Islamic Accounting

Shariah Governance and Auditing

Md. Harashid bin Haron, Ph.D harashid@usm.my; mdharashid@gmail.com E-learning Portal: http://elearning.usm.my

Governance
Corporate governance refers to the method by which a corporation is directed, administered or controlled. The CG is not much different from other organizations except IFI has the responsibility to ensure the compliance with the Shariah principles in its products, instruments, operations, practices, management etc. Shariah governance is one of the components exclusive for IFI

A set of processes, policies, laws affecting the way an organization is directed, administered and controlled. Includes relationship among stakeholders, management and board of directors, employees and customers. Decision making process by which decisions are implemented

 Principle 3.1 of the IFSB Guiding Principles on Corporate Governance states that an appropriate mechanism must be created to ensure the compliance with the Shariah principles. Principle 7.1 of the IFSB Guiding Principles on Risk Management states that IFI shall have in place adequate systems and controls, including Shariah Board/Advisor to ensure compliance with the Shariah principles.

 Shariah compliance (SC) is the backbone of Islamic banking and finance SC gives legitimacy to the practices of Islamic banking and finance SC boosts the confidence of the shareholders and the public that all the practices and activities are in compliance with the Shariah at all times

 Non-Shariah compliant element would not only affect the confidence of the public to Islamic banking & finance But might also expose IFI to risk, e.g fiduciary and reputational risks A Shariah Governance Framework to ensure compliance with the Shariah principles was put in place

Shariah Governance Framework (SGF) for Islamic Financial Institutions.

In Malaysia, a two-tier Shariah governance infrastructure comprising two (2) vital components i) A centralised Shariah advisory body (at the Bank) and ii) An internal Shariah Committee (IFI).

 Shariah Advisory Council of Bank Negara Malaysia (SAC) is a body established under section 51 of the Central Bank of Malaysia Act 2009 Positioned the SAC as the apex authority for the determination of Islamic law for the purposes of Islamic financial business. The mandates of the SAC, among others, are to ascertain the relevant Islamic law on any financial matter and issue a ruling upon reference made to it, as well as to advise the Bank and the IFI concerned on any Shariah issues relating to Islamic financial business operations, activities or transactions.

 At the industry level, the duties and responsibilities of the internal Shariah Committee in advising the respective IFIs on Shariah matters were further deliberated in the Guidelines on the Governance of Shariah Committee for the Islamic Financial Institutions issued in 2004. The guidelines are now superseded in light of new developments in Islamic finance as well as higher expectation of the key stakeholders of the IFI pertaining to the Shariah compliance process.

 Primary objective of SGF is enhancing the role of the board, the Shariah Committee and the management in relation to Shariah matters This also includes enhancing the relevant key organs having the responsibility to execute the Shariah compliance and research functions aimed at the attainment of a Shariah based operating environment.

SGF: Approach
General Requirements of the Shariah Governance Framework Oversight, Accountability & Responsibility Independence Competency Confidentiality & Consistency Shariah Compliance & Research Functions (i) Shariah Review (ii) Shariah Audit (iii) Shariah Risk Management (iv) Shariah Research

 Principle 1: It is the duty and responsibility of an IFI to establish a sound and robust Shariah governance framework with emphasis placed on the roles o f key functionalities in ensuring effective implementation of the Shariah governance framework.

Illustration of Shariah Governance System

Functions Governance Control Typical Financial Additions in IFIs Institution Board of Directors Shariah Board Internal Auditor External Auditor ISRU External Shariah Review ISCU

Compliance

Regulatory and financial compliance officers, unit or departments

Model of Shariah Governance

CBA 2009, section 53A of the IBA, section 69 of the TA, section 126 of the BAFIA and section 126 of the DFIA.

binding on the court as well (obligatory)

BNM issued Shariah Governance Framework for Islamic Financial Institutions.

Auditing
Shariah review (audit) is an examination of the extent of an IFIs compliance, in all its activities, with the Shariah. This examination includes contracts, agreements, policies, products, transactions, memorandum and articles of association, financial statements, reports (especially internal audit and central bank inspection), circulars, etc. [Para 3, GSIFI 2, AAOIFI Standards).

Auditing (our context)

Shariah audit is an examination of the extent of an IFIs compliance with the Shariah in all its activities particularly in financial statements and other operational components of the IFI that are subjected to the risk compliance including but not limited to products, the technology supporting the operations, operational processes, the people involved in key areas of risk, documentations and contracts, policies and procedures and other activities that require adherence to Shariah principles.

Shariah Committee (SC) @ Shariah Supervisory Board (SSB)

SGF: Oversight, Accountability & Responsibility Principle 2: An IFI shall set out the accountability and responsibility of every key functionary involved in the implementation of Shariah governance framework. Board of directors, Shariah Committee (SC), Management

 The SC shall be responsible and accountable for all its decisions, views and opinions related to Shariah matters. Deliberate rigorously the issues at hand before arriving at any decisions (decisions, views and opinions bind the operations of the IFI). Performing an oversight role on Shariah matters related to the institutions business operations and activities aided by the Shariah review and the Shariah audit functions. Identifying issues that require attention and where appropriate, proposing corrective measures (from regular Shariah review reports and the Shariah audit observations)

 Disclosing sufficient information in the IFIs annual financial report on the state of compliance of the IFI, as per the requirements under the Guidelines on Financial Reporting for Licensed Islamic Banks (GP8-i) and Guidelines on Financial Statements for Takaful Operators (GPT6). Further requirements on duties and responsibilities of the SC and the operation procedures for the SC are detailed out in Appendix 4 and Appendix 5 respectively (of the SGF).

SC @ SSB
Types of Shariah Supervision Shariah product consultants (Advisory capacity) Shariah Supervisory Council of Islamic banks (Constitutional Authority & Advisory) Shariah Advisory Council of Bank Negara Malaysia and Securities Commission (Statutory & Advisory)

SC @ SSB
Scope of Supervision Product and system development Financial reporting and Shariah opinion Approval of Shariah financial services and products Approval of listed securities and investment funds

Among common practices

Composition

Qualification (Malaysia)

Roles and Responsibilities

Compliant Criteria (An example of audited criteria from Capital Market)

Shariah Compliant Criteria - KLSE

1. Business of the investee company: The basic business of the investee company should be Halal. Accordingly investment in shares of conventional banks, insurance companies, leasing companies, companies dealing in alcohol, tobacco, pornography, etc. are not permissible. 2. Debt to total assets: The total interest bearing debt of the Investee Company should not exceed 40% of the total assets. 3. Illiquid to total assets: The total illiquid assets of the investee company as a percentage of the total assets should be at least 20%. 4. Investment in Shariah non-compliant activities and income from Shariah non-compliant investments: The following two conditions will be observed for screening purposes: a. Total investment of the investee company in Shariah non-compliant business should not exceed 33% of its total assets. b. The income from Shariah non-compliant investment should not exceed 5% of the gross revenue of the investee company. (Gross revenue means net sales plus other income) 5. Net Liquid assets vs. share price: The net liquid assets (total assets minus tangible fixed assets minus inventory minus total liabilities) per share should be less than the market price of the share.

Ex-DJII Criteria
1. Industry screens: Excluded are companies that represent the following lines of business: Alcohol, Tobacco, Pork-related products, financial services, Defense/weapons, Entertainment 2. Excluded are companies whose total debt divided by trailing 12month average market capitalization is 33% or more 3. Those whose cash plus interest bearing securities divided by trailing 12 month average market capitalization is 33% or more. 4. Excluded are companies whose accounts receivables divided by trailing 12 month average market capitalization is 33% or more.

DJII Filters
1st Filter (Straight-forward) Exclude all companies whose primary business involves forbidden products (e.g. alcohol, pork, tobacco, financial services, weapon production, and entertainment). 2nd set of filters - based on financial ratios 1-Carrying interest-bearing debt. 2-Receiving interest or other impure income. 3-Trading in debts at a price other than their face values.

The Shariah boards of most Islamic fund managers and equity indices have reached very similar compromises. The following is the list of rules/compromises (ibid, p.10) used by DJII:
Exclude companies with a debt to total asset ratio of 33% or more. Exclude companies with impure plus non-operating interest income to revenue ratio of 5% or more. Exclude companies with accounts receivable to total assets ratios of 45% or more.

Auditor & SSB Relationship

Auditor complements SSB of Islamic banks ASIFI No. 1 is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material aspects, in accordance with:
Shariah rules and principles AAOIFI accounting standards and MASB standards

SGF: Shariah Compliance & Research Functions

Principle 7: There shall be a robust Shariah compliance function, comprising review and audit functions, supported by risk management control process and internal research capacity.

Shariah Review
The Shariah review function refers to regular assessment on Shariah compliance in the activities and operations of the IFI by qualified Shariah officer(s), with the objective of ensuring that the activities and operations carried out by the IFI do not contravene with the Shariah. The function involves the examination and evaluation of the IFIs level of compliance to the Shariah, remedial rectification measures to resolve noncompliances and control mechanism to avoid recurrences. The scope shall cover the IFIs overall business operations, including the end-to-end product development process, which start from product structuring to product offering.

The review process shall cover, but is not limited to, the following: (i) planning the review program which includes the objectives, scope, reporting, rectification and follow-up actions followed by the execution of the program; (ii) documentation of the processes involved in the review; (iii) communicating the outcome o f the review and highlighting any noncompliances to the Shariah Committee and the management; and (iv) rectifying any instances of non-compliance with the Shariah to prevent such events from recurring.

Shariah Audit
The periodical assessment conducted from time to time, to provide an independent assessment and objective assurance designed to add value and improve the degree of compliance in relation to the IFIs business operations, with the main objective of ensuring a sound and effective internal control system for Shariah compliance.

 The function shall be performed by internal auditors, who have acquired adequate Shariahrelated knowledge and training. In addition, the internal auditors may engage the expertise of the IFIs Shariah officers in performing the audit, as long as the objectivity of the audit is not compromised. For group structure, the capabilities of the groups internal Shariah audit function should be augmented in line with its responsibilities of serving several financial entities in the group.

 Shariah audit may be conducted as part of the IFIs thematic audit on specialised areas such as management audit and Anti-Money Laundering (AML) audit, according to the risk level and materiality of the impact of Shariah noncompliance in these areas. Shariah audit on critical areas shall be conducted at least once a year depending on the risk profile of the IFI.

 The Board Audit Committee, upon consultation with the Shariah Committee shall determine the deliverables of the Shariah audit function. The deliverables shall be consistent with accepted auditing standards. The scope of Shariah audit shall cover all aspects of the IFIs business operations and activities, including: (i) audit of financial statements of the IFI; (ii) compliance audit on organisational structure, people, process and information technology application systems; and (iii) review of adequacy of the Shariah governance process.

 The process of Shariah audit shall be designed to enable the IFI to assess whether a sound and effective internal control system for Shariah compliance have been implemented, which should cover, but is not limited to, the following: (i) understanding the business activities of the IFI to allow for better scoping of an audit exercise, i.e. auditability and relevance of activities; (ii) developing a comprehensive internal audit program or plan. The program shall include objectives, scope, personnel assignment, sampling, control and duration as well as establish proper audit processes, policies and procedures of IFIs operations;

(iii) obtaining and making reference to relevant sources, including the SACs published rulings, the Shariah Committees decisions, fatwas, guidelines, the Shariah audit results and the internal Shariah checklist; (iv) conducting Shariah audit on a periodical basis; (v) communicating results of any assessment or findings arising from the Shariah audit t o t h e Board Audit Committee and the Shariah Committee; and (vi) providing recommendations on rectification measures taken as well as following-up on the implementation by the IFI.

 The Bank may appoint or employ an external party or person to conduct a Shariah audit on the operations of the IFI, if the Bank considers it is desirable or in the interest of the IFI to do so, in which case the remuneration and expenses relating to the appointment shall be borne by the IFI.

Internal Shariah Audit

Integral elements: Independence & objectivity (organizational status, independent attitude & tasks assigned) Direct and continuous communication to all parties with unlimited access to required documents. Professional Proficiency (including knowledge skills and training in Fiqh al Muamalat) Due professional care

Scope & Role of Internal Shariah Audit

Scope: To examine and evaluate the adequacy and effectiveness of the institution system of internal shariah control and the quality of performance in carrying out assigned responsibilities. Purpose: To ascertain whether the system provides reasonable assurance that objectives set out are complied in effective and efficient manner.

Internal Shariah Audit Work

Planning (include: establishing shariah review objectives, obtaining and making references to fatwas, guidelines, shariah review results, writing internal shariah review programs, communicating the procedures as well as results to parties concerned)

Audit and Governance Committee (AGC)

AGC is to assist in achieving institutions objectives by enhancing greater transparency and disclosure as well as public confidence on institutions application of shariah rules and principles.

Comprise of non-executive directors with sound understanding of the business and shariah supervision.

Audit and Governance Committee

Important functions: Preserving integrity of financial reporting process Safeguarding interests of investors and stakeholders Assurance on financial information reliability Link between management and stakeholders

Audit and Governance Committee

Review of internal controls Review of Accounting practices and audit plan Review of interim and annual accounts and financial reports Review of compliance with shariah rules and principles

Shariah Auditors
External Auditor
To be familiar with Shariah Governance Requirements To undertake Shariah Review Independent (of SSB) samples and tests conducted by auditor

Internal Auditor
To be familiar with Shariah Governance Requirements as well as other related management policies To undertake Internal Shariah Review Constant communication with shariah consultants and Audit Committee can facilitate the review

Audit Report
Audit Opinion
The financial statements as a whole are free from material misstatement based on accumulated audit evidence, refer to the whole audit process and comply with Islamic Shariah rules and principles

Shariah Opinion
Shariah Opinion will be on matters pertaining to:
Contracts, transactions and dealings Equitable allocation of profit & losses Earnings (lawful/prohibited) Zakah Employee welfare? Social obligation, etc

Shariah Audit, Review & Governance for IFI

Independence & Integrity of Shariah Compliance Governance Shariah Audit, Review & Governance: Rules & Guidelines Shariah Compliance Audit & Review Process

Independence & Integrity of Shariah Compliance Governance

Main aim of Shariah supervision is to achieve shariah compliance In actuality In the perception of the outsiders-public confidence Good Shariah compliance governance requires: Independence of judgment Integrity Independence of Shariah Committee from Banks management

Shariah Compliance Audit & Review

Shariah Audit & Review essential check & balance (hisbah); enhance accountability Regulation of Shariah audit essential to ensure independence & integrity: Appointment Process & procedure Reporting Implementation of the reports & recommendations An important indicator of good shariah governance Generate shariah compliance culture Enhance public & stakeholders confidence

Purpose of Shariah Compliance Audit & Review

To mitigate shariah compliance risks Risks arises from the islamic banks failure to comply with the shariah principles and rules

Rate of Return Risk

Displaced Commercial Risk

Credit/ Market Risk

Liquidity Risk

Operational Risk

Shariah Compliance Risk

Shariah Compliance Audit Process (example)

Plan for Audit Conduct Audit Prepare, discuss & confirm findings Report (findings & recommendations) Table report to Audit Committee Follow-up on rectification efforts

Tutorial Questions
1. Elaborate on Shariah Governance and Audit of and their importance to IFIs (in team). 2. List down the types and scope of Supervision of Shariah Committee/SSB (individual)

Terima Kasih Thank You