SHARI’AH AUDITing: between theideals and realities

7th DISTANCE LEARNING PROGRAM

ISLAMIC DEVELOPMENT BANK , JEDDAH

Assoc. Prof. Dr. Shahul Hameed Hj. Mohamed IbrahimKulliyah of Economics and Mangement SciencesInternational Islamic University Malaysia

· Al-Hujurat (The Dwellings) [49:6]O ye who believe! If a wicked person comes to you with any news, ascertain the truthlest ye harm people un wittingly, and afterwards become full of repentance for what ye have done.

Shariah auditing has currently emerged as an important subject of discussion inline with the advance development of Islamic Financial Institutions (IFIs) . This demands the proper governance of the Shari’ah compliance issues. As a new emerging discipline, there are several issues which need to be dealt . It is important that we discuss these issues and make inputs to the development of shariah auditing.

This lecture will proceed as follows:

•

INTRODUCTION

Presentation outline

Types of auditing and review

Financial Statement Audit

International Standards on Auditing (ISA) 200, Objective and General Principles Governing an Audit of Financial Statements, states that: “The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework”.

Audit Definition

Broader definition of auditAAA defined auditing as:

“a systematic process of objectively obtaining and evaluating evidence regarding assertions about

economic actions and events to ascertain the degree of correspondence between those assertions and

established criteria and communicating the results to interested users” (Committee on Basic Auditing

Concepts [COBAC], 1972: 2)

Auditing process

Element Conventional Audit Islamic Auditing

3 party relationship Entity, auditor, user Entity, auditor and broader range of users

Appropriate subject matter

Financial statement assertions

Processes, contracts, personnel, systems, performance, financial statements

Suitable criteria IFRS Shari’a principles and rules, aaoifi standards and appropriate parts of IFRS

Sufficient appropriate evidence

Sufficient and appropriate evidence

SSB rulings, fatwas of international and national fiqh boards, plus all other conventional evidence

Written assurance report

Standard audit report prepared by auditor

A more detailed report prepared by a shari’a auditor

Comparison between conventional and islamic auditing

Evolution of Auditing

Late 1800s/1900s 1960s/1970s 1970s 2000s

Financial statements

Economy, effectiveness and efficiency of resource utilization, programs & activities

Social contribution & environmental compliance

Every aspect of organization’s activities as required by Islamic religiious teaching

Financial Audit Performance Audit Social & Environmental Audit

Shari’ah Audit

Need for shariah auditing research

The advanced development of Islamic financial industry necessitates for an auditing mechanism which can fulfill the unique requirements of the industry

Lack of research (especially empirical-based research) in the field of auditing from Islamic perspective.

The many unresolved issues regarding the conceptual and practical dimensions of Shari’ah audit.

Issues in shariah auditing

Shariah auditing definition

According to GSIFI 2 of AAOIFI,Shari’a review is an examination of the extent of an IFI’s compliance, in

all its activities, with the Shari’a. 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. The objective of a Shari’a review is to ensure that the activities carried out by an IFI do not contravene the Shari’a.

While the SSB is responsible for forming and expressing an opinion on the extent of an IFI’s compliance with the Shari’a, the responsibility for compliance therewith rests with the management of an IFI

• The AAOIFI definition is broad “in all its activities”• It uses the word “review” instead of the word audit• Review =negative assurance, lower level of assurance than audit• Perhaps in the beginning this is better than a full scale audit,

however, the scope in AAOIFI is quite broad

ASSURANCES

REASONABLEASSURANCE

ENGAGEMENT (RAE) (E.g. AUDIT)

(EG AUDIT)

LIMITED ASSURANCE

ENGAGEMENT (E.g. REVIEW)

(E.G. REVIEW)

REDUCTION IN ENGAGEMENT RISK TO A

SUBSTANTIALLY LOW LEVEL IN THE CIRCUMSTANCE OF THE ENGAGEMENT

POSTIVE FORM OF EXPRESSION OF THE

CONCLUSION

REDUCTION IN ENGAGEMENT RISK TO AN ACCEPTABLE LEVEL (BUT AT A HIGHER LEVEL

THAN RAE) IN THE CIRCUMSTANCE OF THE ENGAGEMENT

NEGATIVE FORM OF EXPRESSION

REVIEW AND AUDIT

The meaning of “sharia’” in sharia auditing

Shariah compliance according to AAOIFI means “compliance with Islamic Shari’a Rules and Principles as reflected in the fatwas, rulings and guidelines issued by them (hereinafter, the Shari’a)

This seems contradictory. Unless fatwas, rulings and guidelines covers all activities, then the “extent of shariah compliance in all its activities cannot be reviewed.”

In practice, as our research confirms, the SSB is mainly issuing fatwa's related to financing products and not other activities, hence aaofi’s definition is a bit contradictory.

Auditing by persons based on criteria issued by the auditor themselves poses a “self review” threat to independence.

It does not bode well for the use of audit judgment making the review a mechanistic procedure.

In the conventional accounting world, the IAASB develops International standards on auditing and assurance services and these are pretty established and accepted globally

In the case of shariah auditing, the Accounting and Auditing Association for Islamic Financial Institutions (AAOIFI ) has a set of standards both for conventional and shariah auditing of IFIs.

The shariah auditing standards were reclassified as Governance standards. These are :

Shari’a Supervisory Board: Appointment, Composition and Report

Shari’a Review

Internal Shari’a Review

Audit and Governance Committee for Islamic Financial Institutions

Independence of Shari’a Supervisory Board (new)

Statement on Governance Principles for Islamic Financial Institutions (new)

Corporate Social Responsibility (under development)

Shariah auditing standards

Independence and qualifications of shariah auditors (SSB)

 A unique corporate governance mechanism of Islamic financial Institutions is the shari’a supervisory board (SSB) which is theoretically an independent external body akin to external auditors.

Consisting of at least 3 scholars in fiqh muamalat, who may be supported by experts in Islamic banking with knowledge of fiqh muamalat- problem may not have accounting or auditing expertise

The board is supposed to direct, supervise and review the activities of the Islamic Financial Institution to ensure shari’a compliance in all its activities- problemSelf interest threat to independence.

The SSB is known under various namesIn Malaysia, Bank Negara calls it shari’a committee, although Bank Islam Malaysia Bhd., uses the term Shariah Supervisory Council,

whereas Meezan Bank of Pakistan has both a Shari’a Advisor (who issued the Shari’a Report) and a SSB,

Shamil Bank of Bahrain uses Religious Supervisory Board,

and al Baraka Bank uses the term Shari’a Board.

Bank Negara Malaysia

Shari’a Committee

Bank Islam Malaysia

Shariah supervisory Council

Shamil Bank Bahrain

Religious Supervisory Board

Meezan Bank Pakistan

Shari’a Advisor Al Baraka

Bank Bahrain

Shari’a Board

Confusion in SSB Nomenclature?

Duties of the SSB – A Malaysian view

GPS1 (Shariah Guideline 1 of the Central Bank of Malaysia gives what i believe is a more thought out role of the SSB then the AAOIFI standard i.e.

participate and actively engage in deliberating Shariah issues put before them.

advise the BOD on Shariah matters in its business operation. Endorse Shari’a Compliance Manuals which specify the manner in which

a submission or request for advice is to be made to the SC, the conduct of SC meetings, and the manner of compliance with any shari’a decision.

endorse and validate relevant documentations such as contracts, agreemnts, product manual, marketing, advertisements, sales illustrations and brochures used to describe the product. for shari’a compliance.

To assist related parties such as the IFI’s legal counsel, auditor, or consultant, on shari’a matters for advice upon request.

To advise on matters which have not been endorsed or resolved to the Shariah Advisory Concil of BNM.

To provide written shari’a opinions where the IFI requests advice and on applications for product approvales to the BNM and to assist the SAC on reference for advice e.g by explaining shari’a issues involved and references to jurisprudential literature. And established sources.

Shariah audit procedures

SHARI’A REVIEWCYCLE

Planning Review Procedures

The Shari’a review procedures shall be planned so that it is completed in an effective and efficient manner. The plan shall be adequately developed to include a complete understanding about the IFI’s operations in terms of products, size of operation, locations, branches, subsidiaries and divisions. The planning shall include obtaining a list of all fatwas, rulings and guidelines issued by the SSB. Understanding the activities, products and management’s awareness and attitude towards compliance with the Shari’a is essential. This will have a direct effect on the nature, extent and timing of the Shari’a review procedures. The plan shall be properly documented including the sample selection criteria and sizes, taking into consideration complexity, and frequency of transactions. The review procedures shall be designed based on the above input. The review procedures shall cover all activities, products and locations. These procedures shall ascertain whether the SSB approved transactions and products have been undertaken and all related conditions have been met.

Executing Review Procedures & preparing working papers

At this stage all the planned review procedures are executed. The SSB review procedures shall normally include:

obtaining an understanding of the management’s awareness, commitment and compliance control procedures for adherence to the Shari’a; reviewing of contracts, agreements, etc.; ascertaining whether transactions entered into during the year were for products authorised by the SSB; reviewing other information and reports such as circulars, minutes, operating and financial reports, policies and procedures, etc.; consultation/co-ordination with advisors such as external auditors; and discussing findings with an IFI’s management.

The execution of the above review procedures shall be documented in work papers which shall be complete, neat and cross referenced to review procedures.

Documenting Conclusions & Reporting to shareholders

The SSB shall document their conclusions and prepare their report to the shareholders based on the work done and discussions held. The SSB report shall be read at the annual general meeting of the IFI. A detailed report, when warranted, shall also be issued to an IFI’s management. Quality assurance

The SSB shall implement adequate quality control policies and procedures to ensure that the review is conducted in accordance with this standard. Quality control procedures may include review of all work papers to ensure that review procedures were properly understood and executed. Additional discussions may be held with the IFI’s management, if required, to ensure that all significant matters were covered during the review.

Internal shariah review

In addition to the shari’a review, the IFI is also required to conduct an internal shari’a review by a special shari’a compliance unit or department or a branch of the internal audit department depending on the size of the bank. This is just like the internal audit and external audit which complement each other. It is plainly impossible for the SSB to carry out a vouching audit to verify the shari’ah compliance of an IFI. Therefore, it has to rely on its internal control systems, part of which is the internal shari’a review.

ELEMENTS OF INTERNAL

SHARI’A REVIEW

CHARTER AND OBJECTIVES

INDEPENDENCE & OBJECTIVITY

PROFESSIONAL PROFICIENCY

SCOPE OF WORK PERFORMANCE MANAGEMENT OF

THE INTERNAL SHARI’A REVIEW

QUALITY ASSURANCE OF SHARI’A REVIEW

ELEMENTS OF EFFECTIVE INTERNAL

SHARI’A REVEWI CONTROL SYSTEM

STAFFING AND SUPERVISION

COMPLIANCE WITH CODE OF

ETHICS

KNOWLEDGE, SKILLS AND DISCIPLINES

CONTINUOS EDUCATION

AND TRAINING

DUE PROFESSIONAL

CARE

PLANNING AND DESIGN OF INTERNAL

SHARI’A REVIEW

EXAMININGAND

EVALUATINGINTERNAL

SHARI’A REVIEW INFORMATION

REPORTING

FOLLOW UP

EMPLOYEES

SEGREGATION OF DUTIES

CONTROL PROCEDUES

Elements of internal shariah review

Shariah audit reports

AAOIFI’S SHARIAH AUDIT REPORT

In the name of Allah, The Beneficent, The Merciful

To the Shareholders of The Example Islamic Financial Institution Assalam Alaikum Wa Rahmat Allah Wa Barakatuh

In compliance with the letter of appointment, we are required to submit the following report: We have reviewed the principles and the contracts relating to the transactions and applications introduced by the Example Islamic Financial Institution during the period ended. We have also conducted our review to form an opinion as to whether the Example Islamic Financial Institution has complied with Shari’a Rules and Principles and also with the specific fatwas, rulings and guidelines issued by us. The Example Islamic Financial Institution’s management is responsible for ensuring that the financial institution conducts its business in accordance with Islamic Shari’a Rules and Principles. It is our responsibility to form an independent opinion, based on our review of the operations of the Example Islamic Financial Institution, and to report to you. We conducted our review which included examining, on a test basis of each type of transaction, the relevant documentation and procedures adopted by the Example Islamic Financial Institution We planned and performed our review so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the Example Islamic Financial Institution has not violated Islamic Shari’a Rules and Principles. In our opinion: a) the contracts, transactions and dealings entered into by the Example Islamic Financial Institution during the year ended ... that we have reviewed are in compliance with the Islamic Shari’a Rules and Principles; b) the allocation of profit and charging of losses relating to investment accounts conform to the basis that had been approved by us in accordance with Islamic Shari’a Rules and Principles; (where appropriate, the opinion paragraph shall also include the following matters:) c) all earnings that have been realized from sources or by means prohibited by Islamic Shari’a Rules and Principles have been disposed of to charitable causes; and d) the calculation of Zakah is in compliance with Islamic Shari’a Rules and Principles. We beg Allah the Almighty to grant us all the success and straight-forwardness. Wassalam Alaikum Wa Rahmat Allah Wa Barakatuh (Names and signature of the members of the Shari’a supervisory board) Place and Date

EXTREMES IN PRACTICE - TOO BRIEF (THE MALAYSIAN CASE)

EXTREMES IN PRACTICE – THE GOLD STANDARD – MEEZAN BANK OF PAKISTAN

EXTREMES IN PRACTICE – THE GOLD STANDARD – MEEZAN BANK OF PAKISTAN

LITERATURE REVIEW

The literature on auditing in the Islamic perspective is very limited.

Among the writings which attempt to explore the conceptual framework of auditing from Islamic perspective are for e.g. Khan, 1985; Briston & El Ashker, 1986; Harahap; 2002.

The writings which highlight the auditing issues in Islamic banks (Al Abji, 1989; Janahi, 2000; Simpson & Willing, 2000)

The studies on the role, functions, responsibility and independence of Shari’ah advisors (for example Abu Mouamer, 1989; Abdallah, 1990; Abdul Rahman et al., 2004; Shafei, 2005).

Literature Review

There are also studies that compare the different models of the roles of Shari’ah Supervisory Board (SSB) and external auditors in Islamic banks (Banaga, 1994), the notion of independence between SSB and external auditors (Karim, 1990) and possible interaction between the two parties (Hood & Bucheery, 1999).

The relevance of Islamic auditing to the public audit institutions has been explored by Khan (2001) who analyzes the role of Supreme Audit Institutions (SAIs) in the Islamic economy.

The latest study which is more comprehensive in identifying the issues and challenges of Shari’ah compliance process in the IFIs is a paper by Grais & Pellegrini (2006). Their study has explored the limitations in relying the Shari’ah compliance assurance to the internal party (i.e. SSB) and proposed an effective framework to monitor and assess Shari’ah compliance.

summary

Gap of the Literature on Shari’ah Audit

RESEARCH OBJECTIVE & METHODOLOGY

Research Objective

To explore the perceptions of accounting academicians, audit practitioners and Shari’ah scholars in Malaysia with regards to the issues of Shari’ah auditing.

Research Questions

1. Is it important to develop the discipline of Shari’ah audit and what should be the definition of Shari’ah audit? This question examines the awareness of respondents of the term Shari’ah audit and their perception on the importance to establish the discipline of Shari’ah audit and its definition.

2. What are qualification requirements for Shari’ah auditors and who should appoint Shari’ah auditors? This question seeks to identify who are supposed to perform Shari’ah audit, what should be the qualification requirements for Shari’ah auditors, and who should appoint the Shari’ah auditors.

3. What should be the scope of Shari’ah audit? This question encompasses the investigation on the business areas to be audited under Shari’ah audit

4. To what extent should Shari’ah audit be performed? This question aims to explore the extent of and when Shari’ah audit should be performed.

Question of definitionReview or audit?

Review is defined as “is a service where the auditor’s objective is to provide a moderate level of assurance, being a lower level of assurance than that provided by an audit” (CPA Australia, 2006)

Review has also been defined as “a formal assessment of an activity with the intention of suggesting or implementing changes” or a review “implies an audit type investigation that does not meet the full requirements of Generally Accepted Auditing Standards (GAAS)” (O’Regan, 2004)

GSIFI No.2 on Shari’ah review states that “Shari’ah review is an examination of the extent of an IFI’s compliance in all its activities with the Shari’ah” (AAOIFI, 2002)

Shariah reports indicate an audit not a review

Who should Conduct Shari’ah Audit?

New Professionals

called Shari’ah

auditors??

External Financial

auditors??

Shari’ah Supervisory

Board??

Islamic Jurists

(Ulama)?

Internal auditors

under supervision

of SSB??

Qualification & Competence Requirements

Trax Associates, Sept 2003

Degree/Professional qualification in accounting and specialized certification

in Shari’ah audit??

Degree/Professional qualification in accounting & Fiqh (Islamic Law)??

Degree/Professional qualification in accounting??

?

Processes & Procedures??

Contracts & agreements??

Environmental impact of

operation??

Human resource

Management??

Scope of Shari’ah

Audit

Business Policies??

Scope of Shari’ah Audit

Social contribution??

Marketing & advertising??

Zakat calculation& payment??

To What Extent & When Should Shari’ah Audit be Performed?

Every single activity?To the extent deemed satisfactory by the auditors?Using sampling method?

Throughout financial year?During new product application?At the end of financial year?

To what extent? When?

Respondents’ Background

1. Muslim accounting academicians

Muslim lecturers teaching at the Accounting Program in

public universities in peninsular Malaysia

2. Muslim audit practitioners

Muslim audit practitioners in peninsular Malaysia

3. Shari’ah scholars

Members of the Shari’ah Committee or Shari’ah Supervisory Board (SSB) of the Islamic commercial banks (ICB) and

Islamic subsidiaries of commercial banks (ISCB) in Malaysia

FINDINGS & ANALYSIS

Response Rate

No. Respondents

TotalDistributed Total

ReceivedTotalUsed

ResponseRate (%)

No % No % No %

1. Accounting lectures

187 52.1 62 62 60 61.2 33.2

2. Auditors126 35.1 27 27 27 27.6 21.4

3. Shari’ah Committee

46 12.8 11 11 11 11.2 23.9

Total359 100 100 100 98 100 27.9

Research Question No.1

Awareness of the term “Shari’ah Audit”

No.

Statement

Acctg.Lecturers

AuditorsShari'ah scholars

Overall

N % N % N % N %

1. Awareness of the term “Shari’ah Audit”:YesNot SureNoMissing

289

221

46.715

36.61.7

75

141

2618.551.83.7

7-31

63.6-

27.39.1

4214393

42.814.339.83.1

60 100 27 100 11 100 98 100

Research Question No.1

The Importance of Developing the Discipline of “Shari’ah Audit”

Research Question No.2

Who should perform Shari’ah audit for IFIs

Research Question No.2

Competence and Qualification Requirements of Shari’ah Auditors

No

Statement

Acctg.Lecturers

AuditorsShari'ah scholars

Overall

Kruskal-Wallis Test

(Asymp. Sig.)

NMean

Median

NMean

Median

NMean

Median

NMean

Median

6. It is important for a body to set up qualification and competence requirements for Shari’ah auditors

59 4.68 5 27 4.48 5 9 5 5 95 4.65 5 .023

7. Minimum qualification of the Shari’ah auditor:a)Degree/Professional in accountingb)Degree/Professional in accounting & Fiqh (Islamic Law)c)Degree/Professional qualification in accounting and specialized certification in Shari’ah audit

38

43

54

3.76

4.42

4.54

4

5

5

21

24

24

4.29

4.08

4.37

4

4

4.5

4

6

10

3.75

4.50

4.90

4

4.5

5

63

73

88

3.94

4.31

4.53

4

4

5

.193

.094

.076

Research Question No.2

Who should appoint Shari’ah auditors for IFIs

No StatementAcctg Lecturers Auditors

Shari'ah scholars

Total

N % N % N % N %

5a. Shareholders of the respective IFI through its AGMYesNo

654

1090

720

25.974.1

38

27.372.7

1682

16.383.7

60 100 27 100 11 100 98 100

5b. Bank Negara of Malaysia YesNo

555

8.391.7

423

14.885.2

29

18.281.8

1187

11.288.8

60 100 27 100 11 100 98 100

5c. Islamic Financial Service Board (IFSB)YesNo

2337

38.361.7

1611

59.340.7

110

9.190.9

4058

40.859.2

60 100 27 100 11 100 98 100

5d. A newly established regulatory and supervisory body dedicated to oversee the practice of Shari’ah auditYesNo

4614

76.723.3

1413

51.948.1

56

45.554.5

6533

66.333.7

60 100 27 100 11 100 98 100

Research Question No.3

Areas to be audited under Shari’ah audit

Research Question No.4

To what extent Shari’ah Audit should be performed?

No Statement

Acctg.Lecturers

Auditors Shari'ah scholars Overall

N % N % N % N %

9a. Every single activity 20 33.9 5 18.5 4 44.4 29 30.5

9b. As assumed satisfactory by the auditors

19 32.2 6 22.2 2 22.2 27 28.4

9b. Using sampling method 20 33.9 16 59.3 3 33.3 39 41.1

59 100 27 100 9 100 95 100

Research Question No.4

When Should Shari’ah Audit be Performed?

No Statement

Acctg.Lecturers

AuditorsShari'ah scholars

Overall

N % N % N % N %

10a. Throughout financial year 32 53.3 15 57.7 3 33.3 50 52.6

10b. During new product application - - 3 11.5 1 9.1 4 4.2

10c. At the end of financial year 28 46.7 8 30.8 5 55.6 41 43.1

60 100 26 100 9 100 95 100

CONCLUSION

Conclusion – Research Question No.1

While the subject of Shari’ah audit is gradually attracting the attentions from relevant parties such as scholars in the field of Islamic finance, however generally it has yet to become a popular subject to the academic individuals in the accounting field and to the audit professionals especially.

Despite the respondents’ varying degree of awareness, it is very encouraging to discover that the respondents highly regarded the importance to develop the discipline of Shari’ah audit.

While many of the respondents tend to agree towards defining the term Shari’ah audit based on the definition of Shari’ah review by AAOIFI, several other respondents have instead see the inappropriateness of such association.

Shari’ah audit should be performed by new professionals called “Shari’ah auditors” who are specifically certified in Shari’ah audit

Shari’ah auditors must be appointed by a new independent body dedicated to oversee the practice of Shari’ah audit

It is seen strongly important to establish and standardize the qualification and competence requirements for Shari’ah auditors who are supposed to have minimum degree/professional qualification in accounting and specialized certification in Shari’ah audit

Conclusion – Research Question No.2

Among the areas of the business activities that are perceived as mostly important in Shari’ah audit work are; Zakat calculation and payment, contracts and agreements, processes and procedures,

financial system & reporting, and business policies.

Conclusion – Research Question No.3

Since the term “Shari’ah compliance” implies a broader understanding, responsibility and accountability (i.e. in this world and hereafter), there could be a dilemma of whether the audit to attest such compliance is sufficient by relying on the sampling method or the extent deemed satisfactory by the auditors, or we should go beyond those assumptions by checking and assuring every single activity of the IFIs are in compliant with the Shari’ah precepts and conducting the Shari’ah audit throughout financial year.

Conclusion – Research Question No.4

Discussed the role of Supreme Audit Institutions (SAI) in the Islamic countries.

The scope of Supreme Audit Institutions (SAIs) in the Islamic countries need to be expanded to play an effective role in realizing the objectives of an Islamic economy which stands for freedom, justice, fairness, protection of public interest and elimination of and corruption.

Illustrated the newer expectations of the SAI which covers 15 areas, namely accountability, transparency, corruption and fraud, performance auditing, evaluation of policies, audit of expenditure management systems, audit of privatization, evaluation of regulators, audit of public debt, environmental audits, leadership role in reforming government accounting, audit of social services and public administration, and lastly the framework for realizing Shariah goals through the SAI.

Among the element of framework for realizing Shari’ah goals through Supreme Audit Institution is to train the auditors.

The SAI (perhaps to apply to the regulator of Shari’ah audit practice in general) would need to determine the knowledge and skill requirements of its staff for the expanded role outlined in his study.

back

Literature Review – Khan (2001)

Provided analysis on the factors affecting the notion of the independence of SSB versus the external auditors

It is necessary that both SSB and the external auditors are perceived independence to ensure the credibility of financial statements

The perceived independence of the SSB is very much influenced by moral values while that of external auditors is largely affected by economic factors.

Another incentive for SSB’s independence is due to the belief that a rational management would be very keen to adhere to religious precepts since the cost it would bear for a reported breach would be more than the cost it can impose on the SSB.

He opines that ideally both SSB and external auditors should be from one organizational body since Islam does not recognize any separation between business and religion.

suggested that accounting principles compatible with Islamic law must be developed as guidance for those who conduct the financial audit for Islamic financial institutions or Islamic enterprise and be familiar with the various religious rulings which have a bearing on the financial matters of the bank.

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Literature Review – Karim (1990)

Shari’ah compliance is essential for the Islamic banks given the impact that their products may no longer be acceptable if they fail to comply.Emphasized that one of the relevance of the Islamic banking industry’s infancy is highlighted by the continued lack of an internationally accepted framework of uniform and comprehensive accounting standards or auditing guidelines.

Argued that the role of external auditors in the Islamic banks is seen to be complex due largely to the lack of experience of most external auditors on the Shari’ah principles

Believed that establishment of rules and regulations would enhance the effectiveness of the banks and ensure its compliance to the Shari’ah.

back

Literature Review – Simpson & Willing (2000)

Wrote a book in Indonesian language on Auditing from the Islamic Perspective

Provided discussion on the development of accounting and auditing in the Islamic sphere and urged for the Muslim Intellectuals to develop the discipline of Islamic auditing as it is inline with the development of Islamic Financial System.

Stressed the importance of formulating a philosophical foundation of the auditing theory from Islamic perspective as he elaborated that the absence of a philosophical foundation would lead to the variation and lack of focus in the development of Islamic auditing as a discipline and in practice.

Among other future initiatives to be taken with regards to Islamic auditing are: 1) to transform the social system into Shari’ah based system where currently Muslim society are very much tied to the Western ideology and civilization, and 2) to harmonize the practice among all the Muslims.

back

Literature Review – Harahap (2002)

The Malaysian Practice

The following is the result of interviews conducted by my student Sister Nawal Kassim who is undertaking a PhD in Accounting under my supervision.

22 respondents comprising external auditors, Sharia supervisory board members and staff of shariah compliance units/internal auditors of 9 IFIs and 6 Islamic branches of conventional banks in Malaysia.

Interviews covered: definition and responsibility, organization of the shariah compliance function Reporting structures of shariah compliance units scope of audit, audit procedures, independence, qualifications and authority of SSBs.

Malaysian Practice- DefinitionPreference for shariah review as opposed to audit (in line with aaoifi definition.)One respondent (head of Islamic bank audit dept of local Islamic branch) consider no need for separate audit unit as “procedures and processess are the same as conventional auditing” – minority viewAnother respondent (shariah compliance unit) said that the responsibility for the shariah audit is the responsibility of the Shariah supervsory board or in Malaysia known as the Shariah CommitteeAnother respondent (external auditor) is of the view that shariah compliance audit is an internal matter nothing to do with external auditor because:

Not required by lawLack of expertiseWill increase audit cost

Practice- Organization of the shariah compliance function

Many different structures as illustrated below:

Reporting structures of Shariah compliance units

The shariah departments or units reports to various persons in different IFIs. This includes

Reporting to CEO/MD (3/22 )Reporting to SSB (10/22)Reporting to Risk manager (4/22)Product development manager (3/22)

Problems of independence can be seen. Perhaps should report to audit committee of the BODAll products/findings are endorsed by SSBNo direct contact with Scompliance personnel but through shariah division head or shariah co-ordinator who attends the SSB meetings.

Malaysian Practice- Audit Scope

Most IFIs audit compliance of products only.Cost consideration of extending scopeNewcomers and therefore need to compete by developing new products

• (discuss Implication on audit report on activities and operations)

Education of staff needed before scope expansionPerceived to be difficult

Other scope under research stageExtension of scope in agendaDiscussion on going on staff compliance with sharia dress codes and marketing of productsNot in favour of social and environmental or performance audit as considered not within scope and lack of public awareness

Fear workload increase without adequate resourcesCapitalist mentality- shariah audit is a business unit to make profits.

Malaysian Practice- Audit Procedures

Begins at proposal stageUse of checklist with non-compliance parameters development by shariah division and endorsed by SSBKey Risk indicatorsUse shariah policy, guidelines, circulars and fatwas.Non compliance reported to SSB on a monthly basis

Ex post audit

Documents reviewed includeConcept papers, structure and terms sheetDocumentation examined include agreements, letters of offer, policies and procedures, corporate advertisements/brochures and pamphlets

The above documents are compared withFatwasCentral bank regulationsCompany’s shariah compliance audit manual

Non compliance are noted as comments and queries and post audit monitoring is carried out.Observation: lack of audit judgment, very mechanical process is evidence.

Authority , Independence and Qualifications issues

Internal audit teams who conduct shariah audits are not Muslims nor shariah qualified except in a very few cases.However, they claim to be exposed to concepts/policies and ethics of IslamThey work with shariah qualified officers in the shariah department or compliance unitUse shariah compliance checklist handed down from HeadQuarters but modified for Malaysian environmentSSB is dominant in the process as they must endorse the work of the SC units

Authority , Independence and Qualifications issues

However, there seems to be overdependence on the organizational units to carry out most of the audit work due to:

SSB members are part timeMostly academics who are busy

Therefore their Independence and reliability of the evidence on which their report is based is put into question.SSB meetings discuss Shariah compliance matters in addition to product development approvals

Recommendations for future development of Shariah Auditing

There is need for integrated education of shariah auditors and accountants to produced competent shariah accountants and auditors

Accountants can be certified in shariah audit (short term)Shariah/madrasah/hafiz students with a strong grounding in Arabic and islamic studies should follow an integrated curriculum in both Arabic and English with accounting, auditing, business, fiqh muamalat and usulul fiqh subjects as well as Islamic economics, finance, accounting etc

Shariah auditing needs to evolve to cover marketing, personnel, systems, processes, social and environmental areasSSB functions should be decomposed into advising and directing and the review function should be split to an independent outside professional group known as shariah public accountants and auditors who are independent of the company and the SSB.AAOIFI needs to update its GSIFI standards to differentiate review from audit as well as broadening the scope of shariah audit and develop standards on related audit procedure and better audit report standard.There needs to be a professional body for Shariah accountants and auditors.

Wassalamu’alaikumThank You!

The End