AC 5033: Shariah Audit

ASSIGNMENT 1
Group

Semester January 2018

Prepared by:

Atiqoh Nasution (1700135)

Jubair Al Ameen (1700103)
Maruf Asadullahkhan Killedar (1700001)
Mamaduo Cellou Diallo (1700134)

Facilitator: Mr. ABDUL RASHID ABDUL KADIR

1. INTRODUCTION
Islamic banks have grown rapidly since its establishment throughout the world. Initially,
it was established to hinder the obstacles for the Muslim community to do transactions in the
conventional interest based banks by providing shariah compliant products it has now gained
wide acceptance from both Muslims and non-Muslims. Thus, it can no longer be regarded as
business institution to merely fulfil the religious obligations, but also as the one which can
compete with the conventional counterparts with attracting the customers together with being
compliant to shariah principles. Being shariah compliant means to adhere with the guidelines of
shariah principles in terms of transactional jurisprudence together with the regulatory
requirements provided by the regulators in the respective jurisdiction. Placing the eminent
personalities on the shariah board become one of the ways to assure the public on the shariah
compliance of the Islamic Financial Institutions (IFIs). Public become more aware on the
importance of shariah compliance of the IFI when making decision to put their money in the
Islamic Bank. Shariah non-compliance risk become one of the challenge for IFIs in their
operations, business affairs and activities. Non-shariah compliance may create great
consequences in IFIs. The contract becomes Null and void (batil/fasid) and the income derived
from the transaction could not recognized. It also leads to the reputation risk as the perception of
the stakeholders and public confidence will become dubious towards Islamic bank.

The level of shariah compliance of a bank is essential also to attract the customers and the
higher level of compliance would place Islamic financial Institutions in a better position is
Islamic financial markets. Thus, it motivates this research to be conducted. The aim of this study
is to determine the level of Shariah compliance in an Islamic Financial institution.

2. LITERATURE REVIEW

Shariah requires for all Muamalat transactions to be free from prohibited elements such
as Riba, Gharar, Maysir, and other prohibited activities. These are the foundation for the
practices and operations of Islamic Financial Institutions. In addition, Islamic financial
institutions also need to comply with the requirement from standard, guideline and relevant laws
of local or international jurisdictions. In the context of Malaysia, Islamic financial institutions
shall comply with Islamic principles and the following requirements:

1. Comply with the Islamic Financial Service Act 2013

2. Comply with the relevant law as prescribed by the regulators e.g. Bank Negara Malaysia
(BNM) & Shariah Committee (SC)
3. Comply with the standards and guidelines issued by the regulators BNM & SC
4. Comply with the resolutions of Shariah Advisory Council of BNM &SC
5. Comply with the resolutions of Shariah Committee of the Islamic Financial Institution
6. Periodic Shariah Audit for the IFI
7. Penalty of 8 years or 25 M in case of failure to comply with the Shariah requirements
In this study we have considered several levels of shariah compliance of Islamic financial
institutions namely high compliance, satisfactory compliance, fair compliance, poor compliance.
High level of shariah compliance is excellent as it is strictly adhered to shariah principles and
requirement of relevant law and standard such as Islamic Financial Service Act 2013, resolution
of BNM, SAC and SC. Satisfactory compliance is the level of compliance where the IFIs follow
shariah principle and just meet requirement of relevant law and standard. Fair compliance
denotes as there is need improvement in the shariah compliance level and relevant laws and
regulations. Poor refers as it is not at all in line with shariah guideline and law and regulations in
particular areas.

3. HYPOTHESIS AND THEORITICAL FRAMEWORK

In this study we adopt six independent variables namely Shariah functional structure,
Role of Shariah department, Role of shariah committee, Availability of shariah staff, Shariah
knowledge/awareness and Frequency of shariah compliance and audit program and one
moderating variables; Concern and Commitment of Board of Director to determine the level of
compliance of an Islamic Financials Institutions. The following is the variable used in this study:

Variables Description/Definition relationship

Level of Shariah Compliance to shariah means an act or
compliance activity that fulfills with the requirements
(Independent Variable) of the Shariah, or Islamic law.
Shariah functional A set of institutional and organisational Positive relationship affects
structure arrangements of Islamic financial shariah compliance
institutions to ensure effective independent
(dependent Variable)
oversight of Shariah compliance over the
issuance of relevant Shariah
 pronouncements, dissemination of
information and an internal Shariah
compliance review
Role of Shariah The role of Shariah department is a Positive relationship affects
Department secretariat to serve Shariah Committee. shariah compliance

(dependent Variable)
Role of shariah The members of Shariah Committee are the Positive relationship affects
committee scholars with knowledge and expertise in shariah compliance
Islamic jurisprudence. advising the Bank
(dependent Variable)
on all issues relating to Shariah compliant
products and services.
Availability of shariah Having sufficient staff equipment with Positive relationship affects
staff shariah knowledge to handle all shariah shariah compliance
matters.
(dependent Variable)
Shariah Provide a sufficient shariah knowledge and Positive relationship affects
knowledge/awareness training to Board, Shariah Committee and shariah compliance
the management
(dependent Variable)
Frequency of shariah How often shariah review and shariah audit Positive relationship affects
review and audit are conducted. shariah compliance

(dependent Variable)

Concern and How concern and commit the Board of Positive relationship
commitment of BOD Director on the Shariah compliance of affects shariah
(Moderating IFIs compliance
Variable)

Theoretical Framework:
4. METHODOLOGY

Methodology of gathering data for this research paper has been from primary and
secondary sources. Fundamental concepts were collected from journals, publications, books. The
paper has also undertake analysis from interviews and questionnaires.

5. DISCUSSION AND FINDINGS

Shariah compliance is the hallmark that differentiates Islamic financial institutions from
their conventional counterparts. It is the backbone of the global Islamic finance industry and
unique value proposition that the Islamic institutions offers to its stakeholders. Various initiatives
are being taken in different jurisdiction to ensure the compliance and maintain the credibility of
Islamic finance through financial institution to the stakeholders. In Malaysia, Bank Negara
Malaysia (BNM) places a great emphasize in ensuring the overall Islamic financial system
operates within the shariah principles. In ensuring the shariah compliance, BNM has come out
with several initiatives such as developing a centralized Shariah Advisory Council at the bank
and internal Shariah Committee formed within the Islamic financial institution and Islamic
Financial Service Act 2013 (IFSA). In addition, in 2010 BNM has issued the Shariah
Governance Framework (SGF) for Islamic Financial Institutions with the main objective of
enhancing the role of the board, shariah committee and the management relating to shariah
matters. It is also included the key organ which held responsible to execute the shariah
compliance and research functions to attain the shariah environment in the operation of Islamic
financial institutions.

Based on the literature and engagement with Islamic Financial Institution, several
parameters have been considered in this study to investigate the level of Shariah compliance in
an Islamic Financial Institutions.
- Shariah Functional Structure

The objectives of Shariah governance framework issued by Bank Negara Malaysia

(BNM) are to create the expectations of the bank on an IFIs Shariah governance structures,
process and arrangements in ensuring all the operations and business activities in line with
Shariah principles, to provide a comprehensive guidance to the board, shariah committee and
management in performing their duty and responsibility related to shariah matters in Islamic
financial institutions and lastly to outline the functions in relation to shariah review, shariah
audit, shariah risk management and shariah research. Below is the illustrations of structure of
roles, functions and reporting relationships of key organs in Islamic financial institutions based
on SGF:

According to the graph above of SGF, the IFIs shall establishes a formal reporting line
among the key organs to ensure the effectiveness and timely manner of reporting on shariah
matters. Shariah committee shall functionally report directly to the board of directors which can
be seen from the direct line of SC to the board. Shariah review and shariah research functions
shall report directly to Shariah committee and indirectly report to management which is seen
from the dotted line. Meanwhile, the formal reporting channel of Shariah risk management is to
 board risk management committee and reporting channel of shariah audit function is directly to
board audit committee.

One may argue that there might be a potential of lack of independency whereby SC is the
one who approved the product but in case shariah audit committee found any shariah issues on
the product, at the end shariah audit committee still need to report to SC. To mitigate this
potential risk of conflict of interest BNM has come out with the guideline of introduction of new
product. In launching Islamic new product, IFIs shall follow “NPAP”; New Product Approval
Process and “NPAC”; New Product Approving Committee. As far as the new product is
concerned, whatever has been done should be gone through NPAC and get endorsement from
relevant subject matter expert such as risk committee, IT committee, review committee, audit
committee then Shariah Committee will come into picture to approve the new product.

In addition, one interesting point that we found is in practice sometimes the dotted line is
stronger compared to the full line in the graph. Theoretically, Shariah Audit and shariah risk do
not have the formal reporting to Shariah Committee but to the board in case of some issues on
shariah matters found by shariah audit or shariah risk committee. However, practically whatever
matters in relation to shariah such as internal procedure, policy and guideline are reported by
shariah audit and shariah risk management to the boards, the board committee such as board risk
committee, board audit committee will ask them to refer to Shariah Committee first and get
endorsement from Shariah committee. From here we can see how different is the theory and the
practice.

- Role of Shariah Department

Shariah department is the same as the shariah secretariat to serve the Shariah committee (SGF,
2010). The role of this department is as the coordinating meetings, compiling proposal papers,
circulating the shariah decisions to the relevant parties and engaging with the relevant organs
regarding the shariah matters which will be proposed to shariah committee. In Shariah
Governance Framework by BNM, Islamic financial institutions shall have a robust Shariah
compliance functions, comprising review function, audit function, supported by risk
management control function and research function in order to ensure the operations and
activities of IFIs are in accordance with shariah principles.
 Shariah review function is part of shariah department. it refers to regular assessment on
the shariah compliance of the operations, business affairs and activities including the end-to-end
product development process in Islamic financial institutions by the qualified shariah officers.
Under Shariah Governance Framework, shariah review shall cover all aspects of operations and
activities which include business operations, shariah risk management and internal control
process, transaction and finances, product and services, training, marketing and sales, branches,
business units, entertainment and other related activities. Shariah review also provide
rectification measures and control mechanism to avoid any non-compliance incidents.
Shariah review would come out with the shariah review plan before undertaking the
assessment of the IFIs’ operations and activities. From the interview conducted by the authors, it
is found that shariah review will zoom in and check the compliance of the product offered by IFI
in details such as the existence of subject matters, the sequence of the aqad, and the existence of
signature of the customers in the contract provided the product has been launched at least after 6
months. Moreover, shariah review has also focused on the product, the critical shariah issue such
as Tawarruq and the new product offered by IFIs. For the normal product, Shariah review will
review it once in two years however in case of product having significant shariah issue, shariah
review will come to assess the product every year.
According to SGF, Shariah research refers to the conduct of performing comprehensive
research and studies on shariah issues which include providing day-to-day Shariah advice and
consultancy to relevant parties on shariah matters. This function shall be an internal unit
comprising the qualified shariah officer to conduct pre-product approval process, research,
inspection of issues for submission, handle administrative and secretarial matters in relation to
Shariah committee. Expert on legal, operational and other related aspects are also required as
part of the shariah research committee in order to present the issue or new product review to
Shariah committee.

Apart from shariah review and shariah research, Bank Negara Malaysia also requires IFI to
establish Shariah risk management function and shariah audit function in the operational
structure of IFIs. These function is not under the shariah department. Shariah risk management is
under the risk management department while shariah audit function is under internal audit
department.
 Shariah risks management refers to a function which systematically identify, measure,
monitor and report Shariah non-compliance risks in order to prevent any shariah non-compliance
in Islamic financial institutions. It manages and mitigates shariah non-compliance risk up to the
acceptable level of risk of IFIs. From the interview conducted by the authors, it is mentioned that
this function shall conduct the oversight on the operational aspect and activities of the IFIs
especially in pre and post of launching the product. Shariah risk managements shall identify the
potential risk arising from the process and implementation of the new product. The example
given by the interviewee was the potential risk of shariah non-compliance due to improper
sequence of the aqad and non-existence of the subject matters in the contract.

In addition, according to SGF (2010) Shariah audit is a periodical assessment conducted

from time to time to provide an independent assessment with the objective to add value and
improve the level of shariah compliance in business operations and activities in IFIs. The audit
committee shall ensure the operation and activities of IFI are free from four elements namely
Riba, Gharar, Maysir, and non-halal activities by focusing on the internal control of IFIs.
Meanwhile, according to Auditing Standard for Islamic Financial Institutions (ASIFI) shariah
audit is to express an opinion as whether financial statements are prepared in all material respects
comply with shariah rules and principles, AAOFI accounting standard and other relevant
national accounting standard.

As the best practice, it is recommended that shariah audit must be conducted every year
for all financing units, department or branches of the bank. The transaction of each unit shall be
checked using sampling to determine their conformity to shariah principles. if the transaction is
impermissible, the income generated from the transaction should be transferred to charity
account and disciplinary action must be prescribed if the mistake is intentional.

In addition, ASIFI in principle 6 provides a guideline for the external shariah auditor as
independent engagement to examine and assure shariah compliance within Islamic Financial
institutions. Independent and comprehensive external shariah audit is important to safeguard the
integrity, reputation and sustainability of IFIs. However, in the current practice especially in
Malaysia, such independent assurance by external shariah audit has not been in the practices
among IFIs.
 From the interview conducted by the authors, it is observed that based on SGF it is
written the formal reporting line of shariah review and shariah research is reporting directly to
Shariah Committee while in the dotted line means they also report indirectly to management.
However, in practice it is not always the case and it is still questionable. When shariah review
and shariah research report directly to Shariah committee, this means that the shariah committee
has access to the performance of shariah review and shariah research. However, it is obvious that
shariah committee only come once in every two months or once a month and they will not really
know what the shariah department has done. At the end, CEO and management are the one who
asses the performance of shariah audit and shariah review with the endorsement from Shariah
committee. In fact, all the pool of bonus and salary are in the hand of CEO not in shariah
committee. Thus, we may say again conflict of interest may arise from this practice.

- Role of Shariah Committee

According to Shariah Governance framework, Shariah committee shall be responsible

and accountable for all its decisions, views and opinions related to shariah matters. Shariah
committee oversight shariah matters of Islamic financial institutions’ business operations and
activities. This shall be achieved through shariah review and shariah audit functions. These
functions shall enable Shariah committee to identify shariah issue which require appropriate
attentions and corrective measures. Shariah committee is expected to come out with the report of
shariah compliance of IFIs as per requirement by Guidelines on Financial Reporting for licensed
Islamic Banks.

A well-functioning shariah committee is expected to be effective, efficient, independent,

consistent and transparent in its deliberation and decision. However, as in Shariah governance
framework shariah committee members are remunerated by the board by reflecting their
accountability, duties, and responsibilities in Islamic financial institutions, this could lead to
legitimizing unlawful or dubious operations, products and services because of the monetary
incentive. It is recommended that shariah committee receive remuneration from the central bank
and there is centralize shariah committee under central bank to ensure the independency in
expressing their opinions or resolutions in relation to shariah matters within Islamic financial
institutions. However, the implementation of this may have the disadvantage to IFIs because in
 centralize shariah committee there is potential that each of the banks will know what the other
bank doings from the information disclose by shariah committee.

- Availability of Shariah Staff

One aspect that need not be neglected in order to have innovation of product and services
and to ensure Shariah compliance of Islamic financial institutions is human capital who are
competent officers and shariah committee. Based on Shariah Governance Framework principle
4.1, Board and management is expected to have sufficient knowledge on finance in general and
Islamic finance in particular in order to enable shariah committee to understand Shariah issue
brought before them.

Shariah committee comprises of shariah scholars and industry practitioners. Shariah

scholars are mostly the academician who has a strong credentials in shariah but lacking in
banking experience while industry practitioners are person who has qualified and extensive
banking knowledge/experience and supplemented with certified-shariah trainings or other
credentials. According to SGF, the chairman of shariah committee must be person with shariah
background who has exposure on the banking operation and it is recommended that at least one
member of shariah committee is industry practitioner in order to bridge the gap especially when
it comes to the shariah issue in relation to banking operation. Meanwhile, for shariah officers, the
members are mostly the fresh graduates who have Islamic finance postgraduate but lack in
banking experience and the persons who have experience and qualified in conventional banking
supplemented with certified-shariah qualification and other credentials.

According to Shariah Governance Framework Principle 7.8, shariah audit shall be

performed by internal auditors who have acquired adequate Shariah-related knowledge and
training. As from this principle, it is not necessary to have qualified shariah background person
to sit as one of shariah audit committee members of IFIs. Practically, it is observed that there is
no shariah background person within the shariah audit committee and the argument behind it is
that shariah audit committee only need a person with strong expertise in conventional audit and
adequate shariah related knowledge or training. However, in fact shariah audit committee is just
like the last defense of IFIs. It is necessary to have at least one qualified shariah background sit
in the shariah audit committee.
- Shariah Knowledge/Awareness

In the principle 2.14 of shariah governance framework, the management is responsible to

provide continuous learning and training programs to the key internal stakeholders including the
board, the Shariah Committee, and relevant staff in Shariah and finance matters, to ensure that
every function in the Shariah governance framework is sufficiently exposed to current
developments in Shariah related matters.
Practically it is observed that an Islamic financial institution has fulfilled this principle.
Promoting Shariah compliance and Shariah awareness in Islamic financial institutions is based
on the system driven as well as class room driven. Under system driven basically there is a
compulsory Shariah e-learning for those who just join IFIs, and every 2 years there will be
another Shariah course given to the staffs. Islamic banks arrange Shariah quiz and distribute
informatory brochures in order to raise awareness among staff as well as customers. Training is
also conduct to the staff by inviting the external Shariah training provider or internal staff giving
the training within the department.
- Frequency of Shariah Compliance and Audit

It is necessary to have a regular assessment conducted either by shariah review or shariah

audit function in Islamic financial institutions to create sound and effective internal control
system for shariah compliance. According to SGF, the scope of shariah audit shall covers of IFIs
business operations and activities including audit financial statements of IFIS, compliance audit
on organizational structure, people, process and information technology application system and
review of adequacy of shariah governance framework.

Based on the principle 7.10 of Shariah governance framework, shariah audit shall be
conducted on the critical areas at least once a year depending on the risk profile of IFI. It is
observed that the frequency of shariah audit in IFI is depend on the quality compliance of the
bank. If the bank has good rating, the shariah audit will be conducted every 2 years, but if bank
has bad rating or having significant non-shariah compliance issue, shariah audit will be
conducted every year based on the sampling data.
- Concern and Commitment of BOD

According to Shariah Governance Framework Principle 2.1, board is ultimately

accountable and responsible on overall shariah governance framework and shariah compliance of
IFIs by putting in place the appropriate mechanism to discharge aforementioned responsibilities
in addition the board must ensure effective communication policy among the key functions of
IFIs to facilitate smooth escalation of significant shariah matters to the board to ensure the
shariah compliance at all times.

As per requirement under SGF principle 2.4, board may consider appointing at least one
member of shariah committee as member of board to serve as bridge between board and shariah
committee for greater understanding and appreciation amongst board members on decision made
by Shariah committee. However, it is observed that not all IFIs has taken this principle into their
practice. As Islamic financial institutions, it is necessary to have at least shariah background to
sit as board members.

6. RECOMMENDATION AND CONCLUSION

Several parameters namely Shariah functional structure, Role of Shariah department,

Role of shariah committee, Availability of shariah staff, Shariah knowledge/awareness,
Frequency of shariah compliance and audit program and Concern and Commitment of Board of
Director proposed in this paper to determine the level of shariah compliance of Islamic financial
institutions. It is found that having a good shariah framework and effectively practicing the
framework are two separate issues just like practice is not always as good as the theory.

We may come out with the conclusion that the level of shariah compliance of Islamic
financial institutions is fair shariah compliance. Islamic financial institutions follow shariah
principle and the requirement by the relevant law, standard and guideline. However, there is still
some areas that need to be improved.

First, in term of the reporting line practice in functional structure, it is in practice the
dotted line of reporting seems to be stronger than the full line reporting channel. There shall be a
strict monitoring in this practice to ensure the independency and transparency of business
operations and activities in IFIs. Second, it is recommended that at least one qualified shariah
background sit in the board as the bridge when discussing shariah related matters. Third, it is
recommended that shariah committee receive remuneration from the central bank by the pool of
money contributed by each Islamic financial institution to ensure its independency. Fourth, as
shariah audit is the last defense to shariah non-compliance risk, it is necessary that Islamic
financial institutions to have at least one qualified shariah background with adequate expertise in
conventional audit. Fifth, it is recommended that there is external shariah audit conducted in
Islamic financial institutions. Last, it is recommended that IFIs disclose the rating of its shariah
compliance to the public to create more public confidence to the Islamic financial institutions.

7. REFERENCES

AAOFI (2005), Auditing Standard for Islamic Financial Institutions No. 6 on External Shariah
Audit

BNM (2010), Shariah Governance Framework

BNM (2013), Islamic Financial Service Act

Shamsher, M. and Sori, Z.M., (2016) Effectiveness of Shariah Committees in the Malaysian
Islamic Financial Institutions: The Practical Perspective. Middle East Insights, National
University of Singapore