External Shariah Audit in Financial Services Industry

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The International Islamic Economic System Conference – The 9^th I-iECONS 2021

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INTERNATIONAL ISLAMIC ECONOMIC SYSTEM CONFERENCE (I-iECONS 2021)

External Shariah Audit in Financial Services Industry: Practitioners’ View on Its Merits, Scope And Implementation Challenges

Zakaria, N

¹

, Shafii, Z

²

, Salleh, S

³

1,2,3Faculty of Economics and Muamalat, Universiti Sains Islam Malaysia (USIM), Bandar Baru Nilai, 71800 Nilai, Negeri Sembilan Malaysia

[email protected] (Corresponding author)

1. Introduction

External Shariah audit (ESA) is the latest development in Shariah governance of Islamic financial institutions at the global level. Central Banks of Kuwait, Oman, Pakistan and Bahrain made the practice of ESA compulsory to strengthen their Shariah governance practice. ESA provides an additional layer of independent assurance to stakeholders of IFIs due to their position as an external party to the institution (Ahmed, 2017; UKIFC & ISRA, 2016; Islamic Finance Council & ISRA, 2012). External Shariah auditors have the responsibility to form an opinion whether the products, contracts and conduct of the IFIs are in conformity with Shariah Committee’s resolutions or the central bank. At the international level, Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB) have included ESA as part of their Shariah governance requirement (Ahmed, 2017).

In May 2021, AAOIFI issued its auditing standard number 6 which specifies the criteria for external audit of Shariah compliance in IFIs. From the S&P Global Ratings view, this move is a step forward for the industry and will reinforce governance and enhance market discipline (Damak, Roy, Jagtiani & Mujkic, 2021). In its standard, AAOIFI has adopted an elaborate and prescribed approach where it requires external auditors of financial statements to have knowledge of Shariah rules and principles so that external auditors can perform the dual role of auditing both financial statements and Shariah compliance (Ahmed, 2017).

On the other hand, IFSB did not provide an elaborate or prescribed approach about the role of external Shariah auditors. Some of the aspects highlighted included annual Shariah compliance review; identifying significant breaches in Shariah compliance with the potential to transform into reputational risk; and if required by the supervisory authorities, reporting to them any material Shariah non-compliance identified when auditing the Islamic banks. However, the IFSB has not detailed the audit scope of external Shariah auditors. Instead, it has advocated the supervisory authorities to issue guidelines for an external Shariah audit in their respective jurisdictions (Ahmed, 2017).

Despite ESA’s benefits, the move towards ESA does not come with ease. There are challenges highlighted by countries that had adopted ESA. Ahmed (2017) raised the issue of availability of human resources as he had interviewed regulator and industry practitioner in Pakistan where they had taken the initiatives to train professional accountants and Shariah experts to equip them with necessary skills to conduct effective ESA. Further, in Pakistan ESA report will remain as off-limits to the public. The ESA report are to be submitted to the State Bank of Pakistan and the board of directors of respective banks. This is due to the anticipated sensitivity of the audit opinion. Other issue raised by Kabati (2017) is the determination of audit scope as most IFIs expect the external Shariah auditor to review, discuss and report any Shariah non-compliances. However certain regulators deem the external Shariah auditor’s role to check the institution’s compliance with Shariah scholar’s fatwas.

In countries where ESA is not made mandatory, the Shariah Committee provides assurance on Shariah compliance by relying on the work of internal Shariah review and Shariah audit. However, there are concern on the issue of self-auditing where the Shariah Committee is attesting operations that it signed off earlier as compliant (UKIFC & ISRA, 2016). In this sense, IFIs rely on internal assurance mechanism that some argued to have issues such as conflict of interests and lacks independence.

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In Malaysia, IFIs’ regime of Shariah governance and compliance is equipped with the practice of internal Shariah audit (ISA) since year 2010 as outlined in the Shariah Governance Framework (SGF). ISA has been on a steady development since then with the increasing use of Shariah-risk based auditing, support from top management for training and hiring qualified internal Shariah auditors (Yasoa, Wan Abdullah and Endut, 2020). However, in 2019, the industry saw the possibility of having ESA. In 2019, Bank Negara Malaysia (BNM) issued Shariah Governance Policy Document (SGPD) where Clause G19.5 and G19.6 recommends as best practice for the Board to appoint an independent party for external Shariah audit on the operations, business, affairs and activities of the IFIs with the objective to provide assurance on the effectiveness of Shariah governance practiced by the IFIs. This requirement is aligned with the section 37 of the IFSA, which similarly allow appointment of independent audit on Shariah compliance by the IFIs. Further, it is well known that Malaysia has robust third party annual Shariah inspection by BNM of all IFIs and in normal circumstances the results of the audit is not publicly communicated (Kabati, 2017).

Isa, Mohd Ariffin and Zainal Abidin (2020) conducted a study on 83 practitioners from various IFIs in Malaysia highlighted some issues faced in internal Shariah audit practices where there is lack of independent Shariah audit report, a standalone shariah audit framework, and inadequate competent Shariah auditors. These findings is pointing towards the future of Shariah audit where the next stage in Shariah audit in Malaysia is at the beginning stage of awareness on improving the current structure of Shariah governance by implementing both internal and external assurance. Therefore, the objective of this paper is to obtain industry’s perspective on implementing ESA for IFIs in Malaysia. The paper explores the industry’s point of view on the merits, scope specification and competency requirement.

2. Methods

This study aims to explore the opinion of industry practitioners on the possibility of implementing ESA for IFIs in Malaysia. The study uses focus group discussion (FGD) as it intended to illicit responses from a group of industry practitioners who are involved in the practice of Shariah audit either as internal auditors, Shariah offices and top management of the IFIs. This method is chosen because it is a good way to gather people from similar backgrounds or experiences to discuss a specific topic of interest. The group of participants is guided by a moderator who introduces topics for discussion and helps the group to participate in a lively and natural discussion amongst them (Mishra, 2016). In addition, it is useful to explore and generate new ideas and issues through group interactions and capture certain elements such as thoughts, feelings, and intentions that are impossible to be observed or measured using other methods (Patton, 2002). Another advantage relates to the position of participants in the FGD. This technique also provides insight into the participant’s thoughts, ideas and memories in their own words rather than those of the researchers’ (Reinharz and Davidman, 1992).

A total of 31 invitations were sent to 16 Islamic banks and 15 Takaful operators. However, only 16 representatives from 8 Islamic banks and 4 Takaful operators attended the FGD. The participants comprise of Heads of Internal Audit, Heads of Shariah Audit, Chief Executive Officer, Vice Presidents and Head of Shariah Departments. Interview questions were distributed earlier before the FGD session for respondents to provide their feedbacks. During the online FGD session, respondents further elaborated and provided additional inputs about ESA. Notes taken during the FGD was further refined by cross-verifying with recording of the session.

3. Results and Discussion

Based on respondents’ written and verbal responses, findings were grouped into three areas, merits of ESA, audit scope specification and competency requirement which will be discussed in the following subsections.

Merits for ESA

Respondents were asked on the merits for ESA, such as were there any push factor from stakeholders (i.e., regulator, investment account holders, customers) that require ESA; the value added that ESA provides to IFIs and the need for an independent ESA report by the IFIs.

Respondents unanimously agree that currently there are no push factor from the stakeholders of IFIs, be it regulator or other stakeholders. There is however, one participant highlighted that there is no ESA expertise that can provide reasonable assurance on Shariah coverage.

The BNM SGPD (2019) was a mere recommendation for best practice and participants agreed that the current shariah compliance that is regulatory compliance is sufficient. IFIs have Shariah control functions that comprise of

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Shariah risk management, Shariah review and Shariah audit, thus they agree that having ESA might not be of value adding. Further, respondents believe that the annual internal Shariah audit performed has already cover a wide and comprehensive aspect which assessed on Shariah governance and internal control. In addition, BNM also conduct annual Shariah compliance check on all IFIs.

It can be observed from the current practice at the global level in countries such as Kuwait, Oman, Pakistan and Bahrain, the move for ESA was initiated by respective central banks/regulators giving an indication that IFIs in Malaysia would only have ESA when it is ordained by the regulators.

Audit Scope Specification

An important aspect of ESA is the determination of audit scope. Respondents is of the view that there is a possibility of overlapping of audit scope for the internal and ESA, thus causing overlapping of role as well.

Participants were concerned on the redundancy of audit coverage. Therefore, they opined there is a need for clear deliverables, scope, roles and responsibilities that distinguishes between the ESA and the ISA. Again, in this aspect, participants of the view on the need for regulator opinion on the establishment of ESA. Participants also voted for likely audit scope area for ESA. The top three audit scopes were determination, calculation and disclosure of Shariah non-compliance; calculation of ta’widh, gharamah and ibra’; zakat calculation and reporting; assessing the effectiveness of Shariah Committee in ensuring compliance and lastly reviewing Shariah governance.

It was highlighted by both Ahmed (2017) and Kabati (2017) AAOIFI has provided an elaborated approach to regulating ESA. In AAOIFI’s Auditing Standard No. 6, the scope includes governance structure and control framework; operating effectiveness of controls over transactions, contracts and earnings; operating effectiveness of controls over allocation of profits and charging of losses to investments. AAOIFI outlined that ESA be performed together as part of the audit on financial statements of IFIs.

Competency Requirement

An important factor that determines the implementation of ESA is competency of the Shariah auditors that will perform ESA. Respondents were asked on the institution that should take the lead in issuing guideline for ESA competency requirement. Some of the responses provided included an independent body, similar to accounting practice, BNM and Securities Commission. A respondent mentioned if ESA was to be required, the Chief Internal Auditor and Board Audit Committee of their institution would determine the competency requirement of the appointed ESA. Currently, their institution had appointed external audit firm having knowledge in Islamic finance but for a specific review engagement.

Currently, IBFIM, which is the training arm of BNM, and USIM jointly offers professional certification, that is Certified Professional Shariah Auditor (CPSA). CPSA provides participants with technical understanding and professional skills on Shariah compliance audit and review processes for the Islamic banking and finance industry.

The first cohort of CPSA was 19 external auditors who are members of the Association of Malay Chartered Accountant Firms (AMCAF). Based on feedback received from the first cohort, some were able to perform review on Shariah compliance during their engagement of auditing clients’ financial statements. It can be seen the pathway is being prepared for future practice of ESA in terms of human capital development. Nonetheless, further refinement is needed on the key competency areas for ISA and ESA so as to not overlap their roles and function in the IFIs.

In Pakistan, initiatives were also taken to train professional accountants and Shariah experts with skills to perform effective ESA (Ahmed, 2017). These initiatives were seen as necessary once the regulators have decided to issue guidelines on the implementation of ESA.

4. Conclusion

Industry practitioners have mixed views on the future practice of ESA for Islamic banks and takaful operators in Malaysia regardless of the global move by other countries such as Pakistan, Oman, Bahrain and Kuwait to have established ESA practice. The result from the FGD indicated that, despite various benefits of having ESA, the practitioners believed their current practice of ISA is robust enough and do not warrant for ESA. The main reason is that the existing regime of Shariah assurance in IFIs is adequate due to the existence of other Shariah organs comprising of IFIs’ own Shariah Committee as the oversight body, Shariah review and Shariah risk management. A third-party assurance on Shariah compliance is also conducted by BNM themselves on annual basis. Therefore, practitioners strongly asserted the current regime of Shariah assurance is robust as it has internal (i.e., Shariah review and internal Shariah audit) as well as BNM regulatory compliance review.

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Nonetheless, practitioners still mentioned that it is up to the regulator to decide whether ESA is needed for the Islamic finance industry. Based on observation of the global practice, ESA can be made a practice if it is mandated by regulation. In order for ESA to be effective, the industry need to have necessary infrastructure, in terms of professional certification, an ESA framework and sufficient supply of competent external Shariah auditors.

Acknowledgements

The authors would like to thank the Malaysia Institute of Accountants (MIA) and Universiti Sains Islam Malaysia (USIM) for financial assistance under the grant entitled Shariah Audit Best Practice Guidance (USIM/MG/MIA/FEM/SEPADAN-S/70120).

References

Ahmed, M.U. (2017). External Shariah audit of Islamic banks. Islamic Finance News. 12 April 2017.

Bank Negara Malaysia. (2019). Shariah Governance Policy Document. Kuala Lumpur: Bank Negara Malaysia (BNM).

Damak, M., Roy, D., Jagtiani, S and Mujkic, E. (2021). External auditing of Sharia compliance will likely strengthen governance of Islamic finance. Comments, S&P Global, 24 May 2021.

Isa, F., Mohd Ariffin, N., and Zainal Abidin, N. (2020). Shariah audit practices in Malaysia: Moving Forward. Journal of Islamic Finance, 9(2), 42-58.

Islamic Finance Council & ISRA (2012). Enhancing Shariah Assurance. IFC and ISRA Joint Thought Leadership.

Kabati, M. (2017). External Shariah auditing: New perception and key modern applications. AAOIFI’s Fifteenth Annual Conference of Shariah Boards, 12-13 April, Diplomat Hotel, Manama, Kingdom of Bahrain.

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Patton, M.Q. (2002). Qualitative evaluation and research methods. (3rd ed.). Thousand Oaks, CA: Sage.

Reinharz, S., & Davidman, L. (1992). Feminist methods in social research. New York: Oxford University Press.

UKIFC & ISRA (2016). External Shariah Audit Report. UKIFC and ISRA Joint Thought Leadership.

Yasoa, M.R., Wan Abdullah, W.A. and Endut, W.A. (2020). The role of Shariah auditor in Islamic banks: The effect of Shariah governance framework (SGF) 2011. International Journal of Finance Research, 11(4), 443-452.