AUDIT & SHARIA COMPLIANCE – ISSUES IN ISLAMIC BANKING AND FINANCE

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AUDIT SHARIA COMPLIANCE ISSUES IN ISLAMIC
BANKING AND FINANCE

• Presentation By
• Omar Mustafa Ansari
• Partner
• Ford Rhodes Sidat Hyder Co.
• (Member of Ernst Young Global Limited)

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Role of Auditors and Accountants in Islamic
Finance

• Allah SWT says in Quran that Allah doth command
  you to render back your trusts to those to whom
  they are due And when ye judge between people
  that ye judge with justice.
• According to the code of ethics for accountants
  and auditors of Islamic financial institutions,
  accounting (duly including auditing external,
  as well as, internal) is one of the professions
  that is required by Shariah as a Fard Kifaya.
• In other words it is a duty which, if performed
  by some, would exempt others in the society.
  Otherwise, the whole society is sinful.

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Purity of Transactions and Building Reliance on
Islamic Finance

• Islamic banking industry is presently growing at
  a very high pace.
• One of the critical issues the industry is facing
  is the matter of purity in transactions which, in
  longer run, will ensure reliance of Muslim Ummah
  in this model of Islamic finance and banking.
• If this issue, at this stage, is ignored, it may
  result in a disaster in the name of Islamic
  Finance.

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Strategy to Build Reliance on Islamic Finance and
Banking

• A three fold strategy may help out the industry
  to ensure Shariah compliance on an ongoing basis.
  
• Standardization of Shariah Compliance Regulations
  for Islamic Finance
• Improved governance and Shariah Compliance
  Assurance for Islamic Financial Institutions and
• Shariah Compliance Rating of Islamic Financial
  Institutions and Products.

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STANDARDIZATION OF SHARIAH COMPLIANCE REGULATIONS
FOR ISLAMIC FINANCE
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Standardization of Shariah Compliance Regulations
for Islamic Finance

• Standardization is necessary to ensure that all
  the matters of Islamic financial institutions are
  dealt with, within a framework which is
  acceptable for all Muslims.
• Internationally, there have been a lot of efforts
  for standardization of practices being followed
  by various Islamic financial institutions. These
  efforts include a lot of research work.

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Standardization of Shariah Compliance Regulations
for Islamic Finance

• The most admirable job has been performed by
• the Islamic Fiqh Academy of the Organization of
  Islamic Countries and
• the Accounting and Auditing Organization of
  Islamic Financial Institutions (AAOIFI).
• In respect of governance and risk management,
  Islamic Financial Services Board has also
  performed a commendable job.

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Introduction to AAOIFI

• AAOIFI was established in 1990 in Algiers under
  an Agreement of Association between a number of
  Islamic financial institutions (IFIs). Now it is
  based in Bahrain.
• Its objectives primarily include development of
  accounting, auditing, governance and Shariah
  standards for Islamic financial institutions.
• Accounting, Auditing and Governance Standards
  (AAGS) are issued by AAOIFIs Accounting and
  Auditing Standards Board whereas the Shariah
  Standards Board issues the Shariah Standards.

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Introduction to AAOIFI

• These Boards have, to date, performed a
  remarkable job by issuing accounting, governance,
  auditing and Shariah standards for Islamic
  financial institutions.
• These Boards have been established by choosing
  the experts of the fields from throughout the
  Islamic world. Accordingly, their works, are
  considered to be a consensus (Ijma) of the
  experts from the field.
• These work may be used for standardization of
  practices of Islamic finance and banking
  throughout the world.

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Introduction to IFSB

• Officially inaugurated on November 03, 2002 and
  started operations on March 10, 2003.
• Serves as an international-standard setting body
  of regulatory and supervisory agencies that have
  vested interest in ensuring the soundness and
  stability of the Islamic financial services
  industry.
• Promotes the development of a prudent and
  transparent Islamic financial services industry
  through introducing new, or adapting existing
  international standards consistent with Islamic
  Shariah principles.

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Pakistans Perspective

• Accounting and Financial Reporting
• The Institute of Chartered Accountants of
  Pakistan has issued Islamic Financial Accounting
  Standards for Ijara and Murabaha which are under
  implementation stages. These standards are
  approved by SBP and notified by SECP.
• Shariah Compliance
• SBP has established a Shariah Board.
• SBP has issued essentials for Islamic banking and
  financial products and a bunch of model
  agreements. But all these are considered to be
  guidelines, and not regulations. SBP has also
  issued various circulars in this respect.

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Pakistans Perspective

• Governance What SBP is Doing
• Shariah compliance framework being established.
  Draft Islamic banking guidelines issued and
  comments received.
• A Shariah compliance inspection mechanism is
  being introduced and a Shariah compliance
  inspection manual has been developed.
• Risk management standards are being adopted with
  suitable modifications.

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Pakistans Perspective

• Takaful
• Takaful Rules developed and now being reviewed
  for improvement. Revised Rules will include
  accounting regulations for Takaful.
• SECP has established a Central Shariah Board.
• Mandatory Shariah Compliance Audit for Takaful.
• Modarabas
• All model agreements and products are being
  reviewed from Shariah compliance perspective.
• Religious Board for Modarabas is now in operation
  after a long gap.

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IMPROVED GOVERNANCE AND SHARIAH COMPLIANCE
ASSURANCE FOR ISLAMIC FINANCIAL INSTITUTIONS
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Shariah Non-Compliance Risk What Why?

• Shariah non-compliance risk is a significant risk
  for an Islamic financial institution from two
  perspectives
• It impacts the reputation of the Islamic
  financial institution and deteriorates reliance
  of the depositors, investors, customers and other
  stakeholders in the long-term and
• It impacts the revenue as well, because in case
  of an identified Shariah non-compliance, the
  income arising from such transaction is to be
  given in charity.
• But, for the society, and considering it a step
  towards complete transition of economy on
  Islamic principles, Shariah compliance is the
  essence of Islamic banking and finance.

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How to Manage Shariah Non- Compliance Risk?
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Shariah Compliance Assurance for Islamic
Financial Institutions

• Rules, regulations and standards might not work
  unless and until an effective network of check
  and balance is established to ensure compliance
  of the same in letter and spirit.
• Shariah compliance cannot be ensured merely on
  the basis of approval of products by the Shariah
  Supervisory Boards and the Shariah Advisors.
• Approvals have to be matched with the ground
  realities.

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Shariah Compliance Assurance for Islamic
Financial Institutions

• Shariah compliance review report of Shariah
  Supervisory Board or the Shariah Advisor (May, or
  may not be, based on Internal Shariah Review).
• Shariah compliance audit by the external auditors
  of the Islamic financial institutions.
• Shariah Compliance Inspection of Islamic
  commercial banks.
• Independent Shariah compliance assurance
  (internal or external) from professionals.

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Shariah Compliance Review By Shariah Advisor
Issues

• Competence (From Assurance Perspective)
• Without any disregard to the individuals, and not
  as a generalized rule, it needs to be realized
  that the jurists sitting on the Board or working
  as Shariah Advisors possess little knowledge
  about the accounting and auditing, and more
  importantly, the operations of the financial
  institutions.

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Shariah Compliance Review By Shariah Advisor
Issues

• Consequently, their compliance review generally
  remains limited to the extent of assurance of the
  legal form of transactions i.e. vetting of
  agreements and documents etc.
• On the contrary, the operational matters which
  include the substance of the transaction might
  remain unattended because it is not the core
  competence of these respectable jurists.

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Shariah Compliance Review By Shariah Advisor
Issues

• Managements Attitude
• Generally the management does not wish to bring
  each and every matter in the attention of the
  Board or the Advisor.
• Accordingly, unless they have enough time to
  review things on their own, and they take
  reasonable interest in the same, it is not
  possible for them to have a look on most of the
  operational matters.

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Shariah Compliance Review By Shariah Advisor
Issues

• Independence
• Although we dont have any doubt on the personal
  independence and integrity of these respectable
  jurists, they would themselves appreciate that
  the work performed under ones guidance should
  always be counter checked by an independent
  person.
• Particularly, keeping in view the human tendency
  of errors, it cannot be advised that the person
  supervising and monitoring the transactions is
  also entrusted to recheck and audit the same.

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Shariah Compliance Review By Shariah Advisor
Issues

• Scarcity of Resources (Time and Skilled Staff)
• Generally those on the Shariah Boards and on the
  seat of Shariah Advisors are busy guys. They are
  generally serving a number of Boards and
  educational institutions and are involved in a
  number of social and religious activities.
• In addition, they do not have sufficient budgets
  available for their departments, nor an adequate
  number of skilled staff hired for the purpose of
  assisting them in the assurance work.

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Shariah Compliance Review By Shariah Advisor
Issues

• Consequently, you can easily imagine that it is
  humanly not possible for a single person to
  perform a comprehensive Shariah compliance audit
  of the operations of a full-fledged Islamic
  financial institution which may even have a
  number of branches.

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Shariah Compliance Audit by External Auditors
Issues

• According to AAOIFI standards, the auditor
  should, to a limited extent, ensure compliance
  with Shariah requirements.
• Option being used by certain Islamic mutual
  funds in the country is Shariah compliance audit
  by their external auditors.
• According to Takaful Rules, a Shariah compliance
  audit is required. But this is not being
  performed by external auditors, as the Rules do
  not provide any further detail.

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Shariah Compliance Audit by External Auditors
Issues

• Since the external auditor is also entrusted with
  the task of performing the Shariah compliance
  audit, his expertise in Islamic finance is not
  ensured. You would appreciate that if the auditor
  is not equipped with the necessary skills and
  knowledge, the output of the assignment might not
  be as good as may be expected from an experience
  auditor and
• Since the scope of the audit is pre-defined and
  the matter of permissibility of a transaction is
  generally subject to the opinions and
  perspectives of the Shariah Supervisory Board or
  the Shariah Advisor, the independence of the
  exercise, to some extent, remains in jeopardy.

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Shariah Compliance Inspection by SBP - Issues

• This is a very good approach, as it is
  independent and authoritative in nature.
• Issues identified are forwarded to the SBPs
  Shariah Board so the exercise remains
  independent.
• Nevertheless, since the results of such
  inspections are considered to be confined to the
  management of the Bank and the State Bank, the
  benefits of such exercises cannot be forwarded to
  the general public.

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Shariah Compliance Inspection by SBP - Issues

• Moreover, such exercise is limited to the Islamic
  commercial banks and the Islamic banking branches
  of conventional commercial banks and consequently
  other financial institutions that are governed by
  the SECP including Islamic mutual funds,
  Modarabas, Takaful companies, Housing finance
  companies, Investment finance companies and
  leasing companies shall remain out of ambit of
  such exercise.

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Independent Shariah Compliance Assurance by
Professionals

• This approach is now being applied by a few
  Islamic banks.
• This may be applied in form of
• Internal Shariah Review and
• External Shariah Compliance Assurance / Audit.

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SHARIAH COMPLIANCE RATING OF ISLAMIC FINANCIAL
INSTITUTIONS AND PRODUCTS
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Shariah Compliance Rating of Islamic Financial
Institutions and Products

• Anyone having basic understanding of Islamic
  finance would easily understand that generally
  all the products being launched by Islamic
  financial institutions cannot be termed
  equivalent for Shariah compliance purpose.
• There might be certain provisions in an Ijara
  contract that may render it less desirable as
  compared to a similar Ijara contract. Or in
  general a Murabaha may be less preferable as
  compared to a Modaraba product.

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Shariah Compliance Rating of Islamic Financial
Institutions and Products

• In addition to the products being launched by the
  Islamic financial institutions that are subject
  to the approval of their respective Shariah
  Advisors and Shariah Supervisory Boards there are
  certain Islamic financial products that are
  launched by the conventional financial
  institutions or by various companies and even by
  the Government.
• These products, for example, include the housing
  finance option offered by the House Building
  Finance Corporation, Sukuks being issued by the
  Government of Pakistan and various government
  owned entities, Musharaka TFCs issued by the
  Sitara Energy and operating lease options offered
  by various leasing companies.

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Shariah Compliance Rating of Islamic Financial
Institutions and Products

• In view of the same it is imperative that a
  Shariah compliance rating mechanism be introduced
  so that the general public may be able to
  differentiate between various products being
  launched.
• In addition, this will encourage the financial
  institutions to continuously improve the purity
  factor in their financial products.

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GOVERNANCE STANDARDS BY AAOIFI
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Governance Standards

• Sharia Supervisory Board Appointment,
  Composition and Report
• Sharia Review
• Internal Sharia Review
• Audit and Governance Committee for Islamic
  Financial Institutions

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Sharia Supervisory Board (SSB)

• It is an independent body of specialized jurists
  in fiqh almuamalat (Islamic commercial
  jurisprudence).
• Appointment, Composition and Report
• It is appointed by shareholders in AGM upon
  recommendation of Board of Directors (BOD), they
  may authorize BOD to fix the remuneration of SSB.
  SSB shall be consisted of atleast three members,
  it may seek the service of consultants but
  excludes directors and significant shareholders
  of IFI.

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Sharia Review

• The objective of the Sharia review is to ensure
  that the activities carried out by an IFI do not
  contravene the Sharia. It is the responsibility
  of SSB to form and express an opinion on the
  extent of an IFIs compliance with the Sharia.

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Internal Sharia Review

• The internal Sharia review is an integral part
  of the organs of governance of the IFI and
  operates under the policies established by the
  IFI. It shall be carried out by an independent
  division or part of internal audit department,
  depending on the size of an IFI. The primary
  objective of internal Sharia review is to ensure
  that the management of an IFI discharge their
  responsibilities in relation to the
  implementation of the Sharia Rules and
  Principles as determined by the IFIs SSB.

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Audit and Governance Committee (AGC)

• The importance of the AGC for an IFI emanates
  from its role in
• achieving the fundamental objectives of an IFI,
  by enhancing greater transparency and disclosure
  in financial reporting and
• enhancing the publics confidence of the IFI as
  genuine in its application of Sharia rules and
  principles.

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AUDITING STANDARDS BY AAOIFI
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Auditing

• Objective and Principles of Auditing
• The Auditor's Report
• Terms of Audit Engagement
• Testing for Compliance with Shari'a Rules and
  Principles by an External Auditor
• The Auditor's Responsibility to Consider Fraud
  and Error in an Audit to Financial Statements

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ObjectiveAnd Principles

• Objective
• To enable the auditor to express an opinion as
  to whether the financial statements are prepared,
  in accordance with Sharia Rules and Principles
  and the accounting standards of the Accounting
  and Auditing Organization for Islamic Financial
  Institutions (AAOIFI).

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ObjectiveAnd Principles

• Principles
• The auditor should comply with Code of Ethics
  for Professional Accountants which include
  righteousness, integrity, trustworthiness,
  fairness, honesty, independence, objectivity,
  professional competence, due care,
  confidentiality, professional behavior and
  technical standards.

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Auditors Report

• The auditor should review and assess the
  conclusions drawn from the audit evidence
  obtained as the basis for the expression of an
  opinion on the financial statements, it should
  contain a clear written expression of opinion on
  the financial statements taken as a whole.

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Terms of Audit Engagement

• The auditor and the client should agree on the
  terms of the engagement. The agreed terms would
  need to be recorded in an audit engagement
  letter.
• The engagement letter documents and confirms the
  auditors acceptance of the appointment, the
  objective and the scope of the audit, the extent
  of the auditors responsibilities to the client
  and the form of any reports to be provided by the
  auditor.

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Testing for Compliance with Sharia Rules and
Principles

• When testing for Sharia compliance, the auditor
  shall obtain sufficient appropriate audit
  evidence that provides the auditor with
  reasonable assurance that the Islamic Financial
  Institution (IFI) has complied with Islamic
  Sharia Rules and Principles (the Fatwas, Rulings
  and Guidance issued by Sharia Supervisory Board
  (SSB) constitutes Islamic Sharia Rules and
  Principles).

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Fraud and Errors

• The fact that an audit is carried out may act as
  a deterrent, but the auditor is not and can not
  be held responsible for prevention of fraud and
  error, however, the auditor shall be held
  responsible for negligence and misconduct.

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WHAT ISSUES I HAVE FACED?
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What Issues I Have Faced?

• As External Auditor
• Management is of the view that I have nothing to
  do in respect of Shariah compliance (Even if I
  feel that it has something to do with the Objects
  of the Bank / Modaraba).
• Even if I have some evidence in hand, coupled
  with some sort of research work, I am told that
  the Shariah Advisor is the final authority. (I am
  independent, and without any disregard, he is a
  paid employee and a party to the transaction as
  he approved it).

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What Issues I Have Faced?

• As Internal Shariah Reviewer / External Shariah
  Auditor
• Top management and Shariah Advisor, are on my
  side, but the middle level management makes all
  efforts to fail the exercise.
• I am bound to follow the advice of the Shariah
  Advisor, without any opportunity of being heard
  at any independent forum.

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What Issues I Have Faced?

• As Shariah Compliance Inspector
• Management of the bank under inspection makes all
  efforts that either no inspection be carried out
  or if an inspection is inevitable, then it should
  remain limited to whatever Shariah Advisor has
  approved.
• Shariah Advisor becomes a party along with the
  management, as he has approved the transactions
  and issued a clean Shariah review report.
• SBPs management is not sure as to what extent it
  may interfere into the matters of the Bank with
  respect to Shariah compliance.

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What Issues I Have Faced?

• SBPs management changes its decisions with
  regard to the scope of inspection and the
  responsibility for inspection within various
  departments.
• SBPs Shariah board includes a member who was the
  Governments advocate in the case against the
  declaration of banks interest as Haram, and
  another member, who is on a number of Shariah
  boards and Shariah Advisor of a Bank whose
  independence from this perspective is not
  ensured.

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• Thank you..