Islamic Finance - Audit Issues in Islamic Finance PDF

AUDIT & SHARIA COMPLIANCE –
ISSUES IN ISLAMIC BANKING AND

FINANCE
‫ﺑﺴﻢ اﷲ اﻟﺮﺣﻤٰﻦ اﻟﺮﺣﻴﻢ‬
‫ﺻ ْﺪرِي‬
‫ح ﻟِﻲ َ‬ ‫ﺷ َﺮ ْ‬‫با ْ‬ ‫ل َر ﱢ‬ ‫ﻗَﺎ َ‬
‫ﺴ ْﺮ ﻟِﻲ َأ ْﻣﺮِي‬ ‫َو َﻳ ﱢ‬
‫ﻋ ْﻘ َﺪ ًة ﻣﱢﻦ ﱢﻟﺴَﺎﻧِﻲ‬
‫ﻞ ُ‬ ‫ﺣُﻠ ْ‬
‫وَا ْ‬
‫َﻳ ْﻔ َﻘﻬُﻮا َﻗ ْﻮﻟِﻲ‬
‫)ﺳﻮرﮦ ﻃﻪ(‬
‫‪http://www.LearnIslamicFinance.com‬‬
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.
http://www.LearnIslamicFinance.com
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.
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.
1. Standardization of Shariah Compliance Regulations for
Islamic Finance;
2. Improved governance and Shariah Compliance Assurance
for Islamic Financial Institutions; and
3. Shariah Compliance Rating of Islamic Financial Institutions
and Products.
STANDARDIZATION OF SHARIAH
COMPLIANCE REGULATIONS FOR
ISLAMIC FINANCE
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.
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.
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.
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.
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.
IMPROVED GOVERNANCE AND
SHARIAH COMPLIANCE
ASSURANCE FOR ISLAMIC
FINANCIAL INSTITUTIONS
Shariah Non-Compliance Risk: What &
Why?
Shariah non-compliance risk is a significant risk for an Islamic

financial institution from two perspectives:
1. 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
2. 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.
How to Manage Shariah Non-
Compliance Risk?
Shariah Review
Shariah
Supervisory Board
/ Shariah Advisor
Consideration of
Internal Shariah Shariah
Review Compliance by the
External Auditor
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.
Shariah Compliance Assurance for
Islamic Financial Institutions
1. Shariah compliance review report of Shariah Supervisory

Board or the Shariah Advisor (May, or may not be, based on
Internal Shariah Review).
2. Shariah compliance audit by the external auditors of the
Islamic financial institutions.
3. Shariah Compliance Inspection of Islamic commercial banks.
4. Independent Shariah compliance assurance (internal or
external) from professionals.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Independent Shariah Compliance
Assurance by Professionals
This approach is now being applied by a few Islamic banks.

This may be applied in form of:
1. Internal Shariah Review; and
2. External Shariah Compliance Assurance / Audit.
SHARIAH COMPLIANCE RATING
OF ISLAMIC FINANCIAL
INSTITUTIONS AND PRODUCTS
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.
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.
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.
GOVERNANCE STANDARDS BY
AAOIFI
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
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.
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.
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.
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.
AUDITING STANDARDS BY AAOIFI
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
Objective
And 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).
Objective
And 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.
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.
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.
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).
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.
WHAT ISSUES I HAVE FACED?
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).
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.
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.
SBP’s management is not sure as to what extent it may
interfere into the matters of the Bank with respect to Shariah
compliance.
SBP’s management changes its decisions with regard to the

scope of inspection and the responsibility for inspection
within various departments.
SBP’s Shariah board includes a member who was the
Government’s advocate in the case against the declaration
of bank’s 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.
Thank you…..

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AUDIT & SHARIA COMPLIANCE –

ISSUES IN ISLAMIC BANKING AND

 Allah SWT says in Quran that “Allah doth command you to

 Islamic banking industry is presently growing at a very high

 A three fold strategy may help out the industry to ensure

 Standardization is necessary to ensure that all the matters of

 The most admirable job has been performed by:

 AAOIFI was established in 1990 in Algiers under an Agreement

 These Boards have, to date, performed a remarkable job by

 Officially inaugurated on November 03, 2002 and started

 Shariah non-compliance risk is a significant risk for an Islamic

 Rules, regulations and standards might not work unless and

1. Shariah compliance review report of Shariah Supervisory

 Competence (From Assurance Perspective)

 Consequently, their compliance review generally remains

 Scarcity of Resources (Time and Skilled Staff)

 Consequently, you can easily imagine that it is humanly not

 According to AAOIFI standards, the auditor should, to a

 Since the external auditor is also entrusted with the task of

 This is a very good approach, as it is independent and

 Moreover, such exercise is limited to the Islamic commercial

 This approach is now being applied by a few Islamic banks.

 Anyone having basic understanding of Islamic finance

 In addition to the products being launched by the Islamic

 In view of the same it is imperative that a Shariah

 Shari’a Supervisory Board: Appointment, Composition and

 It is an independent body of specialized jurists in fiqh

 Appointment, Composition and Report

 The objective of the Shari’a review is to ensure that the

 The internal Shari’a review is an integral part of the organs of

 Objective and Principles of Auditing

 The auditor should review and assess the conclusions drawn

 When testing for Shari’a compliance, the auditor shall obtain

 As Internal Shariah Reviewer / External Shariah Auditor

 As Shariah Compliance Inspector

 SBP’s management changes its decisions with regard to the

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Allah SWT says in Quran that “Allah doth command you to

Islamic banking industry is presently growing at a very high

A three fold strategy may help out the industry to ensure

Standardization is necessary to ensure that all the matters of

The most admirable job has been performed by:

AAOIFI was established in 1990 in Algiers under an Agreement

These Boards have, to date, performed a remarkable job by

Officially inaugurated on November 03, 2002 and started

Shariah non-compliance risk is a significant risk for an Islamic

Rules, regulations and standards might not work unless and

Competence (From Assurance Perspective)

Consequently, their compliance review generally remains

Scarcity of Resources (Time and Skilled Staff)

Consequently, you can easily imagine that it is humanly not

According to AAOIFI standards, the auditor should, to a

Since the external auditor is also entrusted with the task of

This is a very good approach, as it is independent and

Moreover, such exercise is limited to the Islamic commercial

This approach is now being applied by a few Islamic banks.

Anyone having basic understanding of Islamic finance

In addition to the products being launched by the Islamic

In view of the same it is imperative that a Shariah

Shari’a Supervisory Board: Appointment, Composition and

It is an independent body of specialized jurists in fiqh

Appointment, Composition and Report

The objective of the Shari’a review is to ensure that the

The internal Shari’a review is an integral part of the organs of

Objective and Principles of Auditing

The auditor should review and assess the conclusions drawn

When testing for Shari’a compliance, the auditor shall obtain

As Internal Shariah Reviewer / External Shariah Auditor

As Shariah Compliance Inspector

SBP’s management changes its decisions with regard to the