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

2-DAY COURSE ON ISLAMIC BANKING AND CAPITAL MARKET:

PRODUCTS & INSTRUMENTS22 -23 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 RayaJalan Ampang, 50450 Kuala LumpurTel:  +603 2034 2545Fax: +603 2034 2546http://www.amanie.com.my

PRESENTATION OUTLINE 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

FINANCIAL REPORTING FRAMEWORK

USERGROUPS

USERGROUPS

ISLAMICFINANCIAL

INSTITUTION

ISLAMICFINANCIAL

INSTITUTION

FINANCIALREPORTINGOBJECTIVES

FINANCIALREPORTINGOBJECTIVES

SHARI’AH PRINCIPLES

SHARI’AH PRINCIPLES

ACCOUNTINGPRINCIPLES

ACCOUNTINGPRINCIPLES

THE NEED FOR SPECIFIC ACCOUNTING STANDARDS IN ISLAMIC BANKING

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

ESTABLISHMENT 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.

AAOIFI’S OBJECTIVES & ROLE 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

STANDARD SETTING APROACHES

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 Shari’ah Principle.

ACCOUNTING STANDARDS1. 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

ACCOUNTING STANDARDS12. 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)

AUDITING STANDARDS

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)

GOVERNANCE STANDARDS &CODE OF ETHICSGovernance Standards1. 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 Ethics1. Code of Ethics for Accounting and Auditors

of Islamic Financial Institutions 2. Code of Ethics for the Employees of Islamic

Financial Institutions

NATURE OF FINANCIAL REPORTING

Financial Accounting Statements No. 1 & 2

Objective of Financial Accounting of Islamic Banks and Financial InstitutionsEmphasizes the importance of contractual

rights and obligations and Shari’ah compliance

Concepts of Financial Accounting for Islamic Banks and Financial InstitutionsAddresses the issue of prohibited earnings &

expenditures as well as ensuring reasonable rates of returns to depositors

FINANCIAL REPORTING OBJECTIVES

Shari’ah compliance (principles, rules and opinions)

Distinguish & disclose prohibited earnings & expenditures

Present entity’s 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 bank’s financing assets

Ensuring reasonable rates of returns to investors

Disclose IB’s discharge of social responsibilities.

DISTINGUISHING FEATURES OF IFI’S FINANCIAL ACCOUNTING & REPORTING OBJECTIVES

Compliance with the principles and rules of Shari’a 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 principlesmeasurement principlesdisclosure & presentation principles

ROLE OF FINANCIAL REPORTING & ACCOUNTING INFORMATION

FINANCIAL REPORTS

Economic Decision Usefulness

Reporting Accountability

Relevance ReliabilityStewardship

function

Representational Faithfulness

Economic Agent

Economic Consequences

CHARACTERISTICS OF USEFUL INFORMATION

Economic Decision Usefulness Relevant (Timely, Feedback, Predictive) Reliable (verifiable, faithful representation, neutral) Cost and Benefit Comprehensiveness Wealth maximization Safety, Liquidity & Profitability of IFI

INFORMATION FOR DECISION MAKING Legitimate Decision

Lawful Transactions fulfilling contractual conditions and

requirementsLawful goods & Services

nature, type and purpose of goods and services

Competitive price & fair valuemarket mechanism and market structures

Equitable Distributionreasonable rates of returns to shareholders

and depositors

USER GROUPS OF ACCOUNTING INFORMATION

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.

USER GROUPS OF ACCOUNTING INFORMATION

Regulators Legislation to be enforced should make reference to the

Shari’ah compliance Shariah Supervisory Boards & Advisory

Council Governance extends beyond audit committee to the

Shari’ah 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

IMPACT OF SHARI’AH CONTRACTUAL CONDITIONS OF TRANSACTIONS ON REPORTING PROCESS

Shari’ah Conditions

Reporting Process

Impact

Existence Recognition Valid contracts

Lawful Recognition Lawful Activities

Performance Measurement Provision for uncertainty

Deliverable Recognition Provision for uncertainty

Equitable Distribution Reasonable rates of return

Accountable Presentation/ Disclosure

True and fair view

Distinguishing contractual relationships render a distinct reporting process to address the lacunae of entity-based reporting

TYPES OF FINANCIAL STATEMENTS

Balance Sheet Income StatementStatement of Owner’s EquityCash Flow StatementStatement of Restricted InvestmentsStatement of Sources & Uses of ZakahStatement of Sources & Uses of Qard

Fund

ELEMENTS OF FINANCIAL STATEMENTS

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

SHARIAH GOVERNANCE: BY WHOM? FOR WHOM?

INVESTMENT ACCOUNT HODERS &

SHAREHOLDERS

REGULATORSSC & BNM

SUPERVISION & SHARIAH ADVISORY COUNCILS

BOARD OF DIRECTORSAUDIT & GOVERNANCE

COMMITEE

EXTERNAL AUDITORS

IFI SHARIAH SUPERVISORY

BOARD & SHARIAH COMMITEE

NATURE OF SHARI’A SUPERVISORY BOARD An independent body of specialised jurists in fiqh al

mu’amalat (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 Shari’a Rules and Principles.

Types of Shari’a Supervision or Advisory? Shari’a Product consultants (Advisory capacity) Shari’a Supervisory Board/Shariah committee of

Islamic bank (Constitutional Authority & Advisory) Shari’a Advisory Council of Bank Negara Malaysia

and Securities Commission (Statutory & Advisory

NATURE OF SHARI’A SUPERVISORY BOARD Scope of Supervision

product and system development financial reporting and Shari’a opinion Approval of Shari’a financial services and products Approval of listed securities and investment funds.

DUTIES & RESPONSIBILITIES OF SHARIAH COMMITTEE

a) Advise BOD on business operations to be Shariah compliant

b) Endorse Shariah Compliance Manualc) Endorse & Validate pertinent documentsd) 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 Opiniong) Assist SAC on reference for adviceh) Shall report to the BOD (act as

independent body of IFI)

SHARIAH COMPLIANCE BEHAVIORLevels Activity Assurance For Whom

Product Endorsement Lawful, Valid, Equitable

Counter Party Interest

Transaction Endorsement Lawful & Valid Counter Party Interest

System ICS Review Effective & Reliable

Management & BOD

Entity Policy, 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

SHARI'AH REVIEW & INTERNAL SHARI’A REVIEW Shari’a review is an examination (by SSB) of

the extent of an institution (IFI’s) compliance, in all its activities, with the Shari’a.

Internal Shari’a 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 Shari’a rules and principles, fatwas and guidelines, and instructions issued by the Institution (IFI) Shari’ah Supervisory Board.

INTERNAL SHARI’A REVIEW 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

SCOPE & ROLE OF INTERNAL SHARI’A REVIEWER Scope: To examine and evaluate the adequacy

and effectiveness of the institution system of internal Shari’a 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 Shari’a Review Work involves planning (include: establishing shari’ah review objectives, obtaining and making reference to fatwas, guidelines, Shari’a review results, writing internal Shari’ah review programs, communicating the procedures as well as results to parties concerns)

AUDITOR & SSB RELATIONSHIP 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

AUDIT REPORT & SHARI’A OPINION Independent samples and tests conducted by

both auditor and SSBAudit 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

AUDIT REPORT & SHARI’A OPINION Shari’a Opinion will be on matters pertaining

to: contracts, transactions and dealings equitable allocation of profit & losses earnings (lawful/prohibited) Zakah …

AUDIT & GOVERNANCE COMMITTEE AGC is to assist in achieving institutions

objectives by enhancing greater transparency and disclosure as well as public confidence on institutions application of Shari’a rules and principles.

Comprise of non-executive directors with sound understanding of the business and Shari’a supervision

AUDIT & GOVERNANCE COMMITTEEROLE & FUNCTIONS 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 Shari’a rules and principles

REPORTING & COMMUNICATION CHANNELS

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 Endorseme

nt

ISLAMIC FINANCIAL SERVICES BOARD (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).

IFSB : PURPOSE & ROLE

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

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

IFSB STANDARDS

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

UNIQUE RISKS OF ISLAMIC FINANCIAL INSTITUTIONS 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

Financing Type Contract Type Risk Exposure

Sales type

Murabaha

Bai Muajjal

Credit Risk

Salam

Istisna’a

Non-delivery &

Credit Risk

Equity Mudaraba

Musharaka

Credit/Market risk

Equity investment Risk

Leasing Ijarah

Ijarah Muntahia Biltamleek

Market risk

Credit risk

Anatomy of Asset Risk Exposures

Financing or Investment?

INCOME DISTRIBUTION TO PER, IRR, SHF & IAH

Income Attributable to IAH

Income distributed to

Shareholders & Investment

Account HoldersBased 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

Source of Funds

Risk Exposures Guarantee/

Reserves

Deposits Liquidity risk Deposit 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

ILLUSTRATION OF IFSB CAR (STANDARD FORMULA)

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

FINANCIAL REPORTING, AUDITING & GOVERNANCE FRAMEWORK

SHAREHOLDERSSHAREHOLDERS

ISLAMICFINANCIAL

INSTITUTION

ISLAMICFINANCIAL

INSTITUTION

AUDITCOMMITTEE

AUDITCOMMITTEE

SHARI’AH SUPERVISORY

BOARD

SHARI’AH SUPERVISORY

BOARD

GOVERNANCECOMITTEE

GOVERNANCECOMITTEE

INVESTMENTACCOUNTHOLDERS

INVESTMENTACCOUNTHOLDERS

OTHERSTAKEHOLDERS

OTHERSTAKEHOLDERS REGULATORY

AUTHORITIES

AAOIFI IFSB

MULTI-DISCIPLINARY PERSPECTIVES ON ROLE OF SHARIAH REVIEW, AUDIT & GOVERNANCE

Financial,Statements,

Reports and other

Useful InformationRequired by

AAOIFI &Relevant

InternationalFinancial

Reporting,Auditing &

GovernanceStandards

PrudentialGuidelines

& StandardsPromulgatedBy IFSB to

EnsureRisk

Management & DisclosureFrameworkRelated to

CapitalAdequacy,Corporate

Governance &Market Discipline

Regulatory requirements by Central Banks,Monetary Authorities or Supervisory Agencies

Shari’ah Goals, Opinions & RulingsPropounded by Shari’ah Scholars

SHARIAHCOMPLIANCE

BEHAVIOR

SHARIAH GOVERNANCE ASSURANCE FRAMEWORK

SC & BNM Supervisory Review

SHARIAH SUPERVISORY BOARDS & SHARIAH

COMMITTEE

EXTERNAL AUDITORS

BOARD OF DIRECTORSAUDIT & 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

THANK YOU & WASSALAM