the profit and loss accounts. Because the assets leased are owned by the banks, therefore, the banks entitled to deduct depreciation charge in the profit and loss accounts. The responsibility of maintenance falls onto the banks because of the ownership. Thus, the banks are required to pay for the insurance or other direct expenses in relation to the assets. Therefore, the banks entitle to deduct insurance expenses in the profit and loss accounts. However, the lessee can be requested to carry out the operating maintenance expenses as a result of using the leased assets. 

Other worthy point to note is that, in the tax computation for the banks, any depreciation expenses are regarded as non-taxable expenses. However, the banks entitle to claim capital allowances. Thus, this will lower down the tax payable for the banks.