lecture shariah cg and auditing - copy

7/28/2019 Lecture Shariah CG and Auditing - Copy

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Islamic Accounting

Md. Harashid bin Haron, [email protected]; [email protected] Portal: http://elearning.usm.my

Shariah Governance and

Auditing


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GovernanceCorporate governance refers to the method by

which a corporation is directed, administered orcontrolled.

The CG is not much different from other

organizations except IFI has the responsibility toensure the compliance with the Shariahprinciples in its products, instruments,

operations, practices, management etc.Shariah governance is one of the components

exclusive for IFI


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A set of processes, policies, laws affecting the way an organization isdirected, administered and controlled.Includes relationship among stakeholders, management and board ofdirectors, employees and customers.

Decision making process by which decisions are implemented


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Principle 3.1 of the IFSB Guiding Principles onCorporate Governance states that anappropriate mechanism must be created toensure the compliance with the Shariahprinciples.

Principle 7.1 of the IFSB Guiding Principles onRisk Management states that IFI shall have inplace adequate systems and controls, including

Shariah Board/Advisor to ensure compliancewith the Shariah principles.


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Shariah compliance (SC) is the backboneof Islamic banking and finance

SC gives legitimacy to the practices ofIslamic banking and finance

SC boosts the confidence of theshareholders and the public that all thepractices and activities are in compliancewith the Shariah at all times


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Non-Shariah compliant element would not

only affect the confidence of the public toIslamic banking & finance

But might also expose IFI to risk, e.gfiduciary and reputational risks

A Shariah Governance Framework to

ensure compliance with the Shariahprinciples was put in place


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Shariah GovernanceFramework (SGF) for Islamic

Financial Institutions.


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In Malaysia, a two-tier Shariah governanceinfrastructure comprising two (2) vitalcomponents

i) A centralised Shariah advisory body (atthe Bank) and

ii) An internal Shariah Committee (IFI).


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Shariah Advisory Council of Bank Negara

Malaysia (SAC) is a body established undersection 51 of the Central Bank of Malaysia Act2009

Positioned the SAC as the apex authority for thedetermination of Islamic law for the purposes ofIslamic financial business.

The mandates of the SAC, among others, are toascertain the relevant Islamic law on anyfinancial matter and issue a ruling upon

reference made to it, as well as to advise theBank and the IFI concerned on any Shariahissues relating to Islamic financial business

operations, activities or transactions.


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At the industry level, the duties and

responsibilities of the internal ShariahCommittee in advising the respective IFIs onShariah matters were further deliberated in the

Guidelines on the Governance of ShariahCommittee for the Islamic Financial Institutionsissued in 2004.

The guidelines are now superseded in light ofnew developments in Islamic finance as well ashigher expectation of the key stakeholders of the

IFI pertaining to the Shariah complianceprocess.


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Primary objective of SGF is enhancing therole of the board, the Shariah Committeeand the management in relation to Shariah

matters This also includes enhancing the relevant

key organs having the responsibility to

execute the Shariah compliance andresearch functions aimed at the attainment

of a Shariah based operating environment.


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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


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Principle 1:

It is the duty and responsibility of an IFI toestablish a sound and robust Shariah

governance framework with emphasisplaced on the roles o f key functionalitiesin ensuring effective implementation of the

Shariah governance framework.


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Illustration of Shariah

Governance SystemFunctions Typical Financial

Institution

Additions in IFIs

Governance Board of Directors Shariah Board

Control Internal AuditorExternal Auditor

ISRUExternal ShariahReview

Compliance Regulatory andfinancialcomplianceofficers, unit ordepartments

ISCU


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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.


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binding on the court as well (obligatory)


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BNM issued Shariah Governance Framework for

Islamic Financial Institutions.


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Auditing

Shariah review (audit) is an examination of theextent of an IFIs compliance, in all its activities,with the Shariah. This examination includescontracts, agreements, policies, products,

transactions, memorandum and articles ofassociation, financial statements, reports(especially internal audit and central bank

inspection), circulars, etc. [Para 3, GSIFI 2,AAOIFI Standards).


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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 andother operational components of the IFI that aresubjected to the risk compliance including but

not limited to products, the technologysupporting the operations, operationalprocesses, the people involved in key areas of

risk, documentations and contracts, policies andprocedures and other activities that requireadherence to Shariah principles.


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Shariah Committee (SC) @

Shariah Supervisory Board (SSB)


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SGF: Oversight, Accountability &

Responsibility

Principle 2:

An IFI shall set out the accountability andresponsibility of every key functionaryinvolved in the implementation of Shariahgovernance framework.

Board of directors, Shariah Committee(SC), Management


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The SC shall be responsible and accountable for

all its decisions, views and opinions related toShariah matters.

Deliberate rigorously the issues at hand before

arriving at any decisions (decisions, views andopinions bind the operations of the IFI).

Performing an oversight role on Shariah matters

related to the institutions business operationsand activities aided by the Shariah review andthe Shariah audit functions.

Identifying issues that require attention andwhere appropriate, proposing correctivemeasures (from regular Shariah review reports

and the Shariah audit observations)


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Disclosing sufficient information in the IFIs

annual financial report on the state ofcompliance of the IFI, as per the requirementsunder the Guidelines on Financial Reporting for

Licensed Islamic Banks (GP8-i) and Guidelineson Financial Statements for Takaful Operators(GPT6).

Further requirements on duties andresponsibilities of the SC and the operationprocedures for the SC are detailed out in

Appendix 4 and Appendix 5 respectively (of

the SGF).


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SC @ SSBTypes of Shariah Supervision

Shariah product consultants (Advisorycapacity)

Shariah Supervisory Council of Islamicbanks (Constitutional Authority & Advisory)

Shariah Advisory Council of Bank Negara

Malaysia and Securities Commission(Statutory & Advisory)


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SC @ SSBScope of Supervision

Product and system development

Financial reporting and Shariah opinion

Approval of Shariah financial services andproducts

Approval of listed securities and

investment funds


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Among common practices


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Composition


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Qualification (Malaysia)


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Roles and Responsibilities


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Compliant Criteria

(An example of audited criteriafrom Capital Market)

h i h li i i


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Shariah Compliant Criteria - KLSE1. Business of the investee company: The basic business of the investee

company should be Halal. Accordingly investment in shares of conventionalbanks, insurance companies, leasing companies, companies dealing inalcohol, tobacco, pornography, etc. are not permissible.

2. Debt to total assets: The total interest bearing debt of the InvesteeCompany should not exceed 40% of the total assets.

3. Illiquid to total assets: The total illiquid assets of the investee company as apercentage of the total assets should be at least 20%.

4. Investment in Shariah non-compliant activities and income from Shariahnon-compliant investments: The following two conditions will be observedfor screening purposes:a.Total investment of the investee company in Shariah non-compliantbusiness should not exceed 33% of its total assets.

b.The income from Shariah non-compliant investment should not exceed5% of the gross revenue of the investee company. (Gross revenue meansnet 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 shouldbe less than the market price of the share.


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Ex-DJ II Criteria1. Industry screens: Excluded are companies that represent the

following lines of business: Alcohol, Tobacco, Pork-relatedproducts, financial services, Defense/weapons, Entertainment

2. Excluded are companies whose total debt divided by trailing 12-month average market capitalization is 33% or more

3. Those whose cash plus interest bearing securities divided bytrailing 12 month average market capitalization is 33% or more.

4. Excluded are companies whose accounts receivables divided bytrailing 12 month average market capitalization is 33% or more.


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DJ II Filters1st Filter (Straight-forward)

Exclude all companies whose primary businessinvolves forbidden products (e.g. alcohol, pork,tobacco, financial services, weapon production, andentertainment).

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 facevalues.

h Sh i h b d f l i f d


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The Shariah boards of most Islamic fund

managers and equity indices have reachedvery similar compromises. The following is thelist of rules/compromises (ibid, p.10) used by

DJ II:

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 totalassets ratios of 45% or more.


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Auditor & SSB RelationshipAuditor complements SSB of Islamic

banksASIFI No. 1 is to enable the auditor to

express an opinion as to whether thefinancial statements are prepared, in allmaterial aspects, in accordance with:

Shariah rules and principles AAOIFI accounting standards and MASB

standards

SGF Sh i h C li &


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SGF: Shariah Compliance &

Research Functions

Principle 7:

There shall be a robust Shariahcompliance function, comprising reviewand audit functions, supported by riskmanagement control process and internalresearch capacity.

Shariah Review


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Shariah Review

The Shariah review function refers to regularassessment on Shariah compliance in the activities andoperations of the IFI by qualified Shariah officer(s), with

the objective of ensuring that the activities andoperations carried out by the IFI do not contravene withthe Shariah.

The function involves the examination and evaluation ofthe IFIs level of compliance to the Shariah, remedialrectification measures to resolve noncompliances andcontrol mechanism to avoid recurrences.

The scope shall cover the IFIs overall businessoperations, including the end-to-end productdevelopment process, which start from product

structuring to product offering.

The review process shall cover but is not


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The review process shall cover, but is not

limited to, the following:

(i) planning the review program which includes theobjectives, scope, reporting, rectification and

follow-up actions followed by the execution ofthe 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.


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Shariah AuditThe periodical assessment conducted from time

to time, to provide an independent assessmentand objective assurance designed to add valueand improve the degree of compliance inrelation to the IFIs business operations, with themain objective of ensuring a sound and effectiveinternal control system for Shariah compliance.

The function shall be performed by internal


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The function shall be performed by internalauditors, who have acquired adequate Shariah-related knowledge and training. In addition, theinternal auditors may engage the expertise ofthe IFIs Shariah officers in performing the audit,as long as the objectivity of the audit is notcompromised.

For group structure, the capabilities of thegroups internal Shariah audit function should beaugmented in line with its responsibilities ofserving several financial entities in the group.

Shariah audit may be conducted as partof the


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Shariah audit may be conducted as part of the

IFIs thematic audit on specialised areas such asmanagement audit and Anti-Money Laundering(AML) audit, according to the risk level and

materiality of the impact of Shariah non-compliance in these areas. Shariah audit oncritical areas shall be conducted at least once ayear depending on the risk profile of the IFI.

The Board Audit Committee upon consultation


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The Board Audit Committee, upon consultation

with the Shariah Committee shall determine thedeliverables of the Shariah audit function. Thedeliverables 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 technologyapplication systems; and

(iii) review of adequacy of the Shariah governance

process.

The process of Shariah audit shall be designed


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The process of Shariah audit shall be designed

to enable the IFI to assess whether a sound andeffective internal control system for Shariahcompliance 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 asestablish proper audit processes, policies and

procedures of IFIs operations;

(iii) obtaining and making reference to relevant


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(iii) obtaining and making reference to relevant

sources, including the SACs published rulings,the Shariah Committees decisions, fatwas,guidelines, the Shariah audit results and theinternal 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 eBoard Audit Committee and the ShariahCommittee; and

(vi) providing recommendations on rectificationmeasures taken as well as following-up on theimplementation by the IFI.

Th B k i t l t l


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The Bank may appoint or employ an external

party or person to conduct a Shariah audit onthe operations of the IFI, if the Bank considers itis desirable or in the interest of the IFI to do so,

in which case the remuneration and expensesrelating to the appointment shall be borne by theIFI.


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Internal Shariah Audit Integral elements:

Independence & objectivity (organizationalstatus, independent attitude & tasks assigned)

Direct and continuous communication to all

parties with unlimited access to requireddocuments.

Professional Proficiency (including knowledge

skills and training in Fiqh al Muamalat)Due professional care

Scope & Role of Internal


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Scope & Role of Internal

Shariah AuditScope: To examine and evaluate the adequacy

and effectiveness of the institution system ofinternal shariah control and the quality ofperformance in carrying out assignedresponsibilities.

Purpose: To ascertain whether the systemprovides reasonable assurance that objectivesset out are complied in effective and efficientmanner.


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Internal Shariah Audit WorkPlanning (include: establishing shariah review

objectives, obtaining and making references tofatwas, guidelines, shariah review results, writinginternal shariah review programs,communicating the procedures as well as resultsto parties concerned)

Audit and Governance


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ud a d Go e a ce

Committee (AGC)AGC is to assist in achieving institutions

objectives by enhancing greater transparencyand disclosure as well as public confidence oninstitutions application of shariah rules andprinciples.

Comprise of non-executive directors withsound understanding of the business and

shariah supervision.


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Audit and Governance


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CommitteeReview of internal controls

Review of Accounting practices and auditplan

Review of interim and annual accountsand financial reports

Review of compliance with shariah rules

and principles

Shariah Auditors


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Shariah AuditorsExternal AuditorTo be familiar with Shariah Governance

Requirements

To undertake Shariah Review

Independent (of SSB) samples and tests conductedby auditor

Internal AuditorTo 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


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Audit ReportAudit Opinion

The financial statements as a whole are free

from material misstatement based onaccumulated audit evidence, refer to thewhole audit process and comply with IslamicShariah rules and principles

Shariah Opinion


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Shariah OpinionShariah Opinion will be on matters

pertaining to:

Contracts, transactions and dealingsEquitable allocation of profit & losses

Earnings (lawful/prohibited)

Zakah

Employee welfare?

Social obligation, etc

Shariah Audit, Review &


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Governance for IFI Independence & Integrity of Shariah

Compliance Governance Shariah Audit, Review & Governance:

Rules & Guidelines

Shariah Compliance Audit & ReviewProcess

Independence & Integrity of


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Shariah Compliance Governance Main aim of Shariah supervision is to achieve

shariah compliance

In actuality

In the perception of the outsiders-publicconfidence

Good Shariah compliance governance requires:

Independence of judgment

Integrity Independence of Shariah Committee from

Banks management

Shariah Compliance Audit &


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Review Shariah Audit & Review essential check & balance

(hisbah); enhance accountability

Regulation of Shariah audit essential to ensureindependence & 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


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Audit & Review To mitigate shariah compliance risks

Risks arises from the islamic banks failure to comply

with the shariah principles and rules

DisplacedCommercial

Risk

Credit/MarketRisk

OperationalRisk

ShariahCompliance

Risk

Rate ofReturnRisk

LiquidityRisk

Shariah Compliance Audit


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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


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Tutorial Questions

1. Elaborate on Shariah Governance andAudit of and their importance to IFIs (inteam).

2. List down the types and scope ofSupervision of Shariah Committee/SSB(individual)


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Terima Kasih

Thank You

lecture shariah cg and auditing - copy

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