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Tuesday, January 5, 2010



It is widely accepted that the primary objective of financial reporting and accounting is to provide useful information to assist users in making economic decisions. Thus, it can be argued that financial reporting and accounting is therefore, a religious obligation. Hence, if accounting is a religious obligation, then the rules of accountability must be purely divine. In order to do so, appropriate accounting framework based on Shariah principles must be in place. The same goes to the auditing and governance standards that applicable to the Islamic financial institutions (IFIs). The concern of this project paper is to explore the rationale behind the needs for application of relevant sets of financial reporting and accounting, auditing and governance standards for IFIs which are presently thought of many people as synonymous to the requirements of its conventional counterpart. There is danger for such kind of perception because the basic building blocks for respective Islamic financial reporting and accounting, auditing and governance standards with its conventional counterpart are worlds apart.

1.0              Introduction

The contemporary experience of Islamic banking is hardly for more than three decades old but has proved to be groundbreaking with far reaching impacts worldwide. Banking success depends on the extent of public trust placed in the financial strength of individual banks, particularly the trust of depositors and investors. In addition to the paramount importance of financial strength, trust in Islamic banking is also relates to the extent of adherence to Shariah, the identity of the Islamic banks. Thus, to enhance the trusts and confidence of public especially the Muslim society towards Islamic banks is the quality of information issued to the investors and depositors about bank’s ability to achieve both financial and Shariah-related objectives. Hence, developing and having a unique accounting and financial reporting standards for the dissemination of such information about Islamic banks becomes a necessity.

The nature of financial intermediation, including the function of banking, is different to the case of Islamic bank. The Islamic precepts influence the structure and activities of IFIs in several ways with the most important principle being the prohibition against the payment and receipt of interest whilst advocating into partnership and equity participation of both side of balance sheet. Only by understanding the nature of Islamic financial intermediation theoretical framework, then, we can come to appreciate on why Islamic financial institutions (IFIs) have different set of risks that applied onto them. Thus, it has leads to the needs for specific sets of standards that adhere to the Islamic principles in regards to the auditing and corporate governance.

This project paper endeavors to analyze the rationales for the needs of different sets of financial reporting, accounting, auditing and governance standards which are following the precepts of Shariah Islamiah. Financial accounting within the boundary of Islamic perspectives will be analyzed before the rationales of Islamic financial reporting. The studies of rationales for the introduction and application of auditing and corporate governance standards will follow subsequently.

2.0       Financial accounting - The Islamic perspectives

The motivation for the development of Islamic accounting comes together with the emergence Islamic economic and Islamic resurgence for the last two to three decades. The awareness for the need for Islamic accounting is due to basic building blocks of conventional accounting itself since the Financial Reporting Standards (FRSs) are based on interest-based elements. Because of the interest-based requirement, the conventional accounting adopts the ‘historical cost and conservatism concept’ to ensure the capital and interests are repaid. This is one of the elements embedded in the conventional accounting which is violating the requirements of Shariah.

As an alternative accounting system, Islamic accounting is gaining more recognition, especially by Islamic countries. It is necessary to have Islamic accounting to be in place rather than conventional accounting in order to provide information on financial success in Islamic organisations. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) was formed for this reason. To this date, AAOIFI has produced a set of accounting standards that could represent a benchmark framework that draws rationales from the Shariah.

Islamic accounting can be initially defined as the “accounting process” which provides appropriate information (not necessarily limited to financial data) to stakeholders of an entity which will enable them to ensure that the entity is continuously operating within the bounds of the Islamic Shariah and delivering its socioeconomic objectives. The meaning of Islamic accounting would be clearer if we compare this with the definition of ‘conventional accounting’. The conventional accounting as we know it is defined to be the identification, recording, classification, interpreting and communication of economic events to permit users to make informed decisions (AAA, 1966). It can be seen that both accounting systems set out similar objective of reporting. Not only that, Islamic accounting shares with their conventional counterparts the same common process of recognition, measurement and recording of transactions and fair presentation of rights and obligations. However, the differences lie in the following;

  • The objectives of providing the information;
  • The type of  information is identified;
  • How the information is it  measured, valued, recorded and communicated; and
  • To whom will the information be communicated (the users).

Having appreciated the basic concepts of Islamic accounting in comparison with the conventional accounting, the following sub-sections will discuss the objectives of Islamic accounting with subsequently the discussion between principles of accounting i.e. Generally Accepted Accounting Principles (GAAPs) with the Islamic worldview requirements that has lead to the development of Islamic accounting in order to appreciate the rationale for the introduction and implementation behind it. Only by appreciating the distinctions, then we can appreciate the important and rationales behind the needs to apply Islamic accounting for IFIs.

2.1       Objectives of Islamic accounting

The objectives of financial accounting determine the type and nature of information which should be included in the financial reports in order to assist users of these reports in making sound decisions. On this basis, the objectives of financial accounting for IFIs are to achieve the following;

*      Determine the rights and obligations of all interested parties, including rights and obligations resulting from incomplete transactions and other events, in accordance with the principles of Shariah and its concepts of fairness, clarity and business ethics.

*      To promote and ensure only Islamically permitted economic activities are carried out.

*     Subscribe to the safeguarding of Islamic banks’ assets, rights of Islamic banks and rights of others in an adequate manner.

*      Subscribe to the enhancement of management and Islamic banks’ productive capabilities, and encourage compliance with the established goals and policies, and above all Islamic Shariah, in all transactions and events.

*      To avoid disputes among society members through providing a fair basis of sharing profits, wealth transfers and full disclosure of activities and values.

*      Provide through financial reports useful information to report users, and thus enable them to make legitimate decisions in their dealings with Islamic banks.

*      To provide a fair basis for the calculation of zakat (Islamic Taxation).

2.2              The principles of accounting concepts and Islamic worldview

Conventional accounting structure in its current structure follows what are known as Generally Accepted Accounting Principles (GAAP) or the fundamental accounting concepts. This takes into account among others historical cost, conservatism, accrual and matching, substance over form, going concern monetary measurement, materiality and consistency and others. These principles nevertheless favour and follow the historical development of western civilisations. In this section, the paper shall discuss this in comparative perspective with the values of the Islamic worldview that has led to the development of Islamic accounting and the rationales behind it.

2.2.1                                Going concern and accruals

These two concepts are considered part of the bedrock of accounting. Going concern is particularly important with regard to measurement. As result,  the conventional accounting standards requires that financial statements be prepared on going concern and requires that the directors assess whether there are significant doubts about the entity’s ability to continue as a going concern. The accruals concept lies at the heart of the definitions of assets, liabilities, gains, losses and changes to shareholders funds. Accruals basis of accounting requires the non-cash effects of transactions to be reflected in the financial statements for the period in which they occur. This concept is closely related to the ‘realisation’ concept whereby the firms can only allow profits that are ‘realised’ by the balance sheet date to be included in the Income Statements.

Basically, the going concern concept embedded in conventional accounting is not in conflict with the requirements of Islamic accounting whereby the directors should making assessment on the firms’ ability to continue as a going concern. Consequently, the financial statements must also be prepared on the basis of going concern basis unless the directors want to liquidate the firms or to cease trading or has no realistic alternative but to do so. The principle does not in conflict to the requirements of Shariah. Thus, it is allowable like in the case of murabahah[1] or bay’ bithaman-ajil (BBA)[2] transactions conducted by IFIs. If the IFIs treat a murabahah or BBA transaction as a financing transaction or purely as a sales transaction, it has the same effect on profit. However, IFIs may differ in terms of the timing of recognition of the margin: at time of sale, as cash received or as payment becomes due. If the cash basis is adopted, the profit will be recognised as and when the instalments are received. On the other hand, the accrual basis method recognises profit based on a proportionate allocation of profits whether cash is received or otherwise. However, AAOIFI rejects the first method, except where the credit period does not exceed the current financial period. Thus the preferred method would be the accrual basis. In this case, the IFIs have to set-up ‘Profit-In-Suspense account’ or ‘Unearned Income account’ whereby the deferred profits (unearned income) shall be offset against murabahah receivables. Consequently, for each payment made by the debtor, the profit related to the payment would ‘realised’ and recorded in the Income Statement of the IFIs. The examples of journal entries are shown as follows:

Journal entries:
*      Recognition of murabahah financing assets;
Dr       Murabahah financing
Cr       Cash (Cost of purchase)
Cr       Unearned income (Profit)

*      Repayment received from customers;
Dr       Cash
Cr       Murabahah financing

*      Income recognition at the end of each period;
Dr       Unearned income (Profit)
Cr       Profit and loss a/c – Revenue

2.2.2                                Prudence and consistency

These two concepts are considered desirable qualities of financial statements rather than part of bedrock of accounting. The prudence concept was closely linked to that of ‘realisation’. The concept of prudence implies that IFIs should take a very pessimistic outlook in estimating income, expenses, assets and liabilities and promotes the need to be cautious in overstating assets or profits especially in the face of inevitable uncertainties in the business world. Circumstances that lead too uncertainties such as collectability of doubtful receivables, the probable useful life of assets and other contingencies are recognised by the disclosure of their nature and extent with a reasonable dose of prudence in the preparation of financial statements. The concept of consistency implies that a company should rarely if ever change the way in which financial information is prepared and presented. However, the comparability is regard to be more fundamental objective than consistency. In particular, any IFIs should not use consistency to justify an accounting policy that is no longer the most appropriate to its particular circumstances.

Apparently AAOIFI Standards are silent on the prudence principle in financial reporting. If IFIs understate the potential income or assets value, the financial report would be ‘unfair’ to the stakeholders and the users of financial statements (because if the report do not show the potential income/ assets, it is in conflict to the very idea of financial reporting in Islam which focus on ‘fair reporting’ of an entity’s financial position). However, if IFIs take a route to ensure in exact detail the value of each element of financial statement, this will increase the costs in the effort of ensuring the full and exact disclosure in the financial statements and this will burden the shareholders. Therefore, AAOIFI Standards are silent with regards to the concept of prudence and leaves it to the best discretion of the preparers of financial statements to comply with their local regulatory requirements or management or to any other regulations that would shape the decision in so far as employing prudence in the reporting process.

The requirement for consistency is also not in conflict with the Islamic accounting requirement whereby the presentation and classification of items in the financial statements should be retained from one period to the next unless circumstances require it to change. This is because comparability is regarded to be more fundamental objective than consistency. Should there is unexpected events occurred that require the reporting entity to change its accounting policy, the comparability would prevail.

2.2.3                                Definition of asset and the concept of ‘substance over form’

A major difference between conventional accounting and Islamic accounting lies in the definition of assets. AAOIFI defines asset as that which the enterprise has acquired rights to hold, use or dispose and does not recognise asset based on ability to control through other than legal ownership. An asset, in the conventional sense, is regarded as an asset when there is any future economic benefit embodied in the asset regardless of whether there is legal control by the reporting firm. From Islamic perspectives, to qualify as an asset, IFIs should have acquired the right to hold, use or dispose of the asset. Thus, AAOIFI does not particularly endorse the concept of ‘substance over form’. In view of the primacy of contract in transactions in Islam, the emerging reality must be constructed or appear to be as the form. This is evident in the treatment of leased assets (ijarah[3]) and murabahah transactions. For murabahah contracts, the essence of the transaction is in fact a sales transaction. Thus, the ownership title will be passed to the purchaser upon acquisition. But, IFIs can require the purchaser to pledge the assets acquired as collateral to the financing amount. The financier or the bank is prohibited to buy back the assets from the purchaser.
Under ijarah contract, AAOIFI recognised ijarah asset as fixed asset (incidental to legal ownership). Thus, repair and maintenance costs are the expense of the lessor (i.e. the financier or the banks) but the conventional practice, it is borne by the lessee. The examples of journal entries are shown as follows:

Journal entries:
*      Cash purchase of equipment for ijarah financing;
Dr       Equipment
Cr       Cash

*      Provides ijarah financing to lessee;
Dr       Ijarah financing asset
Cr       Equipment

*      Repayment received from lessee & income recognition;
Dr       Cash
Cr       Profit and loss a/c – Revenue

*      Depreciation cost of ijarah financing asset;
Dr       Profit and loss a/cDepreciation expenses
Cr       Depreciation

*      Maintenance cost of ijarah financing asset;
Dr       Profit and loss a/cMaintenance expenses
Cr       Cash

2.2.4    Historical cost and conservatism versus current value

Conventional accounting uses monetary units as a common denominator to express basic elements of financial statements. However, the use of monetary units is subject to inflationary and deflationary pressures which may significantly affect its purchasing power. Thus, historical cost concept only provides input to the ‘satisficing’ notion. Some decision makers do not seek to optimize but ‘satisfice’.

The current convention of historic cost and conservatism arose from the needs of bankers and shareholders. This concept has been developed from the requirements of interest-based bankers who are interested not in seeing whether a proposed venture is profitable, but whether capital and interest are repaid. Thus there is needed to be conservative in the valuation of assets by using historical cost but anticipating all liabilities in conservatism concepts (Shahul Hameed, 2005). It is also favourable because the cost of publishing historical cost financial statements are negligible compared with those prepared under current cost accounting. However, these concepts could be contrary to the idea of fairness and justice. For example under valuation of historical cost, zakat or Islamic tax based on historical cost valuation would yield lower receipts and consequently lower transfer payments to the beneficiaries in times of inflation or rising costs. Zakat is basically an income tax and its payment is a religious obligation. Since zakat is based on wealth, current values would satisfy Islam’s concept of justice more adequately than would historical cost. Many writers have called for the provision of a fair zakat with proper valuation base is the most important objective of Islamic accounting. As quoted by Baydoun and Willet (1997), mention that zakat is so central to the Islamic faith that it has to be given a prominent place in the system of Islamic accounting. This may be strange to conventional accountants whereby many of them make their living by giving advice on how to avoid tax.

AAOIFI has also supports the use of current value and very specific on the method of current valuation to be used in the case of Islamic banking environment. The rationale for this position is that present and potential investment account holders (e.g. Mudarabah[4] investment account holders) need information to evaluate the bank’s ability to achieve its investment objectives. Thus if investments are measured using historical costs, inequities would occur in the distribution of investment results between the holders of investment accounts. Therefore, the current values appear to be consistent with the principles of socio-economic justice advocated in Islam. However, due to practical difficulties in the implementation, AAOIFI has put its recommendation on this issue on hold. For time being, AAOIFI accepted the historical cost concept. Its alternative measurement recommended is the “current cash equivalent”. Although the acceptance of the cost concept was not endorsed by all members, the majority of them were of the opinion that ‘it is not evident that adequate means are currently available to apply this (current value equivalent) concept in a manner that is likely to produce reliable information’ (para 135, Statement of Financial Accounting No. 2, AAOIFI).

Karim (1996) mentions that most IFIs tend to adhere to historical costing in the valuation of their assets. According to him, some banks, (e.g. Kuwait Finance House) use the “lower of cost or market value” for valuation of inventories whilst the others (e.g. Bank Islam Malaysia Berhad) use only the historical cost. There is no unanimous agreement among Islamic scholars with regard to this issue. This may be because this area is subject to Ijtihad (continuous exertion), as the Shariah only provides a general rule with regard to valuation and measurement. As mentioned in the Quran:

“Give measure and weight with (full) justice;... whenever you speak, speak justly...” (6:52)

“And O mankind! Give just measure and weight, not withhold from the people the things that are their due...” (11:85)

“And cover not Truth with falsehood, nor conceal the Truth when ye know (what it is)” (Surah Al-Baqarah: 42)

“But verily it is Truth of assured certainty” (Surah Al-Haqqah: 51)

                        2.2.5    Accounting unit

As per resolution No. 65/17, 7th Session of the Fiqh Academy, Jeddah, (-14 March, it is possible in Islamic jurisprudence to form a limited liability company. This provision allows for the treatment of the Islamic bank as a separate accounting unit from its owners.

                        2.2.6    Periodicity

Life of the IFIs should be broken into reporting periods to prepare financial reports that provide information to interested parties about their performances.

3.0       Financial reporting – The Islamic perspectives

Western orientation of financial reporting and accounting was primarily based on the ‘stewardship theory’ and later, on ‘decision usefulness’. These are the factors that gave rise to the development of modern accounting and financial reporting practices by connecting the responsibility value between the “accountor” with specific target audience such as investors, creditors and lenders. According to conventional accounting theory, the “stewardship function of managers” must be the focus of attention of accountants in reporting to external parties. Because of these factors, historical cost concept was designed to satisfy the needs of those specific audiences, without making any provision for changes in purchasing power. According to Kohler (1963); “accounting is what it is today not so much because of the desire of accountants, but because of the influence of businessmen”.

The debacles of world giant conglomerates e.g. Enron, WorldCom, Global Crossing, Adelphia and Parmalat due to financial scandals, have evidence us how critical the issue is. Public begin to criticize openly on how accountants perform their professional duties in providing the true and fair view of the financial position of their client’s company. There have been suggestions that there should be a shift in the focus of financial reporting from ‘decision usefulness’ to ‘accountability’. The ‘decision usefulness’ paradigm is anathema to Islamic society since the primary aim is to serve the needs of stakeholders who are more directly involved with an enterprise such as investors, creditors and lenders.

One of the objectives of accounting is to provide a fair information flow between “accountor” and “accountee”. From an accountant point of view, the accountability is a consequence of responsibility. By using the ‘accountability-based’ framework, the financial reporting would be more responsibility driven and the paradigm is aligning to the Islamic precepts. It is governed by divine injunctions and does not separate the secular and religion and holistic in its reporting. The objective of accounting and financial reporting for the fair information flow to the “accountee” or to the stakeholders and society at large will be achieved, as compared to the ‘decision usefulness’ paradigm endorsed by the West. Its principles do not serve the interest of any particular group, but to the society as a whole which can make corporations accountable for their actions and ensure they comply with Shariah principles.

The ‘accountability-based’ framework of financial reporting within the Islamic precepts is broader than what is generally understood in the West. According to Islam, man has covenant with God. To some extent, the covenant that exists between man and God is similar to the contract existing between the principal and agent as espoused by Gray et al (1987) in the principal-agent accountability framework. Accordingly, this covenant requires the man discharges his accountability in accordance with the responsibilities laid down by Shariah. From this point of view, one would thus expect the scope of Islamic financial reporting cover to be wider than that which is currently practised in the West, give the Islamic ethics and accountability. Accountability, as mentioned in the Quran:

“Then he that will be given his Record in his right hand will say: “Ah here! Read ye my Record!”, “I did really understand that my Account would (one Day) reach me!” (Surah Al-Haqqah: 19-20)

The ‘accountability-based’ framework of financial reporting ‘qualities’ are indeed reflected in the AAOIFI standards; SFA No.1: Objectives of Financial Accounting for Islamic Banks and Financial Institutions and FAS No.1: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial Institutions, The FRSi-1 (previously known as MASBi-1) issued by Malaysian Accounting Standards Board recognises (MASB) and the Guidelines on Financial Reporting for Licensed Islamic Banks (BNM/GP8-i) issued by Bank Negara Malaysia (BNM). These will be analysed on the following sections.

3.1       Regulations for presentation and disclosures in financial reports

The International Accounting Standards committee (IASC), currently known as the International Accounting Standards Board (IASB) has issued standards on accounting disclosure for business enterprises including banking and financial institutions. The International Accounting Standards (IAS 30) is among the standards that specifies the disclosure in financial statements of banks and other financial institutions. However, this standard does not distinguish between Islamic and non-Islamic banks.

On the other hand, for Islamic banks, AAOIFI has introduced the framework and set the standards for reporting, auditing and governance purposes. Amongst the standards are the objectives, concepts and general presentation and disclosures in financial statements of IFIs.

For Malaysian case, as the banking and financial system develops, the MASB recognises the need for a set of comprehensive guidelines and accounting standards, particularly to cater for the growth in Islamic-based transactions as well as to meet the objectives of promoting investment in Islamic banking and capital market in Malaysia. The FRSi-1 (previously known as MASBi-1) issued by MASB provides a basis for the presentation and disclosure of financial statements of institutions that undertake Islamic banking activities. Previously, MASB1 (currently known as FRS 1) and other MASB standards adopted by companies in Malaysia were the conventions accepted. Furthermore, BNM or the Central Bank of Malaysia, governing body for financial institutions in Malaysia, have also issued its own guidelines for disclosures and financial presentations for these institutions: Revised Guidelines on Financial Reporting for Licensed Institutions (BNM/GP8) and Guidelines on Financial Reporting for Licensed Islamic Banks (BNM/GP8-i).

                        3.1.1    FRS-i-1 by MASB

FRSi-1 is the first accounting standard specially created for IFIs that is in harmony with the International Accounting Standards (IASs). In its development, MASB had also taken into consideration the substance of AAOIFI Standards, requirements of the Malaysia’s Companies Act 1965, Basle requirements and the requirements by the Revised Guidelines on Financial Reporting for Licensed Institutions (BNM/GP8). Not only that, MASB also recognises the fundamental importance of Shariah precepts in developing this Standard and has established a formal structure that allows for issues relating to Shariah to be referred to the National Shariah Advisory Council (NSAC) of BNM. The NSAC focuses its attention specifically to the following aspects of the Islamic Banking operations;

  • Cash and accrual accounting basis for income recognition.
  • Allocation and distribution of profits to depositors.

In regards to the issue of selection between the concept of cash and accrual accounting basis for income recognition, the first experts (fuqaha) have determined that cash basis of accounting to be a mode of practice to account for Islamic transactions in the past. As economies develop and new transactions emerge to cater for new ways of doing business, the nature of contracts and its underlying transactions have compelled examination of the cash accounting to ensure that accounting and financial reporting of these transactions reflect the true nature of the business and its underlying transactions. Co-mingling of funds in Mudarabah contracts, separate legal entity, going concern are concepts that cash accounting has failed to address completely but they exist in the Islamic banking business today. However, some fuqaha have allowed the use of accrual basis in income recognition on a concept that assumes that profit can be estimated and distributed prior to completion of a contract and prior to realisation of cash. The NSAC recognises that where fuqaha differ in their opinion. To ensure consistency, fairness and transparency, the NSAC has recommended the MASB to adopt a harmonisation approach along with strategy to achieving standardisation in financial reporting. In this regard, the NSAC recommended an accrual basis of accounting as a benchmark treatment. An alternative to the benchmark treatment is the cash basis of accounting. An IFI that opts for the alternative treatment will have to disclose that fact in the notes to the financial statement, and to disclose a reconciliation to reflect the financial position had accrual basis been used.

With regards to the issue of allocation and distribution of profits to various categories of depositors, most fuqaha are of the opinion that distribution of profit should be made at gross level. This ruling was made after examining the underlying terms and conditions of Mudarabah principles. As a result of this decision, expenditures relating to Mudarabah funds are deductible only to the extent that they are directly attributable to the investment of those funds. Indirect overhead expenses should not be deducted from Mudarabah fund. The NSAC takes note that if the net method is used, the management of the IFIs will be at liberty to declare discretionary expenses such as bonuses, salary increases at the expense of the Mudarabah depositors, and this may be seen to be unjustifiable to the Mudarabah depositors, unless sanction is first obtained from the depositors.

                        3.1.2    BNM/GP8-i by Bank Negara Malaysia

The GP8-i is the first guideline pertaining to IFIs’ financial reports presentations and disclosures, was introduced in August 2003. For commercial banks that practicing Islamic Banking Scheme (IBS) or “Skim Perbankan Tanpa Faedah” (SPTF), GP8-1996 is used, so as to cater to the need for specialized reporting and disclosure requirements for commercial banks participating in the interest free scheme. The minimum components of the specimen under the GP8-i comprise the following;

  • Performance Overview
  • Statement of Corporate Governance
  • Directors’ Report
  • Statement by Directors
  • Statutory Declaration by Directors
  • Reports of the Auditors
  • Report of the Shariah Advisory Board
  • Balance Sheet
  • Income Statement
  • Statement of Changes in Equity
  • Cash Flow Statement
  • Notes to the Accounts

The obvious differences between GP8 and GP8-i are the additional components to GP8-i: (i) the Statement of Corporate Governance, and (ii) Report of the Shariah Advisory Board. BNM has taken into consideration the requirement of AAOIFI and also the Bursa Malaysia Berhad in its Revamped Listing Requirements in 2001 for the issuance of the Statement of Corporate Governance. As prescribed in the guideline, it is to enhance the disclosure practices and presentation of reports and financial statements of IFIs. A requirement of the GP8-i for the presentation of Report by the Shariah Advisory Board is also a requirement by AAOIFI, adopted into GP8-i.

            3.2       Rationales behind the needs for Islamic financial reporting standards

In summary, we can conclude that the needs for Islamic financial reporting standards for IFIs is because of the nature of the IFIs itself that require the information regarding business to be disbursed to the users must be Shariah compliant, or else, it will not represent the true colours of the business operations. Moreover, by using Islamic financial reporting standards, it is governed by divine injunctions and does not separate the secular and religion and holistic in its reporting, and thus, the objective of accounting and financial reporting for the fair information flow to the “accountee” or to the stakeholders and society at large will be achieved. It will also be the basis to provide guidance for preparers in preparing a complete set of financial statements. It will also ensure comparability of operational and financial performance of all IFIs.

4.0       Auditing standards for IFIs

The International Auditing and Assurance Standards Board (IAASB) serves the public interest by setting independently and under its own authority, high quality standards for auditing, review, other assurance, quality control and related services, and facilitating the convergence of national and international standards. This contributes to enhanced quality and uniformity of practice in these areas throughout the world and strengthens public confidence in financial reporting.  IAASB has promulgated the International Standards of Auditing (ISAs) which apply to financial institutions. In addition to that, The International Federation of Accountants (IFAC), the global accountancy profession with the main objective to protect public interest by encouraging high quality practices by the world’s accountants, have also issued the following standards;

*      International Standards on Auditing, Assurance Engagements and Related Services

*      International Standards on Quality Control – 1 (ISQC1). These are the quality control standards for the firms and the engagement teams in the practice areas of audit, assurance and related services.

*      International Code of Ethics

A review of these standards indicates that the IAASB and IFAC did not address specific features and requirements of IFIs. Hence, AAOIFI has promulgated with the Auditing Standards for Islamic Financial Institutions (ASIFIs)

            4.1       Auditing Standards for Islamic Financial Institutions (ASIFIs)

The need for AAOIFI to promulgate the ASIFIs is due to the unique nature of IFIs. The Islamic precepts influence the structure and activities of IFIs in several ways with the most important principle being the prohibition against the payment and receipt of interest whilst advocating into partnership and equity participation of both side of balance sheet. Thus, IFIs are subject to different kind of risks from the context of conventional banks. Having said that, because IFIs operate with different financial instruments and different mechanism as opposed to the conventional banks, auditors of IFIs would require additional audit procedures and different set of audit evidences encompassing all within specific audit scope, in order for the auditors to express an opinion that provides reasonable assurance on the true and fair view of the IFIs’ financial statements. However, AAOIFI do not come out with specific guidelines on the internal audit of IFIs, implies that roles can be assimilated and adopted from these standards by the internal audit. The followings are the ASIFIs;

§  ASIFI No.1: Objective and Principles of Auditing
§  ASIFI No. 2: The Auditor’s Report
§  ASIFI No.3: Terms of Audit Engagement
§  ASIFI No.4: Testing by an External Auditor for Compliance with Shariah Rules and Principles by an External      Auditor
§  ASIFI No.5: The Auditor’s Responsibility to Consider Fraud and Error in an Audit to Financial Statements

It is worth to note that the followings are the IAASB’s standards that have been specifically reviewed by the AAOIFI in order to promulgate the five (5) ASIFIs with specific references to the nature of IFI:

§  ISA 200: Objective and General Principles Governing an Audit of Financial Statements
§  ISA 210: Terms of Audit Engagements
§  ISA 240: The Auditor’s Responsibility To Consider Fraud in an Audit of Financial Statements
§  ISA 700: The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements
§  ISA 701: Modifications to the Independent Auditor’s Report

4.2       Shariah requirements in ASIFIs

An audit is to provide reasonable assurance as to whether the financial statements are free from material statements. ASIFI No. 1 shared the general requirement and purpose of the universal objective of auditing. However, given the unique nature of IFIs that requires to adhere to the Shariah ruling, ASIFI No. 1 stress that not only the auditing objective is to give opinion as to whether the financial statements are free from material misstatements, it must also prepared in all material aspects, in accordance to Shariah rules and principles and other relevant AAOIFI accounting standards and relevant national accounting standards. Thus, the objective set will determine the scope of audit. This is because it will relate to the accumulation of necessary audit evidence. The auditor must satisfy that the transactions examined comply with Islamic Shariah rules and principles as determined by the Shariah Board of the financial institutions.

ASIFI No.4 requires auditors to perform the test for Shariah compliance before they will come out with their opinion. Hence, the responsibility and scope of the auditor’s work requires auditor to be able to make reference to Shariah rules and principles and to test its adoption in IFIs’ products, process and systems which is subsequently reported in the financial statements. Thus, the audit must not only confine to the financial information, but also to the processes that generate such information. These processes need to be Shariah compliant in order to be reported in the financial statements. However, auditor is not in the position to interpret the Islamic Shariah rules and principles, but to use these as a basis to test whether the underlying activities reported in the financial statements as well as the manner of these reported comply with the Shariah rules and principles. Auditors shall also verify that the transactions entered into by IFIs are consistent with the fatwas (legal opinions), rulings and guidance of the Shariah Supervisory Board (SSB) of IFIs.

5.0       Governance standards for IFIs

Corporate governance refers to the method by which a corporation is directed, administered or controlled. It warrants corporate entities to practise accountability not only to shareholders but also to the public at large who may directly affected by the operations of the firms. A large company has a large number of stakeholders and has to balance the demand and the need of each and every one of them. Therefore, there are always conflicts between the stakeholder groups. Hence, the challenge of good corporate governance is to find a way in which the interest of shareholders, directors and other interest group can all be sufficiently satisfied. Corporate governance in financial institutions has been analyzed almost exclusively in the context of conventional banks. Even within the conventional system, corporate governance is a thorny issue with respect to banks because banks generally more opaque than other organizations and expose to various kind of regulations.

IFIs are basically a partner with its depositors on the one side, and also a partner to entrepreneurs, on the other side, when employing depositors’ funds in productive direct investment. This implies that depositors are also having a direct financial stake in IFIs’ investments and equity participation. In addition, IFIs are subject to additional layer of governance since the suitability of its investments and financing must be in strict conformity with Shariah principles and the expectations of Muslim community (Shariah compliant). Thus, IFIs are subject to different kind of risks from the context of conventional banks.

The Malaysian Code of Corporate Governance is an example of universal code that can be applied to any industries. The codes specifically states that the key to good corporate governance lies in getting the right board of directors in place. Board of directors should include a balance of executive directors and non-executive directors (including independent non-executive directors). This requirement encompasses the best practices in corporate governance in relation to; (i) Board balance and the size of boards, (ii) Extent of participation by non-executive directors, (iii) Chairman and the Chief Executive Officer, and (iv) Appointments to the board. The code is also requiring the board of directors to maintain effective communications policy that enables both the board and the management to communicate effectively with its shareholders. The same issue with the standards of auditing standards, the corporate governance standards to be followed by financial institutions do not address specific features and requirements of IFIs.

            5.1       Expanded role of AAOIFI

The role of AAOIFI has expanded due to the requirements for the development of the “best practice” and codified it so that it shall be followed by all IFIs. With this broader mandate, and until now, issued four governance standards, Governance Standard for Islamic Financial Institutions (GSIFI), namely;

§  GSIFI No.1: Shariah Supervisory Board: Appointment, Composition and Report
§  GSIFI No.2: Shariah Review
§  GSIFI No.3: Internal Shariah Review
§  GSIFI No.4: Audit and Governance Committee for Islamic Financial Institutions

These governance standards issued were aimed at addressing some of the specific issues affecting the IFIs. GSIFI No.1 set the standard for the appointment of personnel into SSB. The SSB is an independent body specialized jurists in fiqh muamalat (Islamic commercial jurisprudence) which may include other scholars in related Shariah disciplines.

GSIFI No.3 describes the objectives and processes of internal Shariah reviews. Internal Shariah Review shall be carried out by an independent division/department or part of the internal audit department of IFI. The review activity is to examine and evaluate the extent of compliance with Islamic Shariah rules and principles, fatwas, guidelines and instructions issued by the IFI’s SSB. Thus, the primary objective is to ensure that the management of IFI effectively discharges their responsibilities in relation to the implementation of the Shariah rules and principles as determined by the IFI’s SSB.

GSIFI No.4 specified the importance, establishment, functions and responsibilities of Audit and Governance Committee (AGC) in the IFI. It also outlines specific functions such as the review of accounting practices and audit plan as well as the review of interim/ annual accounts and financial reports as evident in other audit committees. In addition, the review of IFI compliant Shariah rules and principles as well as the use of Restricted Investment Accounts’ funds are also specified.

6.0       Conclusion

The reason why there is a need for a set of specific standards, methods and principles for financial reporting, accounting, auditing and corporate governance and have to be carefully distinguished from their conventional counterparts is the same reason why Islamic financial institutions (IFIs) have existed in the first place. Prohibition of interest in financial dealings is the primary reason, but there are various other issues and fine details which make up for the case of Islamic accounting and financial reporting. In fact, it is a must for every practitioners of Islamic finance to get to know the relevancy and the rationale of these standards. The distinctions and the rationales behind it need to be addressed because the standards that accord to Shariah standards are presently thought by people  as synonymous or do not differ much to its conventional counterparts. There is danger for such kind of perception because the basic building blocks between both standards are worlds apart. Further, such blind acceptance and adoption of conventional standards in Islamic organizations would lead to socio-economic behavior inconsistent with the specific Islamic objectives, the attainment of which these institutions were set up for in the first place.


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[1] Murabahah : The sale of goods at cost plus an agreed profit mark-up. Murabahah receivables are measured at the end of the financial period at their cash equivalent value (i.e. the amount of debt due from the customers at the end of the financial period less any provision for doubtful debts).
[2] Bay’ Bithaman-Ajil or BBA : Price-deferred sale. A variation of Murabahah but the payment for sale is deferred, may be by instalments.
[3] Ijarah : Contract of hiring/ leasing.
[4] Mudarabah : A profit and loss sharing contract in which one party provides the financial capital (account holder) and the other (banker) manages the enterprise. While profit is shared, loss is borne by the financier.

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