AUDIT & SHARIA COMPLIANCE – ISSUES IN ISLAMIC BANKING AND FINANCE

1. 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)

2. بسم اللہ الرحمٰن الرحیم قَالَ رَبِّ اشْرَحْ لِي صَدْرِي وَيَسِّرْ لِي أَمْرِي وَاحْلُلْ عُقْدَةً مِّن لِّسَانِي يَفْقَهُوا قَوْلِي (سورہ طھ)

3. 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.

4. 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.

5. 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.

6. STANDARDIZATION OF SHARIAH COMPLIANCE REGULATIONS FOR ISLAMIC FINANCE

7. 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.

8. 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.

9. 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 AAOIFI’s Accounting and Auditing Standards Board whereas the Shariah Standards Board issues the Shariah Standards.

10. 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.

11. 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.

12. Pakistan’s 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.

13. Pakistan’s 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.

14. Pakistan’s 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.

15. IMPROVED GOVERNANCE AND SHARIAH COMPLIANCE ASSURANCE FOR ISLAMIC FINANCIAL INSTITUTIONS

16. 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.

17. How to Manage Shariah Non- Compliance Risk?

18. 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.

19. 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.

20. 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.

21. 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.

22. Shariah Compliance Review By Shariah Advisor – Issues • Management’s 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.

23. Shariah Compliance Review By Shariah Advisor – Issues • Independence • Although we don’t have any doubt on the personal independence and integrity of these respectable jurists, they would themselves appreciate that the work performed under one’s 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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 SBP’s 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.

29. 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.

30. 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.

31. SHARIAH COMPLIANCE RATING OF ISLAMIC FINANCIAL INSTITUTIONS AND PRODUCTS

32. 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.

33. 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.

34. 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.

35. GOVERNANCE STANDARDS BY AAOIFI

36. Governance Standards • Shari’a Supervisory Board: Appointment, Composition and Report • Shari’a Review • Internal Shari’a Review • Audit and Governance Committee for Islamic Financial Institutions

37. Shari’a Supervisory Board (SSB) • It is an independent body of specialized jurists in fiqh almua’malat (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.

38. Shari’a Review • The objective of the Shari’a review is to ensure that the activities carried out by an IFI do not contravene the Shari’a. It is the responsibility of SSB to form and express an opinion on the extent of an IFI’s compliance with the Shari’a.

39. Internal Shari’a Review • The internal Shari’a 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 Shari’a review is to ensure that the management of an IFI discharge their responsibilities in relation to the implementation of the Shari’a Rules and Principles as determined by the IFI’s SSB.

40. 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 public’s confidence of the IFI as genuine in its application of Shari’a rules and principles.

41. AUDITING STANDARDS BY AAOIFI

42. 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

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

44. 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.

45. Auditor’s 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.

46. 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 auditor’s acceptance of the appointment, the objective and the scope of the audit, the extent of the auditor’s responsibilities to the client and the form of any reports to be provided by the auditor.

47. Testing for Compliance with Shari’a Rules and Principles • When testing for Shari’a 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 Shari’a Rules and Principles (the Fatwas, Rulings and Guidance issued by Shari’a Supervisory Board (SSB) constitutes Islamic Shari’a Rules and Principles).

48. 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.

49. WHAT ISSUES I HAVE FACED?

50. 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).