issues and challenges of shari’ah audit in islamic financial institutions: a contemporary view

7/30/2019 ISSUES AND CHALLENGES OF SHARIAH AUDIT IN ISLAMIC FINANCIAL INSTITUTIONS: A CONTEMPORARY VIEW

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3rd INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC

RESEARCH ( 3rd ICBER 2012 ) PROCEEDING12 - 13 MARCH 2012. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA

ISBN: 978-967-5705-05-2. WEBSITE: www.internationalcon erence.com.m

ISSUES AND CHALLENGES OF SHARIAH AUDIT IN ISLAMIC

FINANCIAL INSTITUTIONS: A CONTEMPORARY VIEW

Hisham Yaacob

Department of Accounting & Finance

Faculty of Business, Economics & Policy Studies

Universiti Brunei Darussalam, Brunei

[email protected]

ABSTRACT

The Islamic Banking and Finance is said to be the alternative to the conventional finance and banking

system. Although it has been around for slightly more than forty years, the tremendous growth in Islamic

Finance has seen the assets under management by the Islamic Financial Institutions (IFIs) have exceeded

one trillion US Dollars. Inevitably, a proper system of audit is envisaged for the IFIs to continue growing

and providing assurance that they are strictly following the shariah in all aspect (of their products, rules

and procedures and contracts). Hence, failure to give reasonable assurance will dampen the objectives of

the IFIs and the achievement of maqasid al shariah. This paper is trying to provide a contemporary view

on the issues and challenges of shariah audit in IFIs. It looks at the actors in Islamic finance especially

the shariah auditors, the regulators and standard setters and the Shariah Supervisory Board (SSB).

Furthermore, the paper highlighted four of the pressing issues and challenges as discussed in extant

literature on auditing in IFIs. This paper is trying to promote the institutions of Hisbah as one the

possible solutions to the issues of shariah auditors independence and accountability. This paper also

touches on the issue of lack of competency among the shariah auditors. This paper concludes that the

IFIs are in dire needs of independent and accountable shariah auditors with high level of competency.

History tells us that the institution of Hisbah has played a major role in ensuring the market comply to the

shariah requirements and it is possible to revive this institution and improvised on its structure and

mechanism not just to give reasonable assurance but to be very sure that the IFIs are shariah based.

Field of research: Shariah auditors, Islamic Financial Institutions, Shariah Supervisory Board, Hisbah,

muhtasib

1. IntroductionModern Islamic banking and financial institutions (IFIs) have been in existence for more than forty years.

The first recorded institution was the Mit Ghamr Savings Bank in Egypt which was led by one Ahmad


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Elnaggar, established in the year of 1962. The bank was later absorbed by the Nasr Social Bank in 1972

(El-Hawary, Grais and Iqbal, 2004). Then the Pilgrims Savings Fund Board was formed in Malaysia in

1963. It still exists until today (Haniffa and Hudaib, 2010). Haniffa and Hudaib (2010) provide an

interesting analysis of the stages in the modern Islamic finance history from the 1940s to present time.

They argued that somehow the sacred intentions became perplexed with the secular goals of modernity

Although it is argued that the establishment of IFIs had started as early as the development of Islam in

Makkah and Madinah (Haron and Azmi, 2009).

The Islamic financial industry instantly expanded over the past few decades and in 2011, Dubai Islamic

Bank argues that Islamic banking and finance is one of the fastest growing economics sectors of the world

today. However, compared to conventional banking and finance, Islamic banking and finance system is

still in its very early stage. The conventional banking and finance system was first started in the 16

th

century when the merchants in Venice established the Banco Della Pizza at Rialto in Venice, Italy (Haron

and Azmi, 2009, pp.43-44)

Today, the estimated assets held under management by the Islamic banking and financial institutions

exceed US$1 trillion (US$1,000 billion)i. It has more than 400 institutions all over the world mostly in the

four major continents, the Middle East, South East Asia, Europe and America. This huge amount of assets

warranted the IFIs to be governed properly and its assets managed and audited to safeguard the

stakeholders interest. This is where the Shariah audit comes into the picture. We surely do not want the

mistakes and failures of the conventional system to occur to the IFIs.

It is argued that IFIs are the institutional vanguard of Islamic economics (Khan, 2000). Abdullah and

Pillai (2010) have rightly state that the IFIs have greater fiduciary duties and responsibility to their

stakeholders than conventional institutions. IFIs must comply with the Shariahii in all aspects of its

operations and management. Therefore, riba (usury or interest) is totally prohibited. This is a Quranic

injunction. It also prohibits all transactions and contracts with the elements ofgharar (uncertainty) and

maysir (gambling) (Islamic Bank of Brunei Berhad, 2001; Karim, 1990, p.34; Sayd Farook, 2007).

Eventually, this paper argues that every IFI should have a proper corporate and shariah governance

mechanism in order to ensure the systems, policies and procedures are in compliance with the Islamic

principles and guidelines in all of its forms, spirit and substance (Aziz, 2007).

The corporate and shariah governance can be defined as a formal system of accountability by the IFIs top

management to their stakeholders and also to the Divine (Nahar and Yaacob, 2011). This involved theprotection of stakeholders interest and right from the corporation (in this context the IFIs) actions and

decisions by taking into account the maqasid al shariah (Hasan, 2009). There are some direct impact to

the Ummah on the corporate practices and policies especially on zakat and on the prohibition of riba.

Zakat and the prohibition of riba are the two major pillars of Islamic economics and wealth distribution

systems. Thus, it is crucial for the shariah auditors to check on the zakat calculation and payment (Khan,

1985).

According to Lewis (2005), the Islamic corporate governance can be divided into three dimensions of by

whom, for whom and with what. Al Shura, (42:38) brings the message of living in mutual

consultation and forbearance, and relies on Allah, which includes the fundamental quality of Islamic


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governance. In Islam, Allah is the ultimate objective and answer the for whom. The shariah governs

the conduct of human being and the institution of hisbah iii is to ensure the compliance of the people and

especially corporations. This religious supervision or auditing is very crucial to ensure corporation

follows the shariah and to give advice to the businesses and provides report to stakeholders.

The shariah audit shares similar functions to the company audit but they focused more on the compliance

of IFIs to shariah precepts and requirement (Sultan, 2007). Haniffa (2010, p.45) stresses that the

conventional financial audit is inadequate to fulfill the needs of the stakeholders of IFIs. This is true as

the International Standards on Auditing (ISAs) did not take into accounts the shariah aspects. The

International Auditing and Assurance Standard Board (IAASB) only sets the international standards for

auditing, quality control, review and other assurance and related services that serves mostly the

shareholders interest. Sometimes the ISAs are catered for specific country or environment needs. Onlyrecently we can see the growing awareness of IFIs to implement shariah audit which is one the core key

elements of good corporate and shariah governance to achieve the objectives of the shariah (Kasim,

Ibrahim and Sulaiman, 2009). Before we discuss further let us look at the operational definition of

shariah audit used by this paper.

Shariah audit is the examination of an IFIs compliance with the shariah, in all of its activities,

particularly the financial statements and other operational components of the IFIs that are subjected to the

risk of compliance including but not limited to products, technology supporting the operations,

operational processes, the people involved in the key areas of risk, documentations and contracts, policies

and procedures and other activities that require adherence to sharia principles (Haniffa, 2010; Sultan,

2007). The shariah audit should ensure that the IFIs have sound and effective internal control systems tocomply with the shariah (ISRA, 2011, p.811).

Shariah audit is to ensure the products, services and all activities by IFIs do not violate the shariah.

There are several scopes of shariah audit, which includes audit of the financial statement, operational

audit, structure and people audit and finally the information technology audit (Sultan, 2007). It is

understood that the International Auditing Standards (IASs) are not able to fully address the shariah audit

requirements as in the words of Khan (1985); the traditional auditing framework is deeply ingrained in the

capitalist and Western secular world view. Therefore, the shariah (external or internal) auditors should

ensure that all shariah regulations and guidelines are followed by the IFIs (Haniffa, 2010). According to

Shafii, Salleh and Shahwan (2010, p.3), it is the duties and responsibilities of the Shariah advisors to

ensure that all IFIs products and services, policies and contracts strictly adhere to the shariah.Meanwhile, Karim (1990) asserts that it is the SSB that need to function as what the external auditors in

conventional corporations.

In this instance, a body was established in Bahrain in 1991 which helps in regulating and providing the

standards for the financial reports and audits of IFIs called the Accounting and Auditing Organization for

Islamic Financial Institutions (AAOIFI). One of the objectives of this body is to develop auditing

standards for the IFIs (Haron and Azmi, 2009). Another equally important organization is the Islamic

Financial Services Board (IFSB) which was formed in Kuala Lumpur Malaysia in 2002 and started

operations in 2003. A brief on the two institutions is presented in the next section.


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2. Auditing Standard Setter in Islamic FinanceThere are currently two independent standards setting organizations involved in the Islamic finance

industry, the Islamic Financial Services Board (IFSB) and the AAOIFI. Both agree to the need for more

specific governance for IFIs. Both bodies have issued standards for accounting and reporting and also

auditing as well as on corporate governance (IFSB, 2006).

In December 2006, the IFSB issued a comprehensive guiding principles paper on corporate governance of

IFIs. These far reaching publications are intended to help IFIs establishment and improve their corporate

governance frameworks and also to assist IFIs regulators. The IFSB takes the position that no single

model suits all IFIs globally and that the effectiveness and soundness of a corporate governanceframework will depend on the specificities of the individual IFI. To that extent, the IFSB recommends

that the implementation of the guiding principles should be proportionate to the size, complexity,

structure, economics significance and risk profile of the IFIs.

Meanwhile, AAOIFI published in the year 2010, the objective of auditing in IFIs is to enable the auditor

to express an opinion on the financial statements , whether they are prepared, in all material aspect

according to and in compliance to the fatwas, rulings and guidelines issued by the shariah supervisory

board of the said IFI, the accounting standards of AAOIFI, national accounting standards and practices,

and relevant legislations and regulations applied in the country where the IFI is operating. The principle

also state that the auditors should comply to the 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

As for the auditors report, the auditors should review and assess the conclusion drawn from audit

evidence obtained as the basis to form an opinion on the financial statements and contain a clear and

written judgment. The term of the audit engagements is an agreement between auditor and auditee and it

confirms the acceptance of the auditor acceptance of appointment, objective and scope of audit and extent

of auditors responsibilities to auditee. The roles and responsibilities of shariah auditors are presented in

the next section.

3. Roles and Responsibilities of Shariah AuditorIt is argued that shariah audit is one of the key pillars in corporate and shariah governance of IFIs. They

need to ensure compliance of the IFIs to all shariah requirements (Karim, 1990). The shariah audit

function is performed by the internal auditors who have adequate shariah related knowledge and skills.

Their ultimate goal is to ensure a sound and effective internal control system which follows the shariah

strictly. The internal auditor may also engage the experts in the Islamic finance in performing the audit as

long as the audit objective is not being compromised. IFIs may also appoint external party to conduct a

shariah audit (PwC, 2011).On the other hand, Rahman (2011) argue that shariah audit is an independent


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audit and may be performed by internal or external auditors and shariah review is a self-assurance work

performed by the management through for example shariah department or internal auditors.

AAOIFI Auditing Standards also states that, in order to test for the compliance with the shariah rules and

principles, external auditors must obtain sufficient and appropriate evidence that provides the auditor with

the reasonable assurance that IFIs complied with the Islamic shariah rules and principles (Fatwas, rulings

and guidance issued by SSB. The auditor is responsible to form and express his opinion on the IFIs

financial statements, as explained in the AAOIFIs governance standards for IFIs (GSIFI, No.1). It further

states that the auditor shall be knowledgeable in shariah; however, he is not expected to not possess the

same shariah knowledge as the SSB members. It should be noted that the shariah auditor is not

responsible in the prevention of fraud and errors; however, they would be if it is due to their negligence

and misconduct during the audit.

In issuing fatwas, a Shariah Supervisory Board (SSB) could be guided by the standard contracts and

practices that could be harmonized by a self-regulatory professional association. A framework with the

suggested internal and external features could ensure adequate consistency of interpretation and enhance

the enforceability of contracts in civil courts where the jurisdiction of shariah court is in absence or

limited. The review of transactions would mainly be trusted to the internal review unit or the internal

auditors, which will collaborate with the external auditors responsible to issue the audit opinion or report

(Grais and Pellegrini, 2006). Next, the issues and challenges in shariah audit are discussed.

4. Issues and Challenges in Shariah AuditKasim et al., (2009) argue that various researchers claim that critical comments and demands for wider

responsibility and accountability of companies have led to many debates of what ought to be the ideal

audit function. In their survey of the gap between the desired and the actual shariah audit practices,

they found that the issues of shariah audit framework, the audit scope, the auditors qualification and

independence to be the four main issues. While this paper agrees on the four issues, however, this paper

is focusing on two additional issues and challenges to shariah auditing practice in IFIs. Such pressing

issues are the issue of shariah auditor independence (which has been intensely debated since the 1990s,

please see Karim, 1990), issues of shariah compliant inspectors which include the Hisbah institution and

the muhtasib, lack of qualification in the accountant and auditor on shariah and finance knowledge in the

shariah personnel, and lastly the lack of accountability of shariah auditors.

4.1Shariah auditor independenceThe integrity of the shariah auditor needs to be perceived as independent enough by those stakeholders of

Islamic finance. It is a common practice for the shariah auditors to rely heavily on or follow the advice of

shariah advisors or the SSB. This is not acceptable if we want to have fully independent shariah

auditors. Shariah audit in Islamic finance is argues as one of the social functions for the benefit of the

ummah. The full benefit of the shariah audit cannot be realized if they are not wholly or truly


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independent. Self- review threats may occurs because there is no clear line of separation of duties (Kasim

et al., 2009). Therefore, the SSB functions should be clearly stated and not to interfere with the shariah

audit and the IFIs could just outsource the shariah audit to outside professional accountants and auditor

who are well-versed in shariah and accounting.

Grais and Pellegrini (2006) assert that prevailing approaches to the regulation of the internal audit

department and external audit firm can provide guidance on how to ensure integrity of pronouncements

on shariah compliance. Literature on internal audit independence pinpoints three factors hat significantly

contribute to the degree of auditor independence, 1) Clarity of definition of the auditors responsibilities,

2) The position of the internal auditor within the institutions organizational structure, and 3) The

reporting structure. It is suggested that the IFIs give clear authority and instruction with powers to the

internal auditor, reporting to the Audit and Shariah Committee of the IFIs board. Furthermore, the Auditand Shariah Committee should report to the shareholders in order to reinforce their real independence

(Karim, 1990).

Haniffa (2010) also raises the question of the SSB independence as they are making fatwas and at the

same time helping the shariah auditors in conducting shariah review or shariah audit. Clearly there is

no clear line on the separation of duties which is essentials for any good internal control practices. The

IFIs need to rethink of where they could clearly separate these roles to avoid the misperception of the

stakeholders on the SSB and/or shariah auditors independence.

4.2Shariah compliant inspectors which include theHisbah institution and the muhtasib (judge)IFIs should understand that the primary importance for them is to ensure the compliance of all products

offered to the shariah. In this instance, the SSB plays vital and crucial roles in ensuring the strict

compliance but the SSB members are paid by the IFIs. Therefore, who is going to check whether the SSB

is following the shariah? Do we just rely on the shariah internal reviews? It is argued that the shariah

audit is only to be conducted by shariah professionals instead of accountants, while some others prefer

the trained internal auditor to undertake the responsibilities.

The Audit Committee of the IFIs should discharge their best effort to ensure that the external auditors are

capable of undertaking the ex-post shariah compliance reviews within their term of references (IFSB,

2006). They should also work with the internal auditor and the shariah auditor, if the internal auditors arenot shariah capable, and more importantly with the SSB. Hence, the IFIs auditing should evolve into a

professional shariah internal and external auditors capable of doing the financial, management and also

the shariah audit.

Chartered audit firms should acquire the necessary knowledge and personnel to undertake the shariah

audit. Although the number of professional firms gaining the knowledge, what is lacking is that an auditor

or accountant who really have the shariah knowledge and training for this purposes.

Some academics are bringing the issue of the Hisbah institution where it is owned and manage under the

state authority. The muhtasib is paid through the state coffers and they are expected to be fully


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independent of the market. And we can see that by having no connections what-so-ever with the market,

especially on the remuneration, they are independence in fact and in appearance. It is argued that the IFIs

should have formed some sort ofHisbah institution where the members are the shariah auditors.

Although, it is not necessarily being under the state authority, it could be an independent body or even as

a non-governmental organization (NGO).

According to Khan (1992) as cited in Kasim (2010), the scope of work of the muhtasib is almost similar

to what the scope of work for the present Islamic financial institutions auditors. Among others to manage

the market equilibrium, ensuring price control mechanism in the market, checking the credit structure,

especially on riba and payment of zakat, ensure the demand and control of goods in the market and

checking the efficiency in the public sector with regards to public funds.

4.3Lack of competency of shariah auditorUntil today, the lack of both shariah and accounting knowledge has dampened the crucial needs of the

shariah auditor. Those with accounting knowledge tend not to have shariah knowledge and vice versa.

This issue has been debated since the early formation of modern Islamic finance in the 1970s. It should be

noted that a shariah auditor must have a good knowledge in accounting and also in shariah to be able to

understand and audit the IFIs. Investments for the education in shariah, accounting and auditing is crucial

to enhance the knowledge and expertise of the actors involve with the shariah audit especially and IFIs in

general (Rahman, 2011; Sulaiman, 2011).

The call for the need to improve the education system especially at the tertiary level is beginning to gain

attention and one of the institutions like international centre for education in Islamic finance and various

others are formed but that is not enough. A strong Arabic and English fluency and understanding with a

good knowledge in shariah, Islamic fiqh, accounting, finance, auditing and business should enable the

shariah auditor to perform better and could help the IFIs improve further and comply with the shariah

(Khan, 1985).

It is also argue that since the IFIs are operating under a different platform that is with the Islamic

worldviews, they may need a different type of accounting and auditing. The IFIs and shariah auditors are

expected to serve the needs of the ummah whose focus and priorities are different from the other

communities and societies (with different worldviews). The managers of the IFIs are accountable for the

funds and the way they manage and utilize it. The shariah auditors are also accountable to ensure that the

IFIs follow all shariah guidelines and principles; otherwise, they have committedzulm (injustice) to the

ummah who had entrusted them to audit and ensure the IFIs comply with the shariah.

4.4Lack of accountability of shariah auditorsShariah audit can be performed by the internal auditors or the external auditors provided they must have

adequate shariah related knowledge and training. Subsequently, the report is forwarded to the shariah


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committee of the IFIs. The Shariah committee may give their opinions only on shariah matters to the

Board of Directors, who will decide or make the final decision (IFSB, 2006; ISRA, 2011). Shariah

auditor should have been more accountable because they have to be accountable to the stakeholders,

which include the shareholders, the society and the Ummah. Next, they are accountable to Allah for every

actions and inactions.

Therefore, the roles of the shariah auditors are very much limited in influencing the decision of the IFIs.

The Board of Directors of the IFIs is the one with the power to change or make the important decisions

regarding the products and services offered. Just to throw a hypothetically question, what happen if the

board refuse to abide by the shariah committee opinion if it is going the affect the IFI, for example huge

losses to the IFI because of a non-compliance issue? The last section of this paper is on the conclusion

and future recommendations.

5. Conclusion and Future RecommendationThe rapid and tremendous growth in Islamic finance requires the IFIs to have competent shariah auditors.

And to provide the check and balance an equally competent auditor who has good knowledge of

accounting, auditing and finance with the equally good shariah and fiqh knowledge and understanding.

They are known as the shariah auditor. The shariah reviews done by the internal auditors with the help

of the shariah advisors are not adequate anymore in current circumstances. Shariah compliant test by the

external auditors are also in question if the external auditors are not competent in shariah and relies

heavily on the shariah reviews done by the internal auditors with the advice of shariah advisors of the

IFIs.

In the early Islamic period, the institution ofHisbah provides the role as the inspector of the market.

They are auditing the businesses whether they comply with the shariah or not and reported the findings

to the institution where corrective actions would have been taken to the offenders (Kasim, 2010). The

Muhtasib, who are knowledgeable in the shariah and also in accounting, finance and business are paid by

the state and this truly enhances their independence. They are not only independence in appearance but

also independence in fact. Can we say the same to the contemporary shariah advisors and auditors where

they receive compensation and payment from the organization (IFIs) that they work for? The external

auditors are also being paid by the organization that they audited. And so far, the external shariah audit isnot a mandatory audit (Shafii et al., 2010). No wonder we have been hearing so many companies failure

due to accounting and auditing scandals especially in the United States, Europe and even in Asia for the

past several decades.

The perception of the shariah auditors are important to be studied as they are the one who is facing the

difficulties in the absence of a complete shariah auditing frameworks and standards. Their views should

be useful to develop the proper shariah auditing standards and frameworks. Some future research may

also want to address the need of various stakeholders of IFIs. A different type of reporting for IFIs is

suggested which requires specialized audit program to cater for the shariah audit (Rahman, 2008 as cited


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in ISRA, 2011). This is also the view of Shafii et al. (2010) but the proposed structures are still not tested.

Lastly, the role ofHisbah institution is worth to be revisit to gain insights as they had provided a very

good and effective shariah assurance services in the past. In fact, it could fully address the shariah

auditors independence, competence and accountability issues. Wallahu aklam.

iwww.dib.ae/en/index.htm

iiShariah is the body of Islamic faith. It has 2 main sources, the Quran and the ahadith (documents that record the

practice or life example from Prophet Muhammad pbuh)(Ali, 2010)iii

This is an institution known as the inspector of the market. Its members are the muhtasib (Qadhi). Similar roles

as the auditor of the present day (Lewis, 2005)


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issues and challenges of shari’ah audit in islamic financial institutions: a contemporary view

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