Auditing Of Islamic Financial Institutions Issues And Challenges Compatibility Mode

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1. Auditing of Islamic Financial Institutions : Issues and Challenges Kabir Tahir Hamid, PhD, FCIFC khtahir2004@yahoo.com, khtahir.acc@buk.edu.ng and Mukhtar Musa Bako, ACA, Department of Accounting, Bayero University, Kano-Nigeria mmbako@yahoo.co.uk Being a Paper Presented at the 1st International Conference on Islamic Banking and Finance, Organized by International Institute of Islamic Banking and Finance (IIBF), Bayero University Kano, with the theme Islamic Banking and Finance: A Leap from Theory to Practice, held at New Campus Bayero University, Kano, from 17th to 19th April, 2014. 1
2. Outline of the Presentation  Introduction  Audit of IFIs  Key Players in the Audit of IFIs  The Role of SSB/ACE in Auditing of IFIs  External Auditing of IFIs  Audit and Governance Committee  Auditing Standards for IFIs  Issues and Challenges of Auditing IFIs  Conclusion and Recommendations 2
3. Introduction Islamic finance has experienced rapid growth in the past four decades . The assets managed by the Islamic financial institution are forecasted to exceed US$1 trillion dollars by the year 2011 (Yaacob, 2012) and US$1.6 trillion this year (Global Islamic Finance, 2012: 1). In addition, there are now more than six hundred (600) Islamic financial institutions in more than seventy five countries. This is rather astonishing, with approximately US$150 billion in the midst of 1990s, it increased to US$1.1 trillion in year 2011(Global Islamic Finance, 2012: 2). The Islamic finance industry annual growth is from 15% to 20% annually for the past decades easily surpassing the rate of the world economic growth (Rammal, 2010). Hence, it is crucial that the Islamic finance industry should have a proper ‘check and balance’ mechanism in the form of auditing which suits the objectives and missions of its formation, the ‘maqasid al shari’ah’ (to achieve the objectives of the shari’ah). 3
4. Introduction … Cont’d Following the emergence and phenomenal growth of IFIs (IFIs) in recent years in various parts of the world, the scope of conventional statutory financial audit is inadequate to fulfill the needs of the stakeholders of IFIs. Because IFIs need to adhere to shariah principles in all their business transactions and operations, a new dimension in auditing, as well as auditing standards which can cope with such principles, is needed. Recognizing the limitations of the International Standards of Auditing (ISA) in addressing issues related to religious compliance, the Accounting and Auditing Organization for IFIs (AAOIFI) has taken steps in producing a number of auditing standards and audit methodologies specifically for IFIs. 4
5. Introduction … Cont’d Auditing Islamic financial institutions (IFIs) covers a wider scope than statutory financial statement auditing. External auditors of IFIs not only conduct financial audits, but also conduct tests on the shariah compliance of IFIs, according to fatawa (religious opinions) and guidelines set by the Shariah Supervisory Board (SSB) (Advisory Committee of Experts-ACE) . Shariah review is unique to IFIs, due to the requirement to ensure that all business activities and operations of IFIs adhere to shariah precepts. Scope of audit of IFIs needs to be comprehensive in order to achieve maqasid alshariah (wider objectives of the shariah) 5
6. Audit of IFIs Auditing of IFIs can be defined as a systematic process of objectively obtaining and evaluating evidence regarding assertions about religious and socioeconomic actions and events , in order to ascertain the degree of correspondence between those assertions and the applicable financial reporting framework, including the criteria specified based on shariah principles as recommended by the Shariah Supervisory Board (SSB) alternatively called the Advisory Committee of Experts (ACE), and communicating the results to all interested parties. 6
7. Audit of IFIs … Cont’d Auditing forms an important element in the process of securing corporate accountability and in enhancing stakeholder faith in management’s stewardship. According to AAOIFI’s Auditing Standard for IFIs No. 1 (ASIFI 1), the objective of an audit of financial statements of IFIs “… 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 Shari’ah Rules and Principles, the accounting standards of the Accounting and Auditing Organization for IFIs (AAOIFI) and relevant national accounting standards and practices in the country in which the financial institution operates.” 7
8. Audit of IFIs … Cont’d Unlike conventional statutory financial audit, which requires auditors to peruse the accounts and express a true and fair view that the financial statements have been prepared according to relevant auditing standards, the audit of IFIs covers a wider scope. This is because auditors must also attest that management has complied not only with the shariah precepts, but also with the wider objective of shariah (maqasid al-shariah), which is to protect and improve the condition of human life in all dimensions. In other words, auditing of IFIs is not only confined to the statutory financial audit but also to what is known as the shariah review, which is the raison d’être for IFIs. 8
9. Key Players in the Audit of IFIs Due to the need to ensure proper adherence to the shariah principles in operations and activities , external auditors are not expected to conduct both types of audit for IFIs. This is because the criteria in deciding whether an activity complies with shariah principles or not are a matter for the SSB/ACE of the individual IFI to decide, as they have expert knowledge in Islamic jurisprudence. The role of the external auditor with respect to shariah compliance is only to test for compliance based on the outlines provided by the SSB/ACE. Besides the SSB/ACE and external auditors, the other two key players involved in the audit of IFIs are the internal auditors and the Audit and Governance Committees. 9
10. The Role of SSB /ACE in Auditing of IFIs The SSB plays a key role in the overall audit and governance framework, both ex-ante and ex-post. Their role ex-ante is to formulate policy and guidelines to be followed by management in their activities, including approval of products. The ex-post role is to conduct shariah review, which is an examination to ensure that the activities carried out by an IFI do not contravene the principles of shariah. The shariah review is a comprehensive review of not only the financial statements but also of contracts, agreements, and transactions, to ensure shariah compliance and to add credibility to management’s activities. 10
11. The Role of SSB /ACE in Auditing of IFIs… Cont’d AAOIFI’s Governance Standard for IFI no. 3 defined shari’ah audit as, “the primary objective of the internal shari’ah review (carried out by independent division or part of internal audit department) is to ensure that the management of an IFI discharge their responsibilities in relation to the implementation of the shari’ah rules and principles as determined by the IFI’s Shari’ah Supervisory Board (SSB)”. The SSB/ACE does not conduct shari’ah audit in order to express their opinions. They only approve the products and services as well as the required legal documentations. Members of SSC are assumed to be people with deep religious commitment. 11
12. The Role of SSB /ACE in Auditing of IFIs… Cont’d Shari’ah audit should involve a systematic review of the operational aspects of the IFIs. This will include an examination of the policies and procedures of the IFIs such as product manuals, operational processes, contracts, among others. Shari’ah audit also needs to review the organizational structure to ensure it is feasible to undertake a shari’ah compliant activity. This will include the availability of qualified staff with a sufficient knowledge of shari’ah to support the operations of the IFIs. 12
13. External Auditing of IFIs One of the unique roles played by the external auditor of an IFI , besides performing the financial statements audit, is to conduct a test of shariah compliance. The audit process involves a structured, documented plan involving a series of steps beginning with planning the audit and ending with expressing an opinion in an external audit report as to whether the financial statements are prepared in accordance with the fatawa (religious opinions), rulings and guidelines issued by the SSB of the IFI, the accounting standards of the AAOIFI, and relevant national accounting standards and practices in the country in which the IFI operates. 13
14. External Auditing of IFIs … Cont’d AAOIFI defined “scope of an audit” as the audit procedures deemed necessary by the auditor in the circumstances to achieve the objective of the audit for the IFI. It further stated: “The procedures required to conduct an audit 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, and, where appropriate, the terms of 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.” The auditors is expected to conduct tests of shariah compliance to ensure that management has adhered to the interest-free and permissibility (halal) principles as specified by the SSBs. External auditors should also be concerned with elements of socioeconomic justice in line with maqasid alshariah, even if they have not been addressed by the SSB. 14
15. External Auditing of IFIs … Cont’d When conducting the audit, the auditor will include procedures in his or her examination to ensure that all new fatawa, rulings, and guidance, and modifications to existing fatawa, rulings, and guidance, are identified and reviewed for each period under examination. The auditor will review the reports issued by the SSB to the IFI concerning shariah compliance as well as the SSB’s minutes of meetings to ensure that all types of products offered by the IFI have been subjected to a review by the SSB. The auditor must also examine the findings of all internal reviews carried out by the IFI’s management, the internal audit, and the report of the internal shariah review. Financial statement audit, on the other hand is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material aspects, in accordance with an identified financial reporting framework. The financial statement audit involves obtaining and evaluating evidence about an entity’s financial affairs so as to establish the degree of correspondence between the management’s assertions and the established criteria, such as legal requirements and accounting standard (Leung, Coram and Cooper, 2007). This type of audit is performed by independent auditors appointed by the shareholders of the company. 15
16. External Auditing of IFIs … Cont’d According to the AAOIFI Auditing Standards (2010), “the auditor shall be knowledgeable about Islamic shari’ah rules and principles. However, he/she would not possess the same level of knowledge as that of shari’ah supervisory board members and thus the auditor shall not be expected to provide interpretation of these (Islamic) rules and principles. The fatwas, rulings and guidance issued by the SSB form the basis on which the auditor considers whether the IFI has complied with the Islamic shari’ah rules and principles. The auditor shall also use this as a basis for concluding whether the financial statements of the IFI have been prepared in accordance with the Islamic shari’ah rules and principles”. • 16
17. Audit and Governance Committee The role of the Audit and Governance Committee (AGC), comprising nonexecutive directors, is described in detail under GSIFI No.4. It is responsible for checking the structure and internal control processes and ensuring that the activities of the IFI are shariah-compliant. The duties of the AGC also include the review of the reports produced by the internal shariah review and the SSB to ensure that appropriate actions have been taken. 17
18. Auditing Standards for IFIs Shareholders and investment account holders likewise expect Islamic banks ’ auditors to deliver a more comprehensive audit that takes Shari‘ah compliance into account. Hence, developing unique accounting and auditing standards for the dissemination of such information about Islamic banks becomes a necessity. In 1991, the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was established by Islamic financial institutions and other interested parties to set international accounting and (recently) auditing standards for Islamic financial institutions based on Shari‘ah precepts. AAOIFI’s pronouncements are intended to serve Islamic financial institutions in the various countries in which they 18 operate.
19. Auditing Standards for IFIs … Cont’d AAOIFI finances its activities from the proceeds of a waqf (endowment) and charity fund (developed from the membership fees paid by institutions joining AAOIFI), annual subscription fees, grants, donations, bequests, and others sources. AAOIFI is responsible for developing and issuing standards for international Islamic finance industry. Supported by over 200 institutional members from over 40 countries. Members are central banks, regulatory authorities, financial institutions, accounting & auditing firms, legal firms, among others. Total of 88 standards were issued as at 31/12/2012, comprising of 48 shari’a standards, 26 accounting standards, 5 auditing standards, 7 governance standards and 2 codes of ethics. In addition, new standards are being developed and existing standards reviewed. 19
20. Auditing Standards for IFIs … Cont’d At present, AAOIFI does not have the power to force IFIs to implement the standards it promulgates. AAOIFI has therefore pursued a strategy of having its standards implemented by cooperating with the concerned governmental and professional agencies—namely, the central banks and bodies responsible for implementing accounting standards. These include working closely with SECs in countries in which Islamic financial institutions operate so that all listed institutions engaged in Islamic banking be required to adhere to AAOIFI’s standards. AAOIFI also seeks the acceptance of its accounting and auditing standards around the world by cooperating with the IASC/IASB and the International Federation of Accountants (IFAC). 20
21. Issues and Challenges of Auditing IFIs There are currently a number of challenges with regard to the auditing of IFIs , especially in terms of shariah compliance audit. First, despite the efforts of AAOIFI in promulgating auditing standards, the focus and scope tend to be on financial statements rather than the broader concept of shariah audit, which involves the audit of all activities of IFIs based on maqasid al-shariah. Furthermore, the use of the term “shariah review” rather than “shariah audit” by AAOIFI may implicate a lower level of assurance in the case of the former. 21
22. Issues and Challenges of Auditing IFIs … Cont’d Second, based on AAOIFI’s auditing standards, the functions of shariah audit or review are distributed to different entities, for example, external auditor, SSB/ACE, internal shariah reviewer, and the Audit and Governance Committee. While external auditors act as the external mechanism in monitoring compliance, their lack of competence makes them rely heavily on the SSB’s fatawa, whereas in fact they should be making an independent judgment on the issue of compliance. 22
23. Issues and Challenges of Auditing IFIs … Cont’d Third, the independence of the SSB/ACE has been questioned as they are involved in making fatawa and in setting up the guidelines on shariah compliance, as well as, in conducting a shariah review or audit of the IFI concerned. Given the rapid growth of IFIs globally, there is the need for a proactive measure by AAOIFI to issue clear auditing standard, which will make the work distinct from over supervisory boards, so as to overcome these challenges and, provide a flat form for the professionalism of shariah compliant auditing. 23
24. Issues and Challenges of Auditing IFIs … Cont’d Fourth, the challenge to undertake shari’ah audit is to establish audit evidence, develop a systematic and thorough audit program and carry out the audit competently and independently. Similarly for shari’ah auditing process, evidence may take many forms including: oral testimony of the auditee; written communication with outsiders; observations by the auditor; as well as electronic data about transactions. A major decision facing every shari’ah auditor would be to determine the appropriate types and amount of evidence to accumulate in order to satisfy that the client has maintained effective internal control over shari’ah matters. 24
25. Issues and Challenges of Auditing IFIs … Cont’d Shari’ah audit programs can be developed to cover variety of Islamic financial products and services such as: (i) Islamic deposit and investment based on wadi’ah and mudarabah; (ii) Islamic home financing based on BBA and musharakah mutanaqisah; (iii) Islamic motor vehicle financing based on ijarah; (iv) Islamic trade financing based on murabahah, wakalah, among others; (v) Islamic personal financing and credit card; and many others. Similarly, shari’ah auditors must strive to maintain a high level of independence to uphold the confidence 25 of users relying on their reports.
26. Conclusion and Recommendations Auditing has always been an important part in the corporate governance machinery in modern organizations (Sultan, 2007). It forms important elements in the process of securing corporate accountability. It also enhances stakeholder’s faith in the stewardship of the company. Unlike conventional statutory financial audit which requires auditors to express their view that the financial statements are prepared according to GAAP and relevant financial reporting standards; the auditing of IFIs cover a wide range of scope. This is because auditors/shari’ah auditors must attest that the management has complied not only with relevant standards but also the shari’ah framework in all of the transactions to achieve the 26 maqasid as shari’ah.
27. Conclusion and Recommendations … Cont’d The absence of shari’ah audit scope has left the industry in the dark. At the moment, the scope is depending on the shari’ah advisors and the Shari’ah Supervisory Board who oversees the shari’ah review or shari’ah audit. Generally, they are still a few unresolved issues in shari’ah audit in terms of its scope, framework, shari’ah auditor’s qualification and their independence. It may give an unhealthy image to the Islamic financial institutions credibility. They should be resolved immediately as it may also threaten the confidence of the public in Islamic financial institution’s product and services compliance to shari’ah rules and guidelines. 27
28. Thank you for listening . 28