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2-DAY COURSE ON ISLAMIC BANKING AND CAPITAL MARKET: PRODUCTS & INSTRUMENTS 22 -23 MAY 2007 Accounting, Auditing and Governance for Islamic Financial Services.

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Presentation on theme: "2-DAY COURSE ON ISLAMIC BANKING AND CAPITAL MARKET: PRODUCTS & INSTRUMENTS 22 -23 MAY 2007 Accounting, Auditing and Governance for Islamic Financial Services."— Presentation transcript:

1 2-DAY COURSE ON ISLAMIC BANKING AND CAPITAL MARKET: PRODUCTS & INSTRUMENTS MAY 2007 Accounting, Auditing and Governance for Islamic Financial Services Dr. Syed Musa Alhabshi Principal Consultant Amanie Business Solutions Sdn Bhd Suite A-D, 14th Floor, Bangunan Angkasa Raya Jalan Ampang, Kuala Lumpur Tel: Fax:

2 P RESENTATION O UTLINE Nature of Islamic Financial Institution (IFI) Financial Reporting Framework for IFI Nature and Reporting Process of IFI Shariah Governance & Auditing of IFI Governance for IFI Accounting and auditing standards for Islamic financial institutions (AAOIFI, MASB, IFSB etc.) Risk management Shariah review and audit Issues and challenges

3 FINANCIAL REPORTING FRAMEWORK USER GROUPS USER GROUPS ISLAMIC FINANCIAL INSTITUTION ISLAMIC FINANCIAL INSTITUTION FINANCIAL REPORTING OBJECTIVES FINANCIAL REPORTING OBJECTIVES SHARIAH PRINCIPLES SHARIAH PRINCIPLES ACCOUNTING PRINCIPLES ACCOUNTING PRINCIPLES

4 T HE N EED FOR S PECIFIC A CCOUNTING S TANDARDS IN I SLAMIC B ANKING The fast development of Islamic banking demands for effective financial reporting framework and information disclosures useful for investors and stakeholders. Existing financial reporting standards for conventional financial institutions are not adequate to address the information needs of IIIFS. Nature of Islamic banking emphasizes importance of lawful and equitable banking business and financial activities - accounting treatments that capture unique features of IIFS activities are required

5 E STABLISHMENT OF AAOIFI The Accounting and Auditing Organization for Islamic Financial Institutions (hereinafter referred to as AAOIFI) is an Islamic international autonomous non-profit making corporate body that prepares accounting, auditing, governance, ethics and Shari'a standards for Islamic financial institutions. AAOIFI was established in accordance with the Agreement of Association which was signed by Islamic financial institutions on 1 Safar, 1410H corresponding to 26 February, 1990 in Algiers. AAOIFI was registered on 11 Ramadan 1411 corresponding to 27 March, 1991 in the State of Bahrain.

6 AAOIFI S O BJECTIVES & R OLE Develop accounting, auditing, governance and ethical thought relating to the activities of Islamic financial institutions taking into consideration the international standards and practices which comply with Islamic Shari'a rules. Disseminate the accounting, auditing, governance and ethical thoughts relating to the activities of Islamic financial institutions and its application through training seminars, publication of periodical newsletters, preparation of reports, research and through other means. Harmonize the accounting policies and procedures adopted by Islamic financial institutions through the preparation and issuance of accounting standards and the interpretations of the same to the said institutions. Improve the quality and uniformity of auditing and governance practices relating to Islamic financial institutions through the preparation and issuance of auditing and governance standards and the interpretation of the same to the said institutions. Promote good ethical practices relating to Islamic financial institutions through the preparation and issuance of

7 S TANDARD S ETTING A PROACHES AAOIFI adopts the standard setting due process by reviewing existing Islamic banking reporting practices followed by formulation of discussion paper, exposure draft and reporting standard. Existing IAS standards are referred to where these are deemed relevant and not contravening the Shariah Principle.

8 A CCOUNTING S TANDARDS 1. General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial Institutions 2. Murabaha and Murabaha to the Purchase Orderer 3. Mudaraba Financing 4. Musharaka Financing 5. Disclosure of Bases for Profit Allocation between Owners' Equity and Investment Account Holders and Their Equivalent 6. Salam and Parallel Salam 7. Ijarah and Ijarah Muntahia Bittamleek 8. Istisna'a and Parallel Istisna'a 9. Zakah 10. Provisions and Reserves 11. General Presentation and Disclosure in Financial Statements of Islamic Insurance Companies

9 A CCOUNTING S TANDARDS 12. Disclosure of Bases for Determining and Allocationg Surplus or Deficit in Islamic Insurance Companies 13. Investment Funds 14. Provisions and Reserves in Islamic Insurance Companies 15. Foreign Currency Transactions and Foreign Operations 16. Investments 17. Islamic Financial Services offered by Conventional Financial Institutions 18. Contributions in Islamic Insurance Companies (New) 19. Deferred Payment Sale 20. Disclosure on Transfer of Assets (New) 21. Segment Reporting (New)

10 A UDITING S TANDARDS 1. Objective and Principles of Auditing 2. The Auditor's Report 3. Terms of Audit Engagement 4. Testing by an External Auditor for Compliance with Shari'a Rules and Principles by an External Auditor 5. The Auditor's Responsibility to Consider Fraud and Error in an Audit to Financial Statements (New)

11 G OVERNANCE S TANDARDS & C ODE OF E THICS Governance Standards 1. Shari'a Supervisory Board: Appointment, Composition and Report 2. Shari'a Review 3. Internal Shari'a Review 4. Audit and Governance Committee for Islamic Financial Institutions Ethics 1. Code of Ethics for Accounting and Auditors of Islamic Financial Institutions 2. Code of Ethics for the Employees of Islamic Financial Institutions

12 N ATURE OF F INANCIAL R EPORTING Financial Accounting Statements No. 1 & 2 Objective of Financial Accounting of Islamic Banks and Financial Institutions Emphasizes the importance of contractual rights and obligations and Shariah compliance Concepts of Financial Accounting for Islamic Banks and Financial Institutions Addresses the issue of prohibited earnings & expenditures as well as ensuring reasonable rates of returns to depositors

13 F INANCIAL R EPORTING O BJECTIVES Shariah compliance (principles, rules and opinions) Distinguish & disclose prohibited earnings & expenditures Present entitys economic resources and obligations and related risks pertaining to its assets and liabilities Determine Zakat obligations of both depositors and shareholders Estimate cash flows & related risk of banks financing assets Ensuring reasonable rates of returns to investors Disclose IBs discharge of social responsibilities.

14 D ISTINGUISHING F EATURES OF IFI S F INANCIAL A CCOUNTING & R EPORTING O BJECTIVES Compliance with the principles and rules of Sharia Islamiyyah need to disclosed in terms of reporting accountability and decision usefulness Different contractual relationships require reporting requirements for both equity and asset based funding and financing contracts which are: recognition principles measurement principles disclosure & presentation principles

15 R OLE OF F INANCIAL R EPORTING & A CCOUNTING I NFORMATION FINANCIAL REPORTS Economic Decision Usefulness Reporting Accountability Relevance Reliability Stewardship function Representational Faithfulness Economic Agent Economic Consequences

16 C HARACTERISTICS OF U SEFUL I NFORMATION Economic Decision Usefulness Relevant (Timely, Feedback, Predictive) Reliable (verifiable, faithful representation, neutral) Cost and Benefit Comprehensiveness Wealth maximization Safety, Liquidity & Profitability of IFI

17 I NFORMATION FOR D ECISION M AKING Legitimate Decision Lawful Transactions fulfilling contractual conditions and requirements Lawful goods & Services nature, type and purpose of goods and services Competitive price & fair value market mechanism and market structures Equitable Distribution reasonable rates of returns to shareholders and depositors

18 U SER G ROUPS OF A CCOUNTING I NFORMATION Investors (potential & existing) [Lawful &Equitable Investments] Includes Shareholders and Depositors with different investment horizons Investors are not only concerned with profits but also its lawfulness, legality and equity Creditors (potential & existing) [Lawful Trade Assets] Creditors exclude debt holders and confined to asset backed or trade assets. Not only concerned with default risk but also validity of contract and lawfulness of the asset.

19 U SER G ROUPS OF A CCOUNTING I NFORMATION Regulators Legislation to be enforced should make reference to the Shariah compliance Shariah Supervisory Boards & Advisory Council Governance extends beyond audit committee to the Shariah governance Customers [Lawful Goods &Services] Customers are concerned about lawful products & facilities Others Any party that directly or indirectly make reference to the financial statement of IFI

20 I MPACT OF S HARI AH C ONTRACTUAL C ONDITIONS OF T RANSACTIONS ON R EPORTING P ROCESS Shariah Conditions Reporting Process Impact ExistenceRecognitionValid contracts LawfulRecognitionLawful Activities PerformanceMeasurementProvision for uncertainty DeliverableRecognitionProvision for uncertainty EquitableDistributionReasonable rates of return AccountablePresentation/ Disclosure True and fair view Distinguishing contractual relationships render a distinct reporting process to address the lacunae of entity-based reporting

21 T YPES OF F INANCIAL S TATEMENTS Balance Sheet Income Statement Statement of Owners Equity Cash Flow Statement Statement of Restricted Investments Statement of Sources & Uses of Zakah Statement of Sources & Uses of Qard Fund

22 E LEMENTS OF F INANCIAL S TATEMENTS BALANCE SHEET Assets Fixed Assets Intangible Assets Investments Financing Liabilities Investment Deposits Equities INCOME STATEMENT Gross Income Distribution to Depositors Net Jointly Financed Income Fee based Income Expenses Net Income

23 S HARIAH G OVERNANCE : B Y W HOM ? F OR W HOM ? INVESTMENT ACCOUNT HODERS & SHAREHOLDERS REGULATORS SC & BNM SUPERVISION & SHARIAH ADVISORY COUNCILS BOARD OF DIRECTORS AUDIT & GOVERNANCE COMMITEE EXTERNAL AUDITORS IFI SHARIAH SUPERVISORY BOARD & SHARIAH COMMITEE

24 N ATURE OF S HARI A S UPERVISORY B OARD An independent body of specialised jurists in fiqh al muamalat (Islamic Commercial Jurisprudence), that is entrusted with the duty of directing, reviewing and supervising the activities of the Islamic Financial Institution in order to ensure that they are in compliance with Islamic Sharia Rules and Principles. Types of Sharia Supervision or Advisory? Sharia Product consultants (Advisory capacity) Sharia Supervisory Board/Shariah committee of Islamic bank (Constitutional Authority & Advisory) Sharia Advisory Council of Bank Negara Malaysia and Securities Commission (Statutory & Advisory

25 N ATURE OF S HARI A S UPERVISORY B OARD Scope of Supervision product and system development financial reporting and Sharia opinion Approval of Sharia financial services and products Approval of listed securities and investment funds.

26 D UTIES & R ESPONSIBILITIES OF S HARIAH C OMMITTEE a) Advise BOD on business operations to be Shariah compliant b) Endorse Shariah Compliance Manual c) Endorse & Validate pertinent documents d) Assist related parties (such as auditors, legal counsel, consultants) that seek advice on Shariah Matters e) Advise IFI to seek clarification or endorsement of unresolved or endorsed by SAC f) Provide written Shariah Opinion g) Assist SAC on reference for advice h) Shall report to the BOD (act as independent body of IFI)

27 S HARIAH C OMPLIANCE B EHAVIOR LevelsActivityAssuranceFor Whom ProductEndorsementLawful, Valid, Equitable Counter Party Interest TransactionEndorsementLawful & ValidCounter Party Interest SystemICS ReviewEffective & Reliable Management & BOD EntityPolicy, Governance & Opinion Lawful, Valid, Reliable & Equitable Investors (Shareholders & IAH) & Stakeholders National Policy Policy, Governance & Regulation Sound, Stable, Sustainable & International Acceptance Investors ( Shareholders & IAH), Stakeholders & Public Interest

28 S HARI ' AH R EVIEW & I NTERNAL S HARI A R EVIEW Sharia review is an examination (by SSB) of the extent of an institution (IFIs) compliance, in all its activities, with the Sharia. Internal Sharia review shall be carried out by an independent division/department or part of the internal audit department, depending on the size of an institution (IFI). It shall be established within the institution to examine and evaluate the extent of compliance with Islamic Sharia rules and principles, fatwas and guidelines, and instructions issued by the Institution (IFI) Shariah Supervisory Board.

29 I NTERNAL S HARI A R EVIEW It forms an integral part of the organs of governance of the Institution (IFI) and operates under the policies established by the Institution (IFI). Reviewers should not have any executive authority or responsibility for the activities they review Integral Elements: Independence & Objectivity (organizational status, independent attitude & tasks assigned) Direct and continuous communication to all parties with unlimited access to required documents. Professional Proficiency (including knowledge skills and training in Fiqh al Muamalat) Due professional Care

30 S COPE & R OLE OF I NTERNAL S HARI A R EVIEWER Scope : To examine and evaluate the adequacy and effectiveness of the institution system of internal Sharia control and the quality of performance in carrying out assigned responsibilities. Purpose : To ascertain whether the system provides reasonable assurance that objectives set out are complied in an effective and efficient manner. Internal Sharia Review Work involves planning (include: establishing shariah review objectives, obtaining and making reference to fatwas, guidelines, Sharia review results, writing internal Shariah review programs, communicating the procedures as well as results to parties concerns)

31 A UDITOR & SSB R ELATIONSHIP Auditor complements SSB of Islamic banks ASIFI No. 1 is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material aspects, in accordance with Shari'ah Rules & Principles, AAOIFI & International accounting standards

32 A UDIT R EPORT & S HARI A O PINION Independent samples and tests conducted by both auditor and SSB Audit opinion the financial statements as a whole are free from material misstatement based on accumulated audit evidence, refers to the whole audit process and comply with Islamic Shari'a Rules and Principles

33 A UDIT R EPORT & S HARI A O PINION Sharia Opinion will be on matters pertaining to: contracts, transactions and dealings equitable allocation of profit & losses earnings (lawful/prohibited) Zakah …

34 A UDIT & G OVERNANCE C OMMITTEE AGC is to assist in achieving institutions objectives by enhancing greater transparency and disclosure as well as public confidence on institutions application of Sharia rules and principles. Comprise of non-executive directors with sound understanding of the business and Sharia supervision

35 A UDIT & G OVERNANCE C OMMITTEE R OLE & F UNCTIONS Preserving integrity of financial reporting process Safeguarding interests of investors and stakeholders Assurance on financial information reliability Link between management and stakeholders Review of internal controls Review of Accounting practices and audit plan Review of interim and annual accounts and financial reports Review of compliance with Sharia rules and principles

36 R EPORTING & C OMMUNICATION C HANNELS External Auditor Shariah Board/Shariah Committee Internal Audit Islamic Financial Institution Audit & Governance Committee ATTEST INTERNAL CONTROL SYSTEM Formulate Policy Express Shariah Opinion on IFI Shariah Review Internal Shariah Review Testing for Shariah Compliance True & Fair Opinion Shariah Endorsement

37 I SLAMIC F INANCIAL S ERVICES B OARD (IFSB) The Islamic Financial Services Board (IFSB), based in Kuala Lumpur, inaugurated on 3rd November 2002 and commenced on 10th March 2003 It serves as an international-standard setting body of regulatory and supervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry (banking, capital market and insurance).

38 IFSB : P URPOSE & R OLE IFSB promotes the development of a prudent and transparent Islamic financial services industry through introducing new, or adapting existing international standards consistent with Islamic Shari'ah principles, and recommend them for adoption. IFSB complements that of the Basel Committee on Banking Supervision, International Organization of Securities Commissions and the International Association of Insurance Supervisors

39 IFSB STANDARD, GUIDELINES & PRINCIPLES GUIDING PRINCIPLES ON CORPORATE GOVERNANCE INSTITUTIONS OFFERING ISLAMIC FINANCIAL SERVICES (IFSI) DISCLOSURE PRINCIPLES TO PROMOTE TRANSPARENC Y & MARKET DISCIPLINE CAPITAL ADEQUACY STANDARDS GUIDING PRINCIPLES OF RISK MANAGEMENT GUIDANCE ON KEY ELEMENTS – SUPERVISORY REVIEW PROCESS

40 IFSB S TANDARDS Guiding Principles on Risk Management Capital Adequacy Standard Guiding Principles on Corporate Governance Disclosure Principles to Promote Transparency and Market Discipline Guidance on Key Elements – Supervisory Review Process

41 U NIQUE R ISKS OF I SLAMIC F INANCIAL I NSTITUTIONS Rate of return risk relates to market factors affecting rate of return on assets in comparison with rate of return for investment account holders Displaced commercial risk relates to market factors affecting rate of return on assets in comparison with rate of return for Shareholders Equity investment risk relates to risk characteristics of equity investments in the form of Mudaraba and Musharaka (including transformation of risks at various stages of investment life cycle) Operational risk in the form of fiduciary risk that relates to Shariah non-compliance

42 Financing TypeContract TypeRisk Exposure Sales type Murabaha Bai Muajjal Credit Risk Salam Istisnaa Non-delivery & Credit Risk EquityMudaraba Musharaka Credit/Market risk Equity investment Risk LeasingIjarah Ijarah Muntahia Biltamleek Market risk Credit risk Anatomy of Asset Risk Exposures Financing or Investment?

43 I NCOME D ISTRIBUTION TO PER, IRR, SHF & IAH Income Attributable to IAH Income distributed to Shareholders & Investment Account Holders Based on PSR Income Attributable to SHF & Other Deposit funds Income Distributabl e to IAH Less: Transfer of Profits to IAH PER Less: Transfer of Profits to SHF PER Return on Equity Return on Unrestricted IAH Less: Transfer of Profits to IAH IRR

44 Source of Funds Risk ExposuresGuarantee/ Reserves DepositsLiquidity riskDeposit Guarantee Unrestricted Investment accounts Liquidity risk Rate of return risk ROA vis-à-vis ROUIAH Profit Equalization Reserve Investment Risk Reserve Shareholders Funds Displaced Commercial Risk Solvency Risk ROA vis-à-vis ROE Profit Equalization Reserve Restricted Investment Accounts Rate of return risk Profit Equalization Reserve Investment Risk Reserve ANATOMY OF FUNDING RISK EXPOSURES

45 I LLUSTRATION OF IFSB CAR (S TANDARD F ORMULA ) CAR =Eligible Capital {Total Risk-Weighted Assets (Credit* + Market* Risks) Plus Operational Risks less Risk Weighted Assets funded by PSIA**(Credit * + Market * Risks) * Credit and Market risk for on and off balance sheet exposures ** PSIA balances include PER and IRR

46 FINANCIAL REPORTING, AUDITING & GOVERNANCE FRAMEWORK SHAREHOLDERS ISLAMIC FINANCIAL INSTITUTION ISLAMIC FINANCIAL INSTITUTION AUDIT COMMITTEE AUDIT COMMITTEE SHARIAH SUPERVISORY BOARD SHARIAH SUPERVISORY BOARD GOVERNANCE COMITTEE GOVERNANCE COMITTEE INVESTMENT ACCOUNT HOLDERS INVESTMENT ACCOUNT HOLDERS OTHER STAKEHOLDERS OTHER STAKEHOLDERS REGULATORY AUTHORITIES AAOIFIIFSB

47 M ULTI -D ISCIPLINARY P ERSPECTIVES ON R OLE OF S HARIAH R EVIEW, A UDIT & G OVERNANCE Financial, Statements, Reports and other Useful Information Required by AAOIFI & Relevant International Financial Reporting, Auditing & Governance Standards Prudential Guidelines & Standards Promulgated By IFSB to Ensure Risk Management & Disclosure Framework Related to Capital Adequacy, Corporate Governance & Market Discipline Regulatory requirements by Central Banks, Monetary Authorities or Supervisory Agencies Shariah Goals, Opinions & Rulings Propounded by Shariah Scholars SHARIAH COMPLIANCE BEHAVIOR

48 S HARIAH G OVERNANCE A SSURANCE F RAMEWORK SC & BNM Supervisory Review SHARIAH SUPERVISORY BOARDS & SHARIAH COMMITTEE EXTERNAL AUDITORS BOARD OF DIRECTORS AUDIT & GOVERNANCE COMMITTEE SC & BNM SAC Shariah rulngs & basis Approved Products & Services Specific Guidelines & Reports on Shariah compliance Comprehensive Shariah Supervisory Report External Audit report Statement of Corporate Governance Promulgate National Shariah Rulings, Opinions & Policies Conduct supervision of IFI on Shariah compliance Formulate and review IFI Shariah opinions and policies Undertake financial audit to express true and fair opinion Structure, internal control processes and activities of IFI are Shariah Compliant

49 THANK YOU & WASSALAM


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