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INCEIF

The Global University in Islamic finance

Kuala Lumpur, Malaysia

CIFP

Shariah Non Compliance through Auditing and Risk Management

In Islamic Banking and Finance

Semester September 2009

Name: Azah Atikah Binti Haji Anwar Batcha

Matric No: 0900157

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Table of Contents Abstract ........................................................................................................................................... 3

The Objectives of the Research ...................................................................................................... 4

Key Terms of the Research ............................................................................................................. 4

Introduction ..................................................................................................................................... 5

1.0 Definition of Shariah Audit & Compliance And How It Works .............................................. 6

1.1 Auditing And Maqasid Al-Shariah ....................................................................................... 7

1.2 Objectives and Scope of a Shariah Audit ............................................................................. 8

1.3 Identifying the Risk Errors and Incongruence in Islamic Banks .......................................... 9

1.4 Why Is Shariah Audit Important To IFIs ....................................................................... 10

1.5 Targeted Users to Benefits from the Audit Report ............................................................. 11

1.6 Qualification and Responsibility of a Shariah Auditor .................................................. 12

1.7 Fiqhi Justification For Having Shariah Audit And Compliance .................................... 12

2.0 The Shariah Audit Process ...................................................................................................... 14

2.1 Tools and instruments used to identify incongruence in IFIs ............................................. 14

3.0 Implications of Non-Compliance with Shariah Audit Practice .............................................. 17

4.0 Real Life Case Example to Reflect the Importance of Shariah Audit .................................... 18

5.0 Benefits of Shariah Audit and Compliance Practice............................................................... 19

6.0 Conclusion .............................................................................................................................. 20

Bibliography ................................................................................................................................. 21

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Abstract

This paper discusses the consequences of Shariah non compliance as a serious risk factor

in Islamic Banking and Finance. This is discoverable and perhaps manageable through genuine

auditing practice of Shariah compliance. For the most part, Islamic banking and finance depends

heavily on its reputation and credibility because of its ethical inclination and its consumers’ high

expectation. In view of the fact that it renders its service based on Islamic law; accordingly it is

expected to exemplify the Shariah at all stages of its intermediating roles. Indeed, risk

management is a critical component of the Banking and financial industry in the conventional. In

fact, the efficiency of any bank depends on its capability in managing its daily risks that it faces.

Therefore, Islamic Banking has an additional risk element. This risk is the non compliance to its

Islamic principles or guidance principles especially with Shariah auditing in place. Hence, this

paper will analyze this related risk management to Islamic banking and finance. The paper finds

that there are grave consequences on Islamic banks when it fails to comply with the rules of

Shariah after the auditing process has identified Shariah breaches. Finally, it concludes that

Islamic banking stands a heavy risk of losing its credibility, customers and finally its income if

the auditing process identifies non Shariah compliance elements. Hence, non Shariah income

may perhaps be deemed haram because of the violation.

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The Objectives of the Research

Among the objectives of this paper are as follows:

• To examine the importance of Shariah audit and compliance to Islamic Financial

Institutions (IFIs) and why is it related to risk management;

• To look into the scope of Shariah audit function and main process;

• The paper shall study on the pros and cons of complying or not complying with Shariah

audit;

• To address auditing matters from Shariah perspective and identify its importance of the

process in IFIs;

• The paper will look at Maqasid al-Shariah in light of Shariah auditing process.

Key Terms of the Research

1-Shariah Auditing, 2-Auditing Tools, 3-Risk Management, 4-Governance, 5-Maqasid Al-

Shariah

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Introduction

This paper attempts to examine the importance of Shariah audit and compliance to Islamic

Financial Institutions (IFIs) and why is it related to its risk management. In addition, the paper

shall look into the scope of Shariah audit function and main process. Furthermore, the paper shall

study on the pros and cons of complying or not complying with Shariah audit. This can be

addressed well in the real life cases example given. This paper will basically address the current

practice of Shariah auditing in IFIs, regardless in whichever country they are in.

IFIs are supposed to charnel funds from the surplus unit of the economy to the deficit unit

efficiently. Their responsibility is a fiduciary type so they are entrusted to act in the best interest

of the depositors. They do their business supposedly in accordance to Shariah rules and

regulations and apply these rules to the letter. These requirements make them subject to Shariah

auditing. The auditing is expected to give objective opinion on the financial statement and most

important on the compliance aspect of the business with Shariah requirement. Unequivocally,

Shariah Audit helps IFIs maintain credibility and reputation that makes them unique and niche.

Without these two critical issues, IFIs will uncompromisingly loss their reputation in the eyes of

their consumers. Therefore, their channeling of funds makes no difference with the conventional

similar function.

Shariah Audit (SA) is related in many ways to risk management. First, compliance risk of the

institution in terms of its commitment to abide by Shariah rules is an earnest issue. Next, any

income derived from non permissible transaction shall not find its way into the system but rather

shipped to charity organizations. Through auditing, these anomalies can be detected earlier and

possibly weeded out. Note that the importance of auditing exercise in a conventional setting is

similar to Islamic setting but with added dimension. This dimension is the Shariah compliance

need and the sources of income Sources of income to IFI are a vital component to risk

management process. Since all the financing stages must remain complaint, the auditing exercise

goes through out the phases. Auditing identifies and subsequently eliminates these areas and any

income thereof shall be remitted to the charity organization as earlier mentioned. When all these

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areas are cared for, the risk management of Islamic banking plus its fundamental become much

easier in the long run.

The relation of this study to risk management is that IFIs will be able to address and solve the

problems of credit risk in various forms counterparty transactions, equity investment risk as per

valuation methodologies, market risk (price volatility), liquidity risk, rate of return risk,

operational risk , impact of risk on capital adequacy of IFIs, shareholder and investment account

holder orientation, and finally IFIs will manage their governance committee complements audit

committee to address investment account holder and other stakeholders.

To sum it all up, this paper will be addressing auditing matters from Shariah perspective and

identify its importance of the process in IFIs. Therefore, it is hope that Shariah audit practice in

IFIs will be taken seriously. The value opens door of improvement in risk management and

better services to customers.

1.0 Definition of Shariah Audit & Compliance And How It Works

According to Sultan (2007, pp.6), due to the lack literature in this Shariah Audit matter, there are

still no widely accepted definitions of what Shariah Audit really is. The AAOIFI’s Governance

standard No.2 (GSIFI) provides probably the most reflective description of what Shariah Audit is

as defined below:

“Shariah review is an examination includes contracts, agreements, policies, products,

transactions, memorandum and articles of association, financial statements, reports especially

internal and central bank inspection, circulars, and etc” (Para 3, GSIFI 2, AAOIFI Standards).

Sultan (2007, pp.7) stated that there are also other areas which Shariah Audit should look at the

organization structure, processes and people including the marketing strategies taken by the IFIs.

All these should be subjected to a Shariah audit as these are potentially risky areas of the

bank.Therefore, the proposed definition of Shariah Audit is that it is an examination of an IFIs

compliance with the Shariah, in all its activity particularly the financial statements and other

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operational components of the IFI which are subjected to the risk of compliance including but

not limited to products, the technology supporting the operations, operational processes, the

people involved in the main risky areas, documentations and contracts, policies and procedures,

and other activities that requires adherence to Shariah principles (Sultan, 2007, pp.8).

The given definition is merely an academic attempt to provide a comprehensive scope of what

Shariah audit ought to be. But in reality, each Shariah audit exercise will have to take into

account the mandate from the management or the statutory requirement and also consider the

auditability of certain functions, before making decision on the scope and scale of audit.

All of us should realize that Shariah auditing has a key importance as there is a growing need and

awareness among Islamic institutions to comply and practice it. As such, every institution should

contribute towards achieving the objectives of the Islamic law which is known as Maq’asid Ash-

Shariah (Shahul and Yaya, 2005, pp.1). Thus, creating a well structured businesses and a better

economy.

1.1 Auditing And Maqasid Al-Shariah

The primary aim of Shariah is to enforce justice and fairness to human relationship. The

Quran states the following: “Verily Allah commands that you should render back the

trusts to those whom they are due; and that when you judge between men, you judge with

justice. Verily, how excellent is the teaching which He (Allah) gives you! Truly, Allah is

Ever All-Hearer, All-Seer" (Quran, pp. 168, Q 4:V 58).

The institution of justice in Islam is that lives, progeny, wealth, intellect and religion

must be protected (Ashur, 2006). The most relevant to this article is wealth. In relation to

protecting wealth, the exercise of auditing financial institutions ensures that the wealth of

investors is protected. When auditing exercise is conducted and a fraudulent move is

dictated, the recovery of the wealth implies that the Shariah objective is achieved in the

process. What all this shows is that auditing is closely linked to maqasid al-Shariah

(Ashur, 2006).

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1.2 Objectives and Scope of a Shariah Audit

The objective of an audit of financial statements is to enable the auditor to express an

opinion as to whether the financial statements are prepared, in all material respects, in

accordance with the Shariah Rules and Principles, the accounting standards of the

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and

relevant national accounting standards and practices in the county in which the financial

institutions operates. In addition to this, the phrase used to express the auditor’s opinion

is to be able to provide true and fair view (Ibrahim, 2009, pp.416).

In addition to this, according to Ibrahim (2009, pp.418), the objectives of a Shariah Audit

would be that IFIs expect Auditors to be able to provide the elements of Assurance by

putting matters into consideration as mentioned below:

1. Being able to know the limitations between the Users, Practitioner and Responsible

party. The Auditors should know the boundaries of 3 party relationships in order to

prevent their integrity to be questioned.

2. Addressing a proper subject matter such as financial statements assertions.

3. Know what standards to apply regardless whether it is IFRS or AAOIFI Standards.

4. Providing sufficient evidence to support their findings.

5. A written assurance report either it is reasonable assurance or limited.

The Scope of an “Audit Scope should refer to the audit procedures which are deemed

necessary by the auditor in the circumstances to achieve the objective of an audit. This

procedure required the Audit to be conduct in accordance with ASIFIs should be

determined by the auditor having regard to the requirements of appropriate Islamic Rules

and Principles, ASIFIs, relevant professional bodies, legislation, regulations which do not

contravene Islamic Rules and Principles, where appropriate, the terms of the audit

engagement and reporting requirements, International Standards on Auditing (ISAs) shall

apply in respect of matters not covered in detail by ASIFIs providing these do not

contravene Islamic Rules and Principles”.

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1.3 Identifying the Risk Errors and Incongruence in Islamic Banks

According to Archer and Karim (2007, pp. 123-124), in the context of Islamic financial

services industry, appropriate systems, processes and products are all recent

developments. This however, poses a continual challenge in areas of development, and

the failure in managing these areas would bring negative consequences.

The authors added that the Operational risks faced by Islamic bank can be divided into

three categories:

(a) Operational risks that are consequential upon various kinds of banking

activities, and which are somewhat similar for all financial intermediaries,

whether Shariah-compliant or not constitute risks. However, asset-based

nature of financing products in Islamic banking such as murabahah, salam,

istisna and ijarah may give rise to forms of operational risk in contract

drafting and execution that are specific to such products.

(b) Shariah compliance risk-that is:

(i) Risks relating to potential non-compliance with Shariah rules and

principles in the bank’s operations;

(ii) The further risks associated with the Islamic bank’s fiduciary

responsibilities as mudarib towards fund providers under the

mudarabah form of contract, according to which in case of

misconduct or negligience by the mudarib the funds invested by

the fund providers become a liability of the mudarib.

Basically, Shariah compliance risk is the risk of non-compliance resulting from a failure

of an Islamic bank’s internal systems and personnel that should ensure its compliance

with the Shariah rules and principles determined by its Shariah board or the relevant body

in the jurisdiction in which the Islamic bank operates.

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(c) Legal risks arising whether from (Balz, 2005):

(i) The Islamic bank’s operations (legal risks common to all financial

intermediaries) or;

(ii) Problems of legal uncertainty in interpreting and enforcing Shariah

contracts.

1.4 Why Is Shariah Audit Important To IFIs

Archer and Karim (2007, pp. 124), reiterated that Shariah compliance is critical to an

Islamic bank’s operations, and such compliance requirements must permeate throughout

the organization and its products and activities. As a majority of the fund providers used

Shariah-compliant banking services as a matter of priciple, their perception regarding the

Islamic bank’s compliance with Shariah rules and principles is likely to be of a great

importance in maintaining their customer’s loyalty (Hasan, 2009).

Shariah audit is important to IFIs in regards of the operational risks which was dicussed

in the previous page. Apart from this, Shariah Audit is important in order for IFIs to

eliminate or prevent fiduciary risk such as risk that arises from an Islamic bank’s

potential failure to perform in accordance with explicit and implicit standards applicable

to its fiduciary responsibilities, especially in its role as mudarib. As a result of losses on

investments, an Islamic bank may become insolvent and therefore unable either to meet

the demands of current account holders for repayment of their funds or to safeguard the

interests of its investment account holders (Archer and Karim, 2007, pp.125).

Apart from this, Archer and Karim (2007, pp.125) agreed that without Shariah

compliance, an Islamic bank may fail to perform due diligence or to act with sufficient

prudence when making and managing investments which can results of foregone profits

or of losses to its investment account holders.

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Basically by opting for Shariah Audit, it will help IFIs to comply with the law as well as

accounting regulations (Iqbal and Gruening, 2008, pp.269). Furthermore, Iqbal and

Gruening 2008, pp.269) added that Shariah Audit would certainly enable IFIs to gain a

sound Corporate Governance by providing the right formulation of principles and

enforcement. Other than this, Shariah Audit report would provide suggestions such as

providing training to inadequately trained staff so that they are well aware of operational

risks as well as risk of income which are not being recognized as permissible when there

is a failure in Shariah compliance (Archer & Karim, 2007, pp.125).

1.5 Targeted Users to Benefits from the Audit Report

Bernstein and Wild (2000, pp.8) has classified users of financial statements into two

groups:

(a) Internal users

This are primarily for the mangers of the company, the ones who are responsible in

making operating and strategic decision for the business, such as the CEO, CFO, or even

the Internal Auditor.

(b) External Users

These are for those who are not directly involved with the business. These users must rely

on the given information provided by the management. Examples of external users of

financial reporting would be the Auditors, Creditors, Investors, potential shareholders,

Board of Directors, Regulatory agencies such as Securities Commission, Intermediaries,

Employees, Suppliers and Customers.

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1.6 Qualification and Responsibility of a Shariah Auditor

Relating to the qualification of Shariah auditors, they should be people of both

qualifications in accounting as well as Shariah. This is important in order for the auditors

to determine the vision and mission of Islam is preserved within the IFIs (Kasim,

Ibrahim, & Sulaiman, 2005, pp.8). Shariah auditors are expected to reflect their

responsibility and accountability not only to the management and stakeholders, but more

important to the God. This will promote the foundations for building public confidence

and assurance that the IFIs are Shariah-compliant in all of their activities (Kasim,

Ibrahim, & Sulaiman, 2005, pp.8).

Auditors should conduct their audit based on the respective standards and principles.

Auditors should be held responsible for negligence and misconduct if reasonable efforts

are not seen to have been made during the audit engagement (AAOIFI, pp.51). They

should also perform the audit with an attitude of professional skepticism and integrity.

Apart from this, the auditors should always consider the fact that there would be a fraud

error within the audit procedures being perform, document all the related data well and

efficiently as well as considering the implications of the effect of the audit report

(AAOIFI, pp.51). In this case, the auditor will have to decide whether to continue

auditing the company or otherwise (AAOIFI, pp.52).

1.7 Fiqhi Justification For Having Shariah Audit And Compliance

Shariah Audit is important as we need to see a full and transparent disclosure of a

business as we are accountable before God. This is mentioned in Surah At-Taubah

(Quran, pp.376, Q 9: V 94) below:

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They will present their excuses to you when ye return to them. Say thou: "Present no

excuses: we shall not believe you: Allah hath already informed us of the true state of

matters concerning you: It is your actions that Allah and His Messenger will observe: in

the end will ye be brought back to Him Who knoweth what is hidden and what is open:

then will He show you the truth of all that ye did."

Another Quran verse that shows how important it is for data and information to be

documented and kept is mentioned in the longest surah, Surah Al-Baqarah (Quran,

pp.101, Q 2, V 282) which says:

“O you who believe! When you deal with each other, in transactions involving future

obligations in a fixed period of time, reduce them to writing; let a scribe write down

faithfully as between the parties: let not the scribe refuse to write: as Allah has taught

him, so let him write. Let him who incurs the liability dictate, but let him fear his Lord

Allah, and not diminish aught of what he owes. If the party liable is mentally deficient, or

weak, or unable himself to dictate, let his guardian dictate faithfully, and get two

witnesses out of your own men, and if there are not two men, then a man and two

women, such as you choose, for witnesses, so that if one of them errs, the other can

remind her. The witnesses should not refuse when they are called on (for evidence).

Disdain not to reduce to writing (your contract) for a future period. Whether it be small or

big: it is juster in the sight of Allah, more suitable as evidence, and more convenient to

prevent doubts among yourselves but if it be a transaction which you carry out on the

spot among yourselves, there is no blame on you if you reduce it not to writing, but take

witness whenever you make a commercial contract; and let neither scribe nor witness

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suffer harm, if you do (such harm), it would be wickedness in you. So fear Allah; for it is

Allah that teaches you. And Allah is well acquainted with all things”.

In a related hadith, Narrated by Abu Hurairah r.a.: Allah’s messenger s.a.w said: “The

signs of a hypocrite are three: Whenever he speaks, he tells a lie; and whenever he

promises, he breaks his promise; and whenever he is entrusted, he betrays which proves

him to be dishonest. (Al-Bukhari, p. Vol.8 No.117). Shariah auditor is not expected to be

one of the three attributes of a hypocrite.

The notion of accountability will propel a Shariah auditor to ensure that he lives up the

expectation people have entrusted him and above all his responsibility on the Day of

Judgment. Allah has required him to render back the trust due on him. Among these

trusts is his reporting the true nature of his findings. Thus the Qur’an urges him

empathetically: “Verily Allah commands that you should render back the trusts to those

whom they are due; and that when you judge between men, you judge with justice.

Verily, how excellent is the teaching which He (Allah) gives you! Truly, Allah is Ever

All-Hearer, All-Seer" (Quran, pp. 168, Q 4:V 58)

2.0 The Shariah Audit Process

There are some tools and instruments can be used in order to identify incongruence in Shariah

Audit process which is the accounting instrument, the legal instrument and the Islamic ruling

(fatwa & resolutions), as well as a Shariah reviewer. These four tools play a crucial role in

identify incongruence in Shariah compliance.

2.1 Tools and instruments used to identify incongruence in IFIs

1. Accounting and Audit

According to Lahsasna and Rosly (n.d., pp. 20), the accounting and audit is a very crucial

instrument to identify incongruence in Shariah, by using different accounting tools such

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as the financial data, and balance sheet and the auditing process, the prohibited elements

in Shariah can be easily identify through this process. The accounting instruments couple

with the audit will be used to meet Shariah compliance in all financial transactions and

business activities which cover the following areas as stated by Lahsasna and Rosly

(2009, pp. 21):

• Lawful and legitimate economic activities

• Valid contracts that exclude interest and uncertainty of contract conditions

• Mutual consent on a willing buyer – willing seller basis with an ascertained

degree of trust through transparency, fairness of representation and equity

between parties in terms of counter value or distribution.

• The balance sheet will show the asset and liability of the bank and classified all

the transaction and source and the use if the funds.

2. Legal Instrument

Legal instrument play a very sensitive role in identify incongruence in Shariah, the legal

approach examine the structure of the contract and product and ensure the Shariah

compliance in the terms and conditions implemented in that particular contrac Lahsasna

and Rosly (2009, pp. 21). The careful examination of the clauses in the contract will

identify the any violation to Shariah rules if any, and provide a correct way of

interpretation of the clauses in the contract Lahsasna and Rosly (2009, pp. 21).

3. Islamic ruling (fatwa & resolutions)

The fatwa is the Islamic ruling pertaining to particular case such contract in order to

validate or invalidate that contract, through the investigation of the whole process of the

application with the observation of the various issues related to banking documents, the

fatwa may identify incongruence in Shariah (Lahsasna and Rosly, 2009, pp. 21). The task

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of Shariah board is to exam the document of the present product to eliminate any element

not consistent with shariah rules and principles (Lahsasna and Rosly, 2009, pp. 21).

4. Shariah review

According to AOOIFI Shariah review is an examination of the extent of an IFI’s

compliance, in all its activities, with the Shariah (Lahsasna and Rosly, 2009, pp. 22). This

examination includes contracts, agreements policies, products, transactions,

memorandum and articles of association, financial statements, reports (especially internal

audit and central bank inspection), circulars, and so on (Lahsasna and Rosly, 2009, pp.

22). The objective of the review is to ensure that the activities carried out by an IFI do not

contravene the Shariah. The achievement of this objective requires that the Shariah is

mandatory (Lahsasna and Rosly, 2009, pp. 22).

2.2 Auditing Techniques

Sultan (2007, pp.73) stated 10 auditing techniques that can be used during the audit

engagement:

(a) Examinations of papers

(b) Interviewing

(c) Direct observation

(d) Benchmarking

(e) Surveys

(f) Case studies

(g) Flow charting

(h) Statistical analysis

(i) Walkthrough and Questionnaires

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3.0 Implications of Non-Compliance with Shariah Audit Practice

The implications of non-compliance with Shariah Audit is that Islamic banks are subjected to

risks on the similar fronts as conventional banks such as credit risk, market risk and operational

risk and reputational risk for the Islamic banks. In addition, there are specific risks which are

uncharacteristic in conventional finance but inherent in Islamic banking, (Sultan, 2007, pp. 127).

Apart from this, people risk which arises from incompetence or fraud exposes Islamic banks to

potential losses. For instance, an internal control problem cost the Dubai Islamic Bank $50

million in 1998 when a bank official did not conform to the bank’s credit terms. As a knock-on

effect, this news triggered a rush to withdraw deposits and resulted in a run on deposits in the

magnitude of $138 million, 7% of the bank’s total deposits, in just one day (Sultan, 2007, pp.

128). This is in addition to technology risk, another type of operational risk, which is associated

with the use of software and telecommunication systems that are not specifically tailored to the

needs of Islamic banks. Terminologies, accounting treatment and profit computation and

distribution methods are all serious issues which if left unchecked could lead to disastrous

implications and impact on the reputation and image of the Islamic Bank as well as incur legal

risks (Sultan, 2007, pp. 128).

On another score, cross border comparison of Islamic banking performances is difficult because

the regulatory frameworks of Islamic banking and jurisdictions are not standardized. Regulatory

and supervisory practices concerning Islamic banking are highly diverse, ranging from

frameworks that explicitly promote dual banking system such as in Malaysia to frameworks that

only recognize Islamic banking like in Sudan (Sultan, 2007, pp. 128). This is another reason why

complying with the Shariah Audit requirements is really vital. And finally, part of the problem

would be lack of avenues for Islamic banks to properly manage their liquidity risks. The

interbank money market mechanism and government Islamic securities are still relatively

underdeveloped and few as well as far in between. This increases the probability of incurring

asset-liability mismatches and increases the exposure of Islamic banks to liquidity stocks. While

significant progress has been made in Malaysia, Sudan, and Iran, the actual compliance of the

operations is still questionable, mainly due to lack of supervision and audit on Shariah

compliance on the operational aspects of these activities (Sultan, 2007, pp. 128).

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4.0 Real Life Case Example to Reflect the Importance of Shariah Audit

There are not many reported cases that have gone through litigation processes to be taken as

examples but that is probably due to the lack of regulation n the transparency requirements of the

Islamic banks in disclosing information regarding their financial statements. Ironically, one of

the more frequently referred case which happened in Egypt, incurred losses to the shareholders

instead of the depositors (Sultan, 2007, pp.125).

Between mid to late 1980s, the International Islamic Bank for Investment and Development in

Egypt distributed all of its profit to investments account holders while the shareholders received

nothing. In 1988, the bank distributed to depositors an amount exceeding its profits, and the

difference appeared in the bank’s accounts as loss carried forward. It is reported that this bank

was subject to temporary takeover by the Central Bank of Egypt (Sultan, 2007, pp.125).

The above issue is known as displaced commercial risk, where the Islamic bank is under the

pressure of paying its investment depositors a rate f return higher than what should be payable

based n the actual performance of the funds. This is as a result of the competitive pressure to

induce its investment account holders not to withdraw their funds from the bank and invest them

elsewhere (Sultan, 2007, pp.125).

Another matter that has been debated is the fiduciary conflict that the management of the bank is

subjected to, due to the “equity” nature of mudarabah deposits. In accepting depositors funds on

the basis of mudarabah, the bank effectively subject itself to fiduciary roles to two categories of

equity holders; the shareholders and the mudarabah investment account holders (Sultan, 2007,

pp.126).This puts the management of the bank in a difficult position and raises the question of

ethical dilemma and possibilities of conflict of interest, particularly when one party is favored

over the ther in the distributin of profits (Sultan, 2007, pp.126).

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5.0 Benefits of Shariah Audit and Compliance Practice

In recent times, many disciplines have recognized the need to independently ascertain either its

quality in production, activities, or its validity in various related applications (Willborn, 2000).

Now, it shows clearly, how most of these disciplines or corporations are beginning to shift in

their paradigms and to reconsider increasingly the importance and relevance of objective reviews

of their documents through internal or external auditing process (Eugene, 2003). For the most

part, if these processes are done independently and impartially, the efforts invested into it will

pay off.

It appears these stakeholders are in consonance with the need to create a more powerful and

impartial auditing exercise which will among other things, conduct, investigate, and report its

findings without fear or favor (Wilson, 1999). In addition, even pundits do agree that audit

findings regardless of their discipline become useless if a follow up is not initiated and pushed

energetically into the whole effort for plain implementation; to ensure the perfection of

discovered lapses after the auditing findings. David Dow (Dow, 1994) cautioned authorities or

individuals who do not respond to audit findings and hence make the valued changes are needed

from the discoveries reported.

Furthermore, (Dow, 1994) argued passionately, that while it is nice to consider fresh

recommendations being tabled by auditing firms; the concerned party has the prerogative to

either accept the report findings or to amend it but in any case; it must justify either of its action.

In fact, accepting these findings, according to the researcher, if done objectively would be an

added bonus to the concerned parties. Again, and above all, data alone are insufficient to proffer

such decision and solutions for managerial consumptions and subsequent improvement. Besides,

the parties concerned, must go further arms length, in doing the right thing but doing it rightly.

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6.0 Conclusion

This paper has addressed auditing from Shariah perspective and identified the importance of the

process in IFIs and concludes that non Shariah compliance should be detected through auditing.

As we know, auditing has always been an important cog in the corporate governance machinery

in modern organizations (Saidi, 2007). Shariah audit shares a similar function but focuses on the

compliance of Islamic financial institutions to Shariah precepts and requirements.

Through the line of argument tabled in this paper, Shariah auditing incredibly vital to all

financial institutions in which Islamic banking and finance is not an exception. The auditing

exercise contributes towards managing the risks inherent in IFIs. And within the grander scheme

of things, it contributes to the growth of the industry and economy by providing adequate

disclosure for the stakeholders to make informed decisions or channel funds to the most

productive investments opportunities or vehicles. It also sets out the supervisory expectations

around key areas such as risk management, compliance and control, corporate governance and

capital policy. The robust framework of financial institutions itself mitigates certain risks

especially risk of the unidentified, or risk of the unknown. And the probabilities of such risks to

occur are higher in newly developing financial systems such as the Islamic financial systems.

This is unhealthy in Islamic banks that in the first place must focus on their business to expand

market size and fulfuil stakeholders’ interest.

Accordingly, the weak or improper supervision of banks can have the disproportionate effect of

destabilizing a country’s economy and indeed reducing market confidence. Many Islamic banks

has crisis over time illustrate a catastrophic consequences flowing from the poor governance of

Islamic banks. These crises have crippled, destabilized goverments and held back development

of less sophisticated economies and emerging nations as well indeed intensified poverty.

Therefore, Shariah Audit is the way forward in order to deal with all these problems.

21

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