1 INCEIF The Global University in Islamic finance Kuala Lumpur, Malaysia CIFP Shariah Non Compliance through Auditing and Risk Management In Islamic Banking and Finance Semester September 2009 Name: Azah Atikah Binti Haji Anwar Batcha Matric No: 0900157
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Shariah Non Compliance through Auditing and Risk Management
This paper discusses the consequences of Shariah non compliance as a serious risk factor in Islamic Banking and Finance. This is discoverable and perhaps manageable through genuine auditing practice of Shariah compliance. For the most part, Islamic banking and finance depends heavily on its reputation and credibility because of its ethical inclination and its consumers’ high expectation. In view of the fact that it renders its service based on Islamic law; accordingly it is expected to exemplify the Shariah at all stages of its intermediating roles. Indeed, risk management is a critical component of the Banking and financial industry in the conventional. In fact, the efficiency of any bank depends on its capability in managing its daily risks that it faces. Therefore, Islamic Banking has an additional risk element. This risk is the non compliance to its Islamic principles or guidance principles especially with Shariah auditing in place. Hence, this paper will analyze this related risk management to Islamic banking and finance. The paper finds that there are grave consequences on Islamic banks when it fails to comply with the rules of Shariah after the auditing process has identified Shariah breaches. Finally, it concludes that Islamic banking stands a heavy risk of losing its credibility, customers and finally its income if the auditing process identifies non Shariah compliance elements. Hence, non Shariah income may perhaps be deemed haram because of the violation.
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INCEIF
The Global University in Islamic finance
Kuala Lumpur, Malaysia
CIFP
Shariah Non Compliance through Auditing and Risk Management
In Islamic Banking and Finance
Semester September 2009
Name: Azah Atikah Binti Haji Anwar Batcha
Matric No: 0900157
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Table of Contents Abstract ........................................................................................................................................... 3
The Objectives of the Research ...................................................................................................... 4
Key Terms of the Research ............................................................................................................. 4
operational risk , impact of risk on capital adequacy of IFIs, shareholder and investment account
holder orientation, and finally IFIs will manage their governance committee complements audit
committee to address investment account holder and other stakeholders.
To sum it all up, this paper will be addressing auditing matters from Shariah perspective and
identify its importance of the process in IFIs. Therefore, it is hope that Shariah audit practice in
IFIs will be taken seriously. The value opens door of improvement in risk management and
better services to customers.
1.0 Definition of Shariah Audit & Compliance And How It Works
According to Sultan (2007, pp.6), due to the lack literature in this Shariah Audit matter, there are
still no widely accepted definitions of what Shariah Audit really is. The AAOIFI’s Governance
standard No.2 (GSIFI) provides probably the most reflective description of what Shariah Audit is
as defined below:
“Shariah review is an examination includes contracts, agreements, policies, products,
transactions, memorandum and articles of association, financial statements, reports especially
internal and central bank inspection, circulars, and etc” (Para 3, GSIFI 2, AAOIFI Standards).
Sultan (2007, pp.7) stated that there are also other areas which Shariah Audit should look at the
organization structure, processes and people including the marketing strategies taken by the IFIs.
All these should be subjected to a Shariah audit as these are potentially risky areas of the
bank.Therefore, the proposed definition of Shariah Audit is that it is an examination of an IFIs
compliance with the Shariah, in all its activity particularly the financial statements and other
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operational components of the IFI which are subjected to the risk of compliance including but
not limited to products, the technology supporting the operations, operational processes, the
people involved in the main risky areas, documentations and contracts, policies and procedures,
and other activities that requires adherence to Shariah principles (Sultan, 2007, pp.8).
The given definition is merely an academic attempt to provide a comprehensive scope of what
Shariah audit ought to be. But in reality, each Shariah audit exercise will have to take into
account the mandate from the management or the statutory requirement and also consider the
auditability of certain functions, before making decision on the scope and scale of audit.
All of us should realize that Shariah auditing has a key importance as there is a growing need and
awareness among Islamic institutions to comply and practice it. As such, every institution should
contribute towards achieving the objectives of the Islamic law which is known as Maq’asid Ash-
Shariah (Shahul and Yaya, 2005, pp.1). Thus, creating a well structured businesses and a better
economy.
1.1 Auditing And Maqasid Al-Shariah
The primary aim of Shariah is to enforce justice and fairness to human relationship. The
Quran states the following: “Verily Allah commands that you should render back the
trusts to those whom they are due; and that when you judge between men, you judge with
justice. Verily, how excellent is the teaching which He (Allah) gives you! Truly, Allah is
Ever All-Hearer, All-Seer" (Quran, pp. 168, Q 4:V 58).
The institution of justice in Islam is that lives, progeny, wealth, intellect and religion
must be protected (Ashur, 2006). The most relevant to this article is wealth. In relation to
protecting wealth, the exercise of auditing financial institutions ensures that the wealth of
investors is protected. When auditing exercise is conducted and a fraudulent move is
dictated, the recovery of the wealth implies that the Shariah objective is achieved in the
process. What all this shows is that auditing is closely linked to maqasid al-Shariah
(Ashur, 2006).
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1.2 Objectives and Scope of a Shariah Audit
The objective of an audit of financial statements is to enable the auditor to express an
opinion as to whether the financial statements are prepared, in all material respects, in
accordance with the Shariah Rules and Principles, the accounting standards of the
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and
relevant national accounting standards and practices in the county in which the financial
institutions operates. In addition to this, the phrase used to express the auditor’s opinion
is to be able to provide true and fair view (Ibrahim, 2009, pp.416).
In addition to this, according to Ibrahim (2009, pp.418), the objectives of a Shariah Audit
would be that IFIs expect Auditors to be able to provide the elements of Assurance by
putting matters into consideration as mentioned below:
1. Being able to know the limitations between the Users, Practitioner and Responsible
party. The Auditors should know the boundaries of 3 party relationships in order to
prevent their integrity to be questioned.
2. Addressing a proper subject matter such as financial statements assertions.
3. Know what standards to apply regardless whether it is IFRS or AAOIFI Standards.
4. Providing sufficient evidence to support their findings.
5. A written assurance report either it is reasonable assurance or limited.
The Scope of an “Audit Scope should refer to the audit procedures which are deemed
necessary by the auditor in the circumstances to achieve the objective of an audit. This
procedure required the Audit to be conduct in accordance with ASIFIs should be
determined by the auditor having regard to the requirements of appropriate Islamic Rules
and Principles, ASIFIs, relevant professional bodies, legislation, regulations which do not
contravene Islamic Rules and Principles, where appropriate, the terms of the audit
engagement and reporting requirements, International Standards on Auditing (ISAs) shall
apply in respect of matters not covered in detail by ASIFIs providing these do not
contravene Islamic Rules and Principles”.
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1.3 Identifying the Risk Errors and Incongruence in Islamic Banks
According to Archer and Karim (2007, pp. 123-124), in the context of Islamic financial
services industry, appropriate systems, processes and products are all recent
developments. This however, poses a continual challenge in areas of development, and
the failure in managing these areas would bring negative consequences.
The authors added that the Operational risks faced by Islamic bank can be divided into
three categories:
(a) Operational risks that are consequential upon various kinds of banking
activities, and which are somewhat similar for all financial intermediaries,
whether Shariah-compliant or not constitute risks. However, asset-based
nature of financing products in Islamic banking such as murabahah, salam,
istisna and ijarah may give rise to forms of operational risk in contract
drafting and execution that are specific to such products.
(b) Shariah compliance risk-that is:
(i) Risks relating to potential non-compliance with Shariah rules and
principles in the bank’s operations;
(ii) The further risks associated with the Islamic bank’s fiduciary
responsibilities as mudarib towards fund providers under the
mudarabah form of contract, according to which in case of
misconduct or negligience by the mudarib the funds invested by
the fund providers become a liability of the mudarib.
Basically, Shariah compliance risk is the risk of non-compliance resulting from a failure
of an Islamic bank’s internal systems and personnel that should ensure its compliance
with the Shariah rules and principles determined by its Shariah board or the relevant body
in the jurisdiction in which the Islamic bank operates.
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(c) Legal risks arising whether from (Balz, 2005):
(i) The Islamic bank’s operations (legal risks common to all financial
intermediaries) or;
(ii) Problems of legal uncertainty in interpreting and enforcing Shariah
contracts.
1.4 Why Is Shariah Audit Important To IFIs
Archer and Karim (2007, pp. 124), reiterated that Shariah compliance is critical to an
Islamic bank’s operations, and such compliance requirements must permeate throughout
the organization and its products and activities. As a majority of the fund providers used
Shariah-compliant banking services as a matter of priciple, their perception regarding the
Islamic bank’s compliance with Shariah rules and principles is likely to be of a great
importance in maintaining their customer’s loyalty (Hasan, 2009).
Shariah audit is important to IFIs in regards of the operational risks which was dicussed
in the previous page. Apart from this, Shariah Audit is important in order for IFIs to
eliminate or prevent fiduciary risk such as risk that arises from an Islamic bank’s
potential failure to perform in accordance with explicit and implicit standards applicable
to its fiduciary responsibilities, especially in its role as mudarib. As a result of losses on
investments, an Islamic bank may become insolvent and therefore unable either to meet
the demands of current account holders for repayment of their funds or to safeguard the
interests of its investment account holders (Archer and Karim, 2007, pp.125).
Apart from this, Archer and Karim (2007, pp.125) agreed that without Shariah
compliance, an Islamic bank may fail to perform due diligence or to act with sufficient
prudence when making and managing investments which can results of foregone profits
or of losses to its investment account holders.
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Basically by opting for Shariah Audit, it will help IFIs to comply with the law as well as
accounting regulations (Iqbal and Gruening, 2008, pp.269). Furthermore, Iqbal and
Gruening 2008, pp.269) added that Shariah Audit would certainly enable IFIs to gain a
sound Corporate Governance by providing the right formulation of principles and
enforcement. Other than this, Shariah Audit report would provide suggestions such as
providing training to inadequately trained staff so that they are well aware of operational
risks as well as risk of income which are not being recognized as permissible when there
is a failure in Shariah compliance (Archer & Karim, 2007, pp.125).
1.5 Targeted Users to Benefits from the Audit Report
Bernstein and Wild (2000, pp.8) has classified users of financial statements into two
groups:
(a) Internal users
This are primarily for the mangers of the company, the ones who are responsible in
making operating and strategic decision for the business, such as the CEO, CFO, or even
the Internal Auditor.
(b) External Users
These are for those who are not directly involved with the business. These users must rely
on the given information provided by the management. Examples of external users of
financial reporting would be the Auditors, Creditors, Investors, potential shareholders,
Board of Directors, Regulatory agencies such as Securities Commission, Intermediaries,
Employees, Suppliers and Customers.
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1.6 Qualification and Responsibility of a Shariah Auditor
Relating to the qualification of Shariah auditors, they should be people of both
qualifications in accounting as well as Shariah. This is important in order for the auditors
to determine the vision and mission of Islam is preserved within the IFIs (Kasim,
Ibrahim, & Sulaiman, 2005, pp.8). Shariah auditors are expected to reflect their
responsibility and accountability not only to the management and stakeholders, but more
important to the God. This will promote the foundations for building public confidence
and assurance that the IFIs are Shariah-compliant in all of their activities (Kasim,
Ibrahim, & Sulaiman, 2005, pp.8).
Auditors should conduct their audit based on the respective standards and principles.
Auditors should be held responsible for negligence and misconduct if reasonable efforts
are not seen to have been made during the audit engagement (AAOIFI, pp.51). They
should also perform the audit with an attitude of professional skepticism and integrity.
Apart from this, the auditors should always consider the fact that there would be a fraud
error within the audit procedures being perform, document all the related data well and
efficiently as well as considering the implications of the effect of the audit report
(AAOIFI, pp.51). In this case, the auditor will have to decide whether to continue
auditing the company or otherwise (AAOIFI, pp.52).
1.7 Fiqhi Justification For Having Shariah Audit And Compliance
Shariah Audit is important as we need to see a full and transparent disclosure of a
business as we are accountable before God. This is mentioned in Surah At-Taubah
(Quran, pp.376, Q 9: V 94) below:
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They will present their excuses to you when ye return to them. Say thou: "Present no
excuses: we shall not believe you: Allah hath already informed us of the true state of
matters concerning you: It is your actions that Allah and His Messenger will observe: in
the end will ye be brought back to Him Who knoweth what is hidden and what is open:
then will He show you the truth of all that ye did."
Another Quran verse that shows how important it is for data and information to be
documented and kept is mentioned in the longest surah, Surah Al-Baqarah (Quran,
pp.101, Q 2, V 282) which says:
“O you who believe! When you deal with each other, in transactions involving future
obligations in a fixed period of time, reduce them to writing; let a scribe write down
faithfully as between the parties: let not the scribe refuse to write: as Allah has taught
him, so let him write. Let him who incurs the liability dictate, but let him fear his Lord
Allah, and not diminish aught of what he owes. If the party liable is mentally deficient, or
weak, or unable himself to dictate, let his guardian dictate faithfully, and get two
witnesses out of your own men, and if there are not two men, then a man and two
women, such as you choose, for witnesses, so that if one of them errs, the other can
remind her. The witnesses should not refuse when they are called on (for evidence).
Disdain not to reduce to writing (your contract) for a future period. Whether it be small or
big: it is juster in the sight of Allah, more suitable as evidence, and more convenient to
prevent doubts among yourselves but if it be a transaction which you carry out on the
spot among yourselves, there is no blame on you if you reduce it not to writing, but take
witness whenever you make a commercial contract; and let neither scribe nor witness
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suffer harm, if you do (such harm), it would be wickedness in you. So fear Allah; for it is
Allah that teaches you. And Allah is well acquainted with all things”.
In a related hadith, Narrated by Abu Hurairah r.a.: Allah’s messenger s.a.w said: “The
signs of a hypocrite are three: Whenever he speaks, he tells a lie; and whenever he
promises, he breaks his promise; and whenever he is entrusted, he betrays which proves
him to be dishonest. (Al-Bukhari, p. Vol.8 No.117). Shariah auditor is not expected to be
one of the three attributes of a hypocrite.
The notion of accountability will propel a Shariah auditor to ensure that he lives up the
expectation people have entrusted him and above all his responsibility on the Day of
Judgment. Allah has required him to render back the trust due on him. Among these
trusts is his reporting the true nature of his findings. Thus the Qur’an urges him
empathetically: “Verily Allah commands that you should render back the trusts to those
whom they are due; and that when you judge between men, you judge with justice.
Verily, how excellent is the teaching which He (Allah) gives you! Truly, Allah is Ever
All-Hearer, All-Seer" (Quran, pp. 168, Q 4:V 58)
2.0 The Shariah Audit Process
There are some tools and instruments can be used in order to identify incongruence in Shariah
Audit process which is the accounting instrument, the legal instrument and the Islamic ruling
(fatwa & resolutions), as well as a Shariah reviewer. These four tools play a crucial role in
identify incongruence in Shariah compliance.
2.1 Tools and instruments used to identify incongruence in IFIs
1. Accounting and Audit
According to Lahsasna and Rosly (n.d., pp. 20), the accounting and audit is a very crucial
instrument to identify incongruence in Shariah, by using different accounting tools such
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as the financial data, and balance sheet and the auditing process, the prohibited elements
in Shariah can be easily identify through this process. The accounting instruments couple
with the audit will be used to meet Shariah compliance in all financial transactions and
business activities which cover the following areas as stated by Lahsasna and Rosly
(2009, pp. 21):
• Lawful and legitimate economic activities
• Valid contracts that exclude interest and uncertainty of contract conditions
• Mutual consent on a willing buyer – willing seller basis with an ascertained
degree of trust through transparency, fairness of representation and equity
between parties in terms of counter value or distribution.
• The balance sheet will show the asset and liability of the bank and classified all
the transaction and source and the use if the funds.
2. Legal Instrument
Legal instrument play a very sensitive role in identify incongruence in Shariah, the legal
approach examine the structure of the contract and product and ensure the Shariah
compliance in the terms and conditions implemented in that particular contrac Lahsasna
and Rosly (2009, pp. 21). The careful examination of the clauses in the contract will
identify the any violation to Shariah rules if any, and provide a correct way of
interpretation of the clauses in the contract Lahsasna and Rosly (2009, pp. 21).
3. Islamic ruling (fatwa & resolutions)
The fatwa is the Islamic ruling pertaining to particular case such contract in order to
validate or invalidate that contract, through the investigation of the whole process of the
application with the observation of the various issues related to banking documents, the
fatwa may identify incongruence in Shariah (Lahsasna and Rosly, 2009, pp. 21). The task
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of Shariah board is to exam the document of the present product to eliminate any element
not consistent with shariah rules and principles (Lahsasna and Rosly, 2009, pp. 21).
4. Shariah review
According to AOOIFI Shariah review is an examination of the extent of an IFI’s
compliance, in all its activities, with the Shariah (Lahsasna and Rosly, 2009, pp. 22). This
examination includes contracts, agreements policies, products, transactions,
memorandum and articles of association, financial statements, reports (especially internal
audit and central bank inspection), circulars, and so on (Lahsasna and Rosly, 2009, pp.
22). The objective of the review is to ensure that the activities carried out by an IFI do not
contravene the Shariah. The achievement of this objective requires that the Shariah is
mandatory (Lahsasna and Rosly, 2009, pp. 22).
2.2 Auditing Techniques
Sultan (2007, pp.73) stated 10 auditing techniques that can be used during the audit
engagement:
(a) Examinations of papers
(b) Interviewing
(c) Direct observation
(d) Benchmarking
(e) Surveys
(f) Case studies
(g) Flow charting
(h) Statistical analysis
(i) Walkthrough and Questionnaires
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3.0 Implications of Non-Compliance with Shariah Audit Practice
The implications of non-compliance with Shariah Audit is that Islamic banks are subjected to
risks on the similar fronts as conventional banks such as credit risk, market risk and operational
risk and reputational risk for the Islamic banks. In addition, there are specific risks which are
uncharacteristic in conventional finance but inherent in Islamic banking, (Sultan, 2007, pp. 127).
Apart from this, people risk which arises from incompetence or fraud exposes Islamic banks to
potential losses. For instance, an internal control problem cost the Dubai Islamic Bank $50
million in 1998 when a bank official did not conform to the bank’s credit terms. As a knock-on
effect, this news triggered a rush to withdraw deposits and resulted in a run on deposits in the
magnitude of $138 million, 7% of the bank’s total deposits, in just one day (Sultan, 2007, pp.
128). This is in addition to technology risk, another type of operational risk, which is associated
with the use of software and telecommunication systems that are not specifically tailored to the
needs of Islamic banks. Terminologies, accounting treatment and profit computation and
distribution methods are all serious issues which if left unchecked could lead to disastrous
implications and impact on the reputation and image of the Islamic Bank as well as incur legal
risks (Sultan, 2007, pp. 128).
On another score, cross border comparison of Islamic banking performances is difficult because
the regulatory frameworks of Islamic banking and jurisdictions are not standardized. Regulatory
and supervisory practices concerning Islamic banking are highly diverse, ranging from
frameworks that explicitly promote dual banking system such as in Malaysia to frameworks that
only recognize Islamic banking like in Sudan (Sultan, 2007, pp. 128). This is another reason why
complying with the Shariah Audit requirements is really vital. And finally, part of the problem
would be lack of avenues for Islamic banks to properly manage their liquidity risks. The
interbank money market mechanism and government Islamic securities are still relatively
underdeveloped and few as well as far in between. This increases the probability of incurring
asset-liability mismatches and increases the exposure of Islamic banks to liquidity stocks. While
significant progress has been made in Malaysia, Sudan, and Iran, the actual compliance of the
operations is still questionable, mainly due to lack of supervision and audit on Shariah
compliance on the operational aspects of these activities (Sultan, 2007, pp. 128).
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4.0 Real Life Case Example to Reflect the Importance of Shariah Audit
There are not many reported cases that have gone through litigation processes to be taken as
examples but that is probably due to the lack of regulation n the transparency requirements of the
Islamic banks in disclosing information regarding their financial statements. Ironically, one of
the more frequently referred case which happened in Egypt, incurred losses to the shareholders
instead of the depositors (Sultan, 2007, pp.125).
Between mid to late 1980s, the International Islamic Bank for Investment and Development in
Egypt distributed all of its profit to investments account holders while the shareholders received
nothing. In 1988, the bank distributed to depositors an amount exceeding its profits, and the
difference appeared in the bank’s accounts as loss carried forward. It is reported that this bank
was subject to temporary takeover by the Central Bank of Egypt (Sultan, 2007, pp.125).
The above issue is known as displaced commercial risk, where the Islamic bank is under the
pressure of paying its investment depositors a rate f return higher than what should be payable
based n the actual performance of the funds. This is as a result of the competitive pressure to
induce its investment account holders not to withdraw their funds from the bank and invest them
elsewhere (Sultan, 2007, pp.125).
Another matter that has been debated is the fiduciary conflict that the management of the bank is
subjected to, due to the “equity” nature of mudarabah deposits. In accepting depositors funds on
the basis of mudarabah, the bank effectively subject itself to fiduciary roles to two categories of
equity holders; the shareholders and the mudarabah investment account holders (Sultan, 2007,
pp.126).This puts the management of the bank in a difficult position and raises the question of
ethical dilemma and possibilities of conflict of interest, particularly when one party is favored
over the ther in the distributin of profits (Sultan, 2007, pp.126).
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5.0 Benefits of Shariah Audit and Compliance Practice
In recent times, many disciplines have recognized the need to independently ascertain either its
quality in production, activities, or its validity in various related applications (Willborn, 2000).
Now, it shows clearly, how most of these disciplines or corporations are beginning to shift in
their paradigms and to reconsider increasingly the importance and relevance of objective reviews
of their documents through internal or external auditing process (Eugene, 2003). For the most
part, if these processes are done independently and impartially, the efforts invested into it will
pay off.
It appears these stakeholders are in consonance with the need to create a more powerful and
impartial auditing exercise which will among other things, conduct, investigate, and report its
findings without fear or favor (Wilson, 1999). In addition, even pundits do agree that audit
findings regardless of their discipline become useless if a follow up is not initiated and pushed
energetically into the whole effort for plain implementation; to ensure the perfection of
discovered lapses after the auditing findings. David Dow (Dow, 1994) cautioned authorities or
individuals who do not respond to audit findings and hence make the valued changes are needed
from the discoveries reported.
Furthermore, (Dow, 1994) argued passionately, that while it is nice to consider fresh
recommendations being tabled by auditing firms; the concerned party has the prerogative to
either accept the report findings or to amend it but in any case; it must justify either of its action.
In fact, accepting these findings, according to the researcher, if done objectively would be an
added bonus to the concerned parties. Again, and above all, data alone are insufficient to proffer
such decision and solutions for managerial consumptions and subsequent improvement. Besides,
the parties concerned, must go further arms length, in doing the right thing but doing it rightly.
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6.0 Conclusion
This paper has addressed auditing from Shariah perspective and identified the importance of the
process in IFIs and concludes that non Shariah compliance should be detected through auditing.
As we know, auditing has always been an important cog in the corporate governance machinery
in modern organizations (Saidi, 2007). Shariah audit shares a similar function but focuses on the
compliance of Islamic financial institutions to Shariah precepts and requirements.
Through the line of argument tabled in this paper, Shariah auditing incredibly vital to all
financial institutions in which Islamic banking and finance is not an exception. The auditing
exercise contributes towards managing the risks inherent in IFIs. And within the grander scheme
of things, it contributes to the growth of the industry and economy by providing adequate
disclosure for the stakeholders to make informed decisions or channel funds to the most
productive investments opportunities or vehicles. It also sets out the supervisory expectations
around key areas such as risk management, compliance and control, corporate governance and
capital policy. The robust framework of financial institutions itself mitigates certain risks
especially risk of the unidentified, or risk of the unknown. And the probabilities of such risks to
occur are higher in newly developing financial systems such as the Islamic financial systems.
This is unhealthy in Islamic banks that in the first place must focus on their business to expand
market size and fulfuil stakeholders’ interest.
Accordingly, the weak or improper supervision of banks can have the disproportionate effect of
destabilizing a country’s economy and indeed reducing market confidence. Many Islamic banks
has crisis over time illustrate a catastrophic consequences flowing from the poor governance of
Islamic banks. These crises have crippled, destabilized goverments and held back development
of less sophisticated economies and emerging nations as well indeed intensified poverty.
Therefore, Shariah Audit is the way forward in order to deal with all these problems.
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