Ijarah Muntahia Bittamleek: Residual and Depreciation Judgement
Bank Raqaba leases equipment under ijarah muntahia bittamleek for 5 years. Cost is 5,000,000; expected useful life is 8 years; the lease ends with a transfer of ownership to the lessee for a nominal 1,000. The finance team proposes to depreciate the asset over the 5-year lease term to a residual of 1,000, arguing that 'the asset leaves the bank at the end, so its life to us is 5 years.' Separately, the lessee has fallen 90 days behind on rentals and the bank's credit team wants to derecognise the asset and book a full impairment, treating it like a defaulted loan.
1. Over what period should the ijarah asset be depreciated, and to what residual value? Critique the finance team's proposal.
Read the worked answer
The finance team's proposal is wrong on both period and residual.
Reasoning:
- In ijarah, the bank is the owner and bears ownership risk; the asset is the bank's non-current asset, depreciated over its useful economic life (8 years), not over the lease term. The lease term is a financing/contract feature, not the asset's life.
- Depreciating over 5 years to 1,000 would over-depreciate and front-load cost, understating profit in early years and creating an artificial gain/loss at transfer.
- Residual: the transfer price of 1,000 is a nominal sale, not evidence of the asset's residual value. The estimated residual at end of useful life should reflect the asset's expected value; if the bank expects to transfer at year 5, the carrying amount at transfer should approximate the expected transfer proceeds, with any difference recognised at that date.
Practical approach: depreciate over 8 years (useful life) to estimated residual; if a genuine expectation exists that the asset will be sold at year 5 for a determinable amount, align depreciation so carrying amount at year 5 equals expected proceeds, and disclose the estimate. Do not use the nominal 1,000 as residual.
2. Can the bank derecognise the ijarah asset and book a full impairment merely because rentals are 90 days overdue? Advise.
Read the worked answer
No - 90 days' arrears alone does not justify derecognition or full impairment.
Reasoning:
- Derecognition requires loss of control/transfer of ownership risks and rewards. Arrears do not transfer the asset; the bank remains owner and the asset remains on balance sheet.
- Impairment is assessed on the recoverable amount of the asset (or the receivable for rentals), using evidence - not a single ageing trigger. A full write-down requires evidence the asset is impaired in full (e.g., asset lost/destroyed, no recoverable value).
- Distinguish two exposures: (a) the ijarah asset itself, tested for impairment on its own merits; (b) overdue rentals, which are a receivable subject to expected-credit-loss provisioning on a graduated basis.
- Action: provision the overdue rentals per the ECL model, keep the asset on balance sheet, assess recoverability, and only derecognise/impair fully if supported by evidence. Disclose the arrears and provisioning.