1

ISLAMC BANKING AND TAKAFUL

(LBA 3013)






Members:
Nabilah Huda bte Abdul Ghani (1090237)
Nurathiqah bINTI Mohd Fadzil (1090220)

Semester: 2011/2012
Lecturer: Mr. MustaIa AIiIi Abdul Halim


Discuss the Roles and Functions of Shari'ah
Audit, Audit and Governance


CONTENTS
CONTENTS PAGE
1.0 INTRODUCTION
2.0 CORPORATE GOVERNANCE
2.1 IMPORTANCE OF CORPORATE
GOVERNANCE IN BANKS
2.2 THE STRUSTURE OF SHARIAH
GOVERNANCE
2.3 THE FRAMEWORK OF SHARIAH
GOVERNANCE IN MALAYSIA
3.0 SHARIAH AUDIT
3.1 OBJECTIVE AND SCOPE OF
SHARIAH AUDIT
3.2 FRAMEWORK OF SHARIAH AUDIT
3.3 ROLES AND FUNCTION OF
SHARIAH AUDIT
3.4 PROCEDURES OF SHARIAH
ADVISOR
3.5 SHARIAH AUDIT PROGRAMS AND
PROCEDURES
3.6 SHARIAH AUDIT IN SAUDI ARABIA
4.0 SHARIAH AUDIT AND
GOVERNANCE
5.0 CONCLUSION

1
2
3

4

5

8
9

10
11

14

16

17

18
21


1.0 INTRODUCTION

In Malaysia, a comprehensive Shariah audit program has not been developed much.
Shariah audit program means a manual-based document that explain step-by-step oI
Shariah audit procedures, policies and processes when oIIering Islam Iinancial services. The
audit program should also include standard operating procedure including accounting
(MASB, AAOIFI etc), regulatory requirements (BNM) and other requirements. Since
Shariah audit is yet to be made a regulatory requirement by BNM there is a need Ior external
Iinancial auditors, internal auditors, and Shariah unit department within the Islamic
Financial Institutions (IFIs) to work closely with Shariah advisors to ensure Shariah
compliance oI Islamic Iinancial activities.
Institutions that oIIer Islamic Iinancial services must operate with the guidelines oI
Islamic ethics and must act within the limits oI Shariah. In order to ensure that the
operations oI IFIs do not contravene with Shariah, the Shariah Advisory Council (SAC)
and Shariah Supervisory Board or Council (SSC) play their Iunctions as advisors or
supervisors oI Islamic banking activities. Internationally, a numbers oI governance standards
and guideline have been issued by the Accounting and Auditing Organizations oI Islamic
Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB). In
Malaysia, Bank Negara Malaysia (BNM) has also issued the relevant guidelines to ensure
prudent regulation oI Shariah matters in Islamic Iinancial institutions.
In Malaysia, Bank Negara Malaysia (BNM) has also issued the relevant guidelines to
ensure prudent regulation oI Shariah matters in Islamic Iinancial institutions. The Central
Bank oI Malaysia (BNM) has started to develop and enhancing the Shariah Framework and
the recent Iramework has included Shari`ah compliance & research Iunctions which
prescribes the Iunctions oI the internal Shariah review, Shariah audit, Shari`ah risk
management and Shariah research.



.0 CORPORATE GOVERNANCE

The Cadbury Committee (1992) deIined corporate governance as the system by which
companies are directed and control`
1
. Formally, corporate governance can be deIined as a set
oI organizational arrangements whereby the actions oI the management oI a corporation are
aligned as Iar as possible with the interests oI its stakeholders
2
.
Organisation Ior Economic Co-operation and Development (OECD) Principles oI
Corporate Governance deIines Corporate Governance as 'a set oI relationships between a
company`s management, its board, its shareholders and other stakeholders. Corporate
Governance also provides the structure through which the objectives oI the company are set,
and the means oI attaining those objectives and monitoring perIormance are determined
3
.
The deIinition oI corporate governance adopted by Malaysia is 'the process and
structure used to direct and manage the business and aIIairs oI the company toward
enhancing business prosperity and corporate accountability with the ultimate objective oI
realizing long-term shareholder value, while taking into account the interest oI other
stakeholders
4
.
From the deIinitions above, corporate governance mainly Iocuses on the process used
to direct and manage the business and aIIairs oI the company with the objectives oI striking a
balance on:
O The attainment oI the company's objectives.
O The alignment oI corporate behavior to meet the expectations oI shareholders.
O Accountability and good stewardship, taking into consideration the interests oI
shareholders, stakeholders, corporate participants and society at large.
In the Islamic bank context, good governance should encompass oI:

1
DeIinition by Sir Adrian Cadbury, head oI the Committee oI the Financial Aspect oI Corporate Governance in
the United Kingdom: 'Corporate governance is the system by which the companies are directed and
controlled (Cadbury Committee, 1992, introduction).
2
Mervyn K. Lewis and LatiIa M. Algaoud (2001). Islamic Banking. Edward Elgar Publishing Limited. p159.
3
ProI. Dr. Mohd. Ma`sum Billah. Shariah Frameworks of Islamic Corporate Governance. (Online Posting).
n.d. http://www.applied-islamicIinance.com/spcorporategovernance2.htm~
4
Nor Azizah Zainal Abidin and Halimah Nasibah Ahmad. 2007. 'Corporate Governance in Malaysia: The
EIIect oI Corporate ReIorms and State Business Relation in Malaysia. Asian Academy of Management
Journal, Vol. 12, No. 1. January. p 25.


O A set oI organizational arrangements whereby the actions oI the management oI
Islamic bank are aligned, as Iar as possible, with the interests oI its stakeholders.
O The provisions oI proper incentives Ior the organs oI the governance such as the
board oI directors (BOD), the Shariah board and management to pursue
objectives that are in the interests oI the stakeholders and Iacilitate eIIective
monitoring, thereby encouraging Islamic banks to use resources more eIIiciently.
O Compliance with Islamic Shariah rules and principles.
5


.1 IMPORTANCE OF CORPORATE GOVERNANCE IN BANKS

Banks are critically important Ior industrial expansion, the corporate governance oI Iirms,
and capital allocation. When banks eIIiciently mobilize and allocate Iunds, this lowers the
cost oI capital to Iirms, boosts capital Iormation, and stimulates productivity growth. Thus,
the Iunctioning oI banks has ramiIications Ior the operations oI Iirms and the prosperity oI
nations.
The governance oI banks themselves assumes a central role. II bank managers Iace
sound governance mechanisms, they will be more likely to allocate capital eIIiciently and
exert eIIective corporate governance over the Iirms they Iund. In contrast, iI banks managers
enjoy enormous discretion to act in their own interests rather than in the interests oI
shareholders and debt holders, then banks will be correspondingly less likely to allocate
society`s savings eIIiciently and to exert sound governance over Iirms
6
.
Besides, iI bankers allocate capital eIIiciently, exert good and eIIective corporate
governance in their own institutions, and also promote good corporate governance in their
customers, there will be a built-in discipline over those institutions and those customers. In
contrast, iI bankers enjoy too much discretion to act in their own interests over their
stakeholders` interests, then the banks will likely Iail to allocate Iunds eIIiciently and to
promote sound corporate governance in their customers
7
.

5
Hamid Yunis. 2007. 'Corporate Governance Ior Banks in Islamic Finance. The Regulatory Challenge. Simon
Archer and RiIaat Ahmed Abdel Karim (comp. & ed.). .John Wiley & Sons (Asia) Pte Ltd. p 300.
6
Ross Levine. 2004. 'The Corporate Governance oI Banks:A Concise Discussion oI Concepts and Evidence.
World Bank Policy Research Working Paper 3404. September. p 2.
7
Supra no. 5 p 296.


Corporate governance arrangements may also serve to built trust, elicit cooperation
and create a shared vision amongst those involved in the Iirm. This outcome seems especially
likely where the governance structures can build upon a set oI pre-existing shared values,
belieIs, concepts, traditions and moral attitudes which give those involved with the
organization a common bond, such as that which may derive Irom religious precepts
8
.
The corporate governance in Islamic banking is also known as Shariah governance.
Shariah governance is important as the backbone oI the Islamic banking which is
compliance with the Shariah. Hence, it gives the Islamic banks the legitimacy to practice
Islamic banking and Iinance. Besides, the Shariah governance itselI indicates that the
Islamic banking practices and activities are compliance with the Shariah thus raise the
conIidence oI the shareholders and the public towards Islamic banking and Iinance
9
.

. THE STRUCTURE OF SHARIA'H GOVERNANCE

A governance structure under Islamic banking is base on proIit-and-loss sharing methods,
which is diIIerent Irom the interest-based borrowing and lending relationship oI conventional
banking. There are two major diIIerences oI Islamic banking governance Iramework Irom the
conventional Iramework. First, and Ioremost, an Islamic organization must serve God. It must
develop a distinctive corporate culture, the main purpose oI which is to create a collective
morality and spirituality which, when combined with the production oI goods and services,
sustains the growth and advancement oI the Islamic way oI liIe.
Second, interest-Iree banking is based on the Islamic legal concepts oI mudarabah
(proIit-sharing) and musyarakah (partnership). An Islamic bank is conceived as Iinancial
intermediary mobilizing savings Irom the public on a mudarabah basis and advancing capital
to entrepreneurs on the same basis.
A mudarabah can be deIined as contract between at least two parties whereby one
party, the Iinancier (sahib al-mal), entrusts Iunds to another party, the entrepreneur
(mudarib), to undertake an activity or venture. In arrangements based on musharakah there is
also proIit-sharing, but all parties have the right to participate in managerial decisions. In

8
Supra no. 2. p 160.
9
Dr. Aznan bin Hasan. n.d. Optimal Shariah Governance in Islamic Finance. (Slide). Gombak: IIUM.


mudarabah, the Iinancier is not allowed a role in management oI the enterprise.
Consequently, mudarabah represents a proIit and loss sharing contract where the return to
lenders is a speciIied share in the proIit/loss outcome oI the project in which they have a
stake.
Under mudarabah, the yield is not guaranteed in proIit-sharing and Iinancial losses
are borne completely by the lender. The entrepreneur as such losses only the time and eIIort
invested in the enterprise. This distribution eIIectively treats human capital with Iinancial
capital equally.
Under musharakah, the entrepreneur adds some oI his own to that supplied by the
investors, so exposing him to the risk oI capital loss. ProIits and losses are shared according
to pre-Iixed proportions, but these proportions need not coincide with the ratio oI Iinancing
input
10
.
Apart Irom that, the process oI Shariah supervision is an important governance
structure in Islamic banks. Thus, it imposing that the central Iramework oI corporate
governance in Islamic banks is the Shariah Supervisory Board (SSC) and the internal
controls which support it. The SSC is vital Ior two reasons. First, those who deal with an
Islamic bank require assurance that it is transacting with Islamic law. Should the SSC reports
that the management oI the bank has violated the Shariah, it would quickly lose the
conIidence oI the majority oI its investors and clients. Second, some Islamic scholars argue
that strict adherence to Islamic religious principles will act as a counter to the incentive
problems such as promoting non-Islamic products or instilling trust and discipline in the
organizations
11
.

.3 THE FRAMEWORK OF SHARI'AH GOVERNANCE IN MALAYSIA

Over the last decade, Malaysia has actively and progressively developed Islamic Finance
which is supported by Iirmly established Iinancial institutional structures and a robust
regulatory Iramework. The Shariah Governance Iramework is guided by two important

10
Halil Paino, Anis Barieyah Bahari, and Rosliza Abu Bakar. 2011. 'Shariah, Social Responsibilities and
Corporate Governance oI the Islamic Banks in Malaysia. uropean Journal of Social Sciences. Volume 23,
Number 3. p 383-384.
11
Supra no.2. p 167-168.


legislation and guideline which are the Central Bank oI Malaysia Act 2009 and the Shariah
Governance Framework Ior IFI (SGF).
By virtue oI section 51 oI the Central Bank oI Malaysia Act 2009, SAC oI BNM will
have the highest authority Ior the determination oI Islamic law Ior the purposes oI Islamic
Iinancial business. Other Iunctions oI the SAC are to ascertain the relevant Islamic law on
any Iinancial matter and issue a ruling upon reIerence made to it, as well as to advise the
Bank and the IFI concerned on any Shariah issues relating to Islamic Iinancial business
operations, activities or transactions.
On industry level, section 3(5)(b)
12
oI Islamic Banking Act, 1983, speciIies the need
Ior the establishment oI Shariah Committee (SSC) to advise the bank on its banking
operation business. The Islamic banks may seek advice Irom their respective SSC regarding
the Shariah matters in their business and they shall comply with the council advices. It is
provided under s 13A(1) oI the Islamic Banking Act.
A sound and robust Shariah governance Iramework is reIlected by eIIective and
responsible board and management, an independent SCC that is both competent and
accountable, supported by a strong internal Shariah research capacity, and monitored
through active Shariah review, Shariah audit and Shariah risk management process.
The board is ultimately responsible Ior the establishment oI an appropriate Shariah
governance Iramework oI an IFI. In setting up the Shariah governance Iramework, the board
is expected to understand the Shariah non-compliance risks associated with Islamic Iinance
business and the issues relating to such risks, as well as the potential implications to the
institution.
A SCC is a committee that able to deliberate Islamic Iinance issues brought beIore
them and provide sound Shariah decisions. In this regard, every IFI is required to establish a
SCC which the majority shall comprise persons with appropriate qualiIications and
experience in Shariah.
The management responsibilities is to provide adequate resources and capable
manpower support to every Iunction involved in the implementation oI Shariah governance,

12
Section 3(5)(b) oI Islamic Banking Act, 1983 stated: 'that there is, in the articles oI association oI the bank
concerned, provision Ior the establishment oI a Shariah advisory body to advise the bank on the operation oI
its banking business.


in order to ensure that the execution oI business operations are in accordance with the
Shariah.
An internal Shariah review is conducted on a continuous basis, which is a review oI
processes and deliverables, as well as determining that such processes and outcomes satisIy
the needs oI the Shariah.
A Shariah audit will veriIy that the IFI`s key Iunctions and business operations
comply with Shariah at least on an annual basis while the internal Shariah research team
role is to assist SCC and conduct research on Shariah matters. A Shariah risk management
process is to identiIy all possible Shariah non-compliance risks and, where appropriate,
remedial measures that need to be taken to reduce the risk.
To ensure that the reporting on Shariah matters is carried out eIIectively and on
timely manner, the SCC shall Iunctionally report to the board oI directors. The Shariah
review Iunction shall report concurrently to the SCC and management, and the Shariah audit
Iindings shall be reported to the Board Audit Committee and SCC. All Shariah non-
compliance events are to be reported to the board oI the IFI and the Bank
13
.
The SGF outline Iour guiding principles oI Shariah governance; First, oversight,
accountability and responsibility where an IFI shall set out the accountability and
responsibility oI every important body involved in the implementation oI Shariah
governance Iramework.
Second, independence where the independence oI the SCC shall be observed at all
times in exercising their duties to make objective and inIormed judgment. The goal is to
saIeguard the independence oI the SCC in ensuring sound Shariah decision-making, and
emphasis on the role oI the board oI directors in recognizing the independence oI the SCC.
Third, competency which reIers to any person with responsibilities under the Shariah
governance Iramework Ior an IFI shall possess the necessary competency and continuously
enhance their knowledge and understanding on the Shariah as well as keep abreast on the
latest developments in Islamic Iinance.

13
Bank Negara Malaysia (BNM). 2011. Shariah Governance Framework for Islamic Financial Institutions.
10

Fourth, conIidentiality and consistency sets minimum rules that emphasizes on the
importance oI observing and preserving conIidentiality and improving the level oI
consistency in decision making by the SCC
14
.

3.0 SHARI`AH AUDIT

In order to know what is the Iunction and roles oI Shariah
15
Audit, we have to know Iirst
what is meant by audit itselI. Generally, Audit is a set oI activities to evaluate an
organization`s processes, projects, systems perIormance and adherence to regulatory
principles and guidelines. Audit is the tool to promote corporate governance in the
organization. There are usually statutory measures drawn up by the regulatory bodies or
government agencies to promote corporate governance among the organization under their
purview, and there could also be voluntary measures undertaken by an organization to
promote the cause oI corporate governance.
Whereas deIinition Ior Shariah Audit, there is no deIinite or accurate deIinition Ior it
due to the lack oI literature on this subject matter. Presently, it uses the term Shariah audit or
Shariah review. However, the AAOIFI
16
`s Governance standard No.2 (GSIFI 2) provides
probably the most reIlective description oI what Shariah audit is which is 'Shariah review
is an examination oI the extent oI an IFI`s compliance, in all its activities, with the Shari`ah.
This examination includes contracts, agreements, policies, products, transactions,
memorandum and articles oI association, Iinancial statements, reports (especially internal
audit and central bank inspection), circulars, etc
17


14
Rustam Mohd Idris. 2011. 'Shariah Governance Framework Ior IFIs: Raising Shariah Competency to the
Next Level. International Conference on Islamic Business and Finance, Islamabad, Pakistan. February.
15
The word Shariah literally means the road to the watering place, the straight path to be Iollowed (Laldin,
2006, p.2). It is a doctrine oI duties, a code oI obligations needed to regulate all human actions Ior the
purpose oI establishing human order (Ibn Ashur, 2006, p.1)
16
The Accounting and Auditing Organization Ior Islamic Financial Institutions (AAOIFI) is an Islamic
international autonomous non-Ior-proIit corporate body that prepares accounting, auditing, governance, ethics
and Shariah standards Ior Islamic Iinancial institutions and the industry. ProIessional qualiIication programs
(notably CIPA, the Shariah Adviser and Auditor "CSAA", and the corporate compliance program) are
presented now by AAOIFI in its eIIorts to enhance the industry`s human resources base and governance
structures.
17
Para 3, GSIFI 2, AAOIFI Standards
11

According to BNM`s Shariah Iramework, Shariah audit is periodical assessment
conducted Irom time to time, to provide an independent assessment and objective assurance
designed to add value and improve the degree oI compliance in relation to the IFI`s business
operations, with the main objective oI ensuring a sound and eIIective internal control system
Ior Shariah compliance.
18


3.1 OB1ECTIVE AND SCOPE OF SHARI'AH AUDIT

By looking at the objective and scope oI Shariah audit, we might diIIerentiate between
conventional audit and Shariah audit. In general, the objective oI a Shariah audit exercise is
oI course to ensure that the activities carried out by the IFI do not contravene the Shariah.
The objective oI a Shariah audit is sets the stage Ior the activities that need to be undertaken
within the audit exercise.
As Ior the scope oI Shariah Audit, it shall cover the audit oI Iinancial statements oI
the IFI. In this respect, the audit would be considered to review iI the Iinancial statements are
drawn up according to the existing Iinancial reporting disclosure standards and whether the
Iinancial entries truly and accurately reIlect the rights and obligations Irom the various
Shariah contracts that the IFI enters into. II the requirement oI IFIs is to adopt AAOIFI
standards that spell out Iinancial reporting standards would be construed as the Shariah
compliance yardstick.
The next area as a scope oI Shariah audit is the operational aspects oI the IFI. This
largely depends on the type oI business the IFI is involved in and the key business activities
undertaken by the IFI. This will involve an examination oI the policies and procedures oI the
IFI on the key business activities, product manuals, operational processes, contracts and
agreements oI products, memorandum and articles oI association oI the organization and
observation oI reports issued by the management or Shariah supervisory board and internal
review unit.
The other area which is the organizational structure and the people involved in
executing key activities oI each business area oI the IFI. Audit on this scope will ensure that

18
Mohd Nazri Chik. 2011. 'Shariah Audit: Shariah Perspective. International Shariah Audit Conference.
Mei.
1

the organization structure is Ieasible to undertake a Shariah compliant business activity and
that there are qualiIied personnel in the areas oI Iiqh al muamalat to support the operations oI
the IFI.
Finally the scope should also cover the IT application systems that are in place to
support the key business activities oI the IFI. An audit into this area would look into whether
the Iunctionalities and Ieatures oI the application system are suIIicient and adequate to
support an Islamic banking business by the IFI.

3. FRAMEWORK OF SHARI'AH AUDIT

The salient Ieatures oI Islamic Iinance can be optimized in Iour basic principles which are
1) Avoidance oI SinIul Activities 2) Risk sharing 3) No exploitation 4) Materiality &
productive purpose.
19

First basic principle is avoidance oI sinIul activities. Islamic Iinance is about
prohibition oI receiving Iunds or channeling these Iunds in a sinIul way as clearly outlined by
Shariah law. Hence, transactions that pay interest to depositors or investments in interest
bearing stocks are prohibited as this involve riba, which is a strictly prohibited in Islamic
law. Other prohibitions include doubtIul and uncertain transaction and the production and
consumption oI liquor and pork.
Second principle is risk sharing. Islamic Iinance requires each party to a transaction to
share the risks and rewards in an equitable manner. In Iact, the rules and conditions oI
contracts deemed compliant to Shariah have in-built mechanisms to uphold this principle.
Third principle is no exploitation. Islamic Iinance promotes Iairness in dealings by
requiring the parties to the contract to explicitly spell out key aspects regarding rights,
liabilities and obligations oI the transaction leaving no room Ior ambiguities. The contract
shall also be entered into with mutual and voluntary consent oI both parties.

19
Mohamed Sultan, S.A. 2007. A Mini-Guide to Shariah Audit for Islamic Financial Institutions A Primer,
CERT Publications.

1

The Iourth principle is materiality & productive purpose. Islamic Iinance requires
transactions entered into by the IFI to have real economic purpose and to Iinance socially
productive sectors oI the economy. The importance oI materiality is also upheld in requiring
the issuance oI sukuk to have an underlying physical asset, instead oI mere monetary
receivables.

3.3 ROLES AND FUNCTIONS OF SHARI'AH AUDIT

In the latest Shari`ah Governance Framework by BNM, it stated that the Shari`ah
Audit Function are providing independent assessment & objective assurance designed to
value add & improve IFI`s compliance with Shari`ah, scope oI audit covers all aspects oI
IFI`s business operations & activities, internal auditors must be perIormed by who have
acquired adequate Shari`ah-related trainings.
This new Iramework aims to strengthen the Shari`ah governance process, decision
making, accountability and independence. To strengthen the Shari`ah compliance Iunctions,
internal Shari`ah review and audit requirements will be introduced, supported by an
appropriate risk management process and research capability. It is envisaged that the
implementation oI the Iramework will contribute towards evolving a more healthy
development oI Shari`ah governance Iramework within Islamic fnancial institutions which,
in turn, will promote Shari`ah compliance throughout the organization.
20

In an attempt to implement Shari`ah audit in an organization, the Shari`ah auditors
must understand the role to be played. The need oI Shari`ah auditor has increased in Islamic
Iinancial system as the country is moving towards the goal to be known as a regional Islamic
Iinancial center. Mr. Ab Manan Mansor
21
, states that so Iar in 2006, there is no Shari`ah-
compliant audit conducted in any Iinancial institution in Malaysia. This explains how the
industry requires expertise to ensure the transparency oI Iinancial practices Islamic-based.
As a Muslim, we are obliged to conduct our business according to Islamic principles and
not contrary to God`s command. We can say that Shari`ah audit is a part oI our duty and it is
original basis Ior having the Islamic Iinancial system. With the establishment oI Shari`ah

0
Rustam Mohd Idris. 9 February 2011. Shariah Governance Framework for IFIs. Raising Shariah
Competency to the Next Level. International ConIerence on Islamic Business and Finance Islamabad, Pakistan.
1
One oI the seminar panelists in First Malaysian Shari`ah Audit 2006
1

Audit also will clearly distinguish Islamic Bank Irom conventional bank. As we know, people
are still not conIident with Islamic Banking since they alleged that most oI Islamic product
have no diIIerent Irom conventional product, thus with the establishment oI Shari`ah Audit
this might help to clear this conIusion and gain more conIident towards the Islamic Banking
system in Malaysia.

Since Shari`ah is the Ioundation oI Islamic Iinancial products and services, iI
the customers Iind that the products are not Shari`ah compliant, this would seriously
undermine the conIidence in the Islamic Iinancial services industry as a whole. Thus,
Shari`ah non-compliance risk is clearly a major challenge Ior regulators. Some regulators
have sought to Iind a solution through the implementation oI adequate systems and
controls that ensure compliance with Shari`ah. Such Shari`ah systems and controls should
ensure that the rulings and Iatwa oI the SSC are circulated and implemented throughout the
Iinancial institution.
However, the Shari`ah systems and controls need to be supplemented with
external and internal Shari`ah audit requirements. These audit requirements will provide
mechanisms Ior a regulator to monitor, control and take action against the Iinancial
institutions iI they do not meet the Shari`ah requirements based on a Iailure to maintain and
comply with its internal systems and controls. In addition, every regulatory structure needs to
have adequate enIorcement power to ensure the necessary action can be taken in the
event oI violation oI Shari`ah.
Current practice to ensure Shari`ah compliance relies essentially on internal
corporate structure in particular SSC. These certainly oIIer stakeholders a level oI comIort.
Nevertheless, they Iace a number oI challenges relating to their independence, the
conIidentiality oI institution-speciIic proprietary inIormation, the limited availability oI
proIessionals with both Shari`ah scholarship and Iinancial skills, and the need Ior
consistency in pronouncements between the various SSCs.

One oI the most important responsibilities oI an Islamic bank is to create conIidence in
its customers as well as all the other operators in the market that its operations are really in
line with the Shari`ah principles. To carry out these responsibilities, two important steps need
to be taken. The Iirst step is to get a clearance Irom the Shari`ah Board about the Shari`ah
1

compatibility oI all its products. The second step is to provide an assurance that all its
transactions are actually in conIormity with the verdicts oI the Shari`ah Board.

For the Iirst step is like going to a legal expert to determine whether a speciIic action oI
the bank is in line with the country`s laws and, iI it is contravene, they need to introduce the
changes that need to be taken. The second is the job oI auditors and banking supervisors to
do which is to ensure that none oI the bank`s transactions violates the law.

The Shari`ah Boards can easily perIorm the Iirst step but it is quite diIIicult Ior them to
perIorm the second task, which needs a review oI all the diIIerent transactions that have taken
place in diIIerent branches oI the bank to ensure that they are in conIormity with the decision
oI the Shari`ah Board. They need to pay a visit to the bank`s premises to examine its
operations in the same way as auditors and supervisors do. It is generally assumed that the
Shari`ah Boards perIorm this task.


Shari`ah auditor must provide services that can be will add value to the organization. Among
these roles are:
a) Preparing themselves with the relevant expertise and skills needed to perIorm this
task.
b) Achieving accountability and integrity improve operations to make recommendations
on risk management organization, work according to Islamic ethics, governance
organization and incorporates the conIidence among the masses and the shareholders oI
the organization.
c) Knowing what is required by the organization to produce quality service by inserting
the elements oI Shari`ah in it.
d) Be creative and innovative in perIorming their tasks, whether in terms oI valuation or
arranged meetings as long as it does not conIlict with Shari`ah.

The institution must also have a big role in Shari`ah audit success, among which are:
a) Provide a strong support and cooperation to the Committee Shari`ah Audit
established.
1

b) Supporting the governance responsibilities oI oversight, insight and Foresight.


3.4 PROCEDURES OF SHARI`AH ADVISOR

There are some methods and procedures oI the process which Shari`ah advisors undertake to
examine and ascertain Shari`ah compliance oI the product and operation oI Islamic banking.
These methods and procedures are termed as 'instrument Ior supervision', which according to
'Abd al-Hamid al-Ba'li, there are three instruments Ior supervisory activities:
22

researching and evaluating the operation oI the bank;
issuing decisions relating to the product and operation which may be
periodically, daily, weekly, monthly, annually, etc; and
Withdrawing or cancelling decisions and operations which are not in line with
the Shari`ah principles.
To achieve the eIIectiveness in Shari`ah supervision on compliance, it is an urgent task
Ior the Shari`ah advisors to examine the whole aspects related to the operation oI the bank, as
the responsibility oI the board is to ensure that the whole aspects are conducted on the basis
oI Shari`ah principles. The Shari`ah supervision is not limited solely in giving Shari`ah
opinions or issuing fatwas or advices beIore certain products are launched by the bank, rather,
reviewing and auditing exercises aIter the products or schemes are launched are also
compulsory. For such reason, there are three stages oI the supervision method that may be
adopted pre-supervision (qabliyyah/sabiqah), ongoing supervision (athna al-amal), and
post-supervision (badiyyah/laiqah).
Pre-supervision means ascertaining Shari`ah compliance by analyzing portIolios and
the simulation oI the products. This stage normally involves an advisory nature oI the
supervision whereby the Shari`ah advisor will be advising on the proper concept to be
adopted Ior the proposed product or instruments, Iollowed by the decision made by the bank
authority to choose the most suitable concept Ior its structure and operations. The ongoing
supervision means the control along the practical operations oI the banking business, such as
how various Iinancial contracts are Iactually undertaken by the parties involved. Post-

Sharl'ah Covernance lramework

1

supervision means that the rechecking aIter the banking business is being undertaken.
Through these three steps oI control and evaluation, the compliance to Shari`ah can be
assured.
6

Islamic Iinancial institutions (AAOIFI`), in this regard, have come up with a set oI
legal Iramework to ascertain that the product and operations oI Islamic banking comply with
Shari`ah principles. Shari`ah advisors, who are assigned to undertake the responsibility oI
ensuring Shari`ah compliance, have been associated with duties and responsibilities, which
encompasses the Iollowing aspects:
planning review procedures to be adopted by the Islamic banking and Iinancial
institutions;
executing review procedures and preparation, and also review oI working papers;
and
(3) Documenting conclusions and reports aIter the review has been completed.

In particular reIerence to the procedures to exercise Shari`ah review, there are various stages
that must be taken:
obtaining and understanding oI the management's awareness, commitment and
compliance control procedures Ior adherence to the Shari`ah;
reviewing contracts, agreements, etc;
ascertaining whether transactions are authorised by Shari`ah Board;
reviewing other inIormation and reports issued;
consultation/coordination with advisors, such as external auditors; and
Discussing Iindings with the management oI the bank.

The above procedures require the collaborative eIIorts oI the Shari`ah advisors with
other parties relevant to the banking business, such as auditors, legal advisors, and
compliance oIIicers and the management oI the bank. It also shows that the assurance oI
Shari`ah compliance is an inter division responsibility in which Shari`ah advisors cannot
work alone.


1

3.5 AUDIT PROGRAMS AND PROCEDURES
The challenge to carry out Shari`ah audit would be to develop a systematic and
thorough audit program. The list oI audit procedures Ior an entire Shari`ah audit is known as
a Shari`ah audit program. There will be an audit program Ior legal documentations, Ior
operational procedures, and so on. An audit program is designed to audit a particular area oI
the general scope oI the audit exercise. ThereIore, it is common to have several diIIerent
audit programs Ior the various departments and business activities.
Shari`ah audit programs can be developed to cover variety oI Islamic Iinancial
products and services such as:
(i) Islamic deposit and investment based on wadi`ah and mudarabah;
(ii) Islamic home Iinancing based on BBA and musharakah mutanaqisah;
(iii) Islamic motor vehicle Iinancing based on ijarah;
(iv) Islamic trade Iinancing based on murabahah, wakalah, etc ;
(v) Islamic personal Iinancing and credit card and many others. The Shari`ah
audit program also needs to be written in the language that can be easily
understood by the potential stakeholders. Their Ieedbacks are required aIter a
period oI testing the Shari`ah audit program in practice.
There are at least 3 phases oI the Shari`ah audit i.e. (1) Planning; (2) Examination;
and (3) Reporting. At the planning stage, the auditors need to understand the business
oI the Islamic Iinancial institutions including the nature oI contracts used Ior diIIerent
types oI Islamic Iinancial services. Then, the Shari`ah auditors need to identiIy the
appropriate techniques, resources and scope to develop the audit program. The audit
program will then identiIy the key activities to be undertaken the objectives oI each
activity and techniques to be used including sampling technique in order to achieve each
audit objective. Among techniques that can be utilized include examination oI papers,
interviewing, benchmarking, surveys, case studies, Ilow charting and others.
During the examination stage, the right audit techniques need to be identiIied
and deployed. The right techniques are needed to gather the required evidence both in
quality and quantity, to enable reasonable conclusions to be reached on the Shari`ah
compliance. There will be certain aspects oI the audit Iieldwork which will require
sampling techniques. A more detailed examination oI the documentations would be
1

necessary whether sampling methodology is used or not. OI massive importance during the
Iield work are the working papers and audit records. The main purpose oI retaining working
papers is to Iurnish systematic record oI work carried out during the audit and they also
represent a record oI inIormation and Iacts obtained to support the Iindings and
conclusions.

The Iinal stage, the reporting stage, embodies deliverables Irom the audit exercise.
This will include preparing the Shari`ah audit report, which is the communication oI the
auditor`s Iindings to users. Reports diIIer in nature, but all must inIorm readers oI the degree
oI correspondence between inIormation and established criteria.


3.6 SHARI`AH AUDIT IN SAUDI ARABIA

This is an example oI Shariah Audit in Al-Rajhi Al-MasraIiyyahLil Istitmar (Saudi Arabia)
Company. Shariah Audit Unit at Al-Rajhi Company was established on the 30
th
May 1993.
The unit will conduct audits at headquarters and branches based on the documents and
speciIic procedures that comply with Shariah principles and auditing. At the end oI this unit
will prepare a report, comments and recommendations on the audit results.
Among the main tasks oI this unit are:
a) Ensure that all activities, products, services and contracts complied with as approved by
haiah syariyyah
23
.
b) Review the examples oI contracts, agreements and procedures manual (standard
operating procedure) prior to implementation seeks to ensure that it is consistent with the
results haiah syariyyah.
c) Ensure that each branch to comply with and implement syariyyah haiah verdicts.
d) To ensure that companies comply with its objective as-siyasah as-syariyyah.
e) Conduct periodic audits Shariah whether at headquarters or branches.
I) Providing regular audit reports, making several reminders, comments or suggestions in
order to make improvement the Iollowing matters:

23
Shariah Supervisory Board
0

The things that are not allowed by haiah syariyyah.
ConIirmation sighah or contract in place beIore it is implemented.
The situation, matter or thing contrary to a Iatwa, or haiah syariyyah verdicts.
The company manuals.
syariyyah political policy oI the company.


4.0 SHARI`AH AUDIT AND GOVERNANCE

In principle, SSCs` prerogatives lie in Iive main areas: certiIication oI permissible Iinancial
instruments through fatwas (ex-ante Shariah audit), veriIication oI transactions` compliance
with issued fatwas (ex-post Shariah audit), the calculation and payment oI Zakat, disposal oI
non-Shariah compliant earnings, and advice on the distribution oI income or expenses
among the bank`s shareholders and investment account holders. Each SSC issues a report to
certiIy the Shariah compliance oI all Iinancial transactions. This report is usually an integral
part oI the institution`s annual report.
Shariah compliance audit is conducted to enable the SCC to express an opinion that
the operations oI IFIs are conducted in accordance with the fatwas, rulings and guidelines
issued by the SSC oI the IFI, the accounting standards oI the Accounting and Auditing
Organization Ior Islamic Financial Institutions (AAOIFI), national accounting standards and
practices, and relevant legislation and regulations applied in the country in which the IFI
operates. Shariah review is an examination oI the extent oI an IFI`s compliance in all its
activities, with the Shariah. This examination includes contracts, agreements, policies,
products, transactions, M&A, Iinancial statements, reports and circular.
Besides Shariah boards, most IIFS, particularly those complying with AAOIFI
standards, have established another internal Shariah review structure, generally in the Iorm
oI review units. These internal Shariah review units are independent Irom other departments
or are an integral part oI the Internal Audit and Control Department. The array oI tasks that
they perIorm is parallel to those oI audit departments reviewers generally use all necessary
powers to ascertain that all Iinancial transactions implemented by management comply with
SSC rulings. In some instances Shariah review units have exclusive competence on ex-post
monitoring.
1

These review units and SSCs Iace similar challenges, relating, in particular, to
independence and competence. First, like SSCs and internal auditors, internal Shariah
reviewers may be subject to a conIlict oI interest stemming Irom their employment status,
with their appointment and remuneration determined by management, and their role as
assessors oI managerial processes and decisions. The scarcity oI proIessionals with combined
Shariah knowledge and Iinancial skills also aIIects internal Shariah review departments.
Like SSC members, internal Shariah reviewers should be knowledgeable in Fiqh al-
Muamalat. Yet, as already observed, the scarcity oI such experts is likely to bear on the
quality oI Shariah reviews in IIFS. The issue may have greater implications in this case,
because Shariah reviewers would also be assigned to the training oI other employees on the
principles oI Fiqh al-Muamalat. Thus, their pronouncements and counsel could have
pervasive eIIects throughout their respective IIFS.
The actions oI SSCs and Shariah reviewers at the individual institutional level have
so Iar been relied upon to provide some degree oI comIort in assuring IIFS`s compliance with
Shariah. However, in line with the Ioregoing discussions, IIFS, national regulators and
international standard setters could Iurther address the issues oI: (a) independence oI the SSC,
(b) conIidentiality oI its activities, (c) competence oI its members, (iv) consistency oI
pronouncements and (d) disclosure oI Shariah decisions and audit.
The issue oI independence is common to Shariah review bodies. Prevailing
approaches to the regulation oI internal audit departments and external audit Iirms can
provide guidance on how to ensure integrity oI pronouncements on Shariah compliance. The
literature on internal audit independence pinpoints three Iactors that signiIicantly contribute
to the degree oI auditor independence: (i) clarity oI deIinition oI the auditor`s responsibilities,
(ii) the position oI the auditor within the organizational structure oI the institution, and (iii)
the reporting authority Ior audit results.
This would suggest that the independence oI both Shariah advisors and reviewers
could be enhanced by clearly deIining their responsibilities and powers in the articles oI
association oI the company or in a charter oI independence. Their powers would include the
authority to access all records and staII necessary to conduct the audit and to require
management to respond Iormally, and in a timely manner, to signiIicant adverse audit
Iindings by taking appropriate corrective action. Such powers should not include operational
tasks that could impair their independence.


Second, the organizational status oI internal Shariah bodies should be suIIiciently
articulated to permit the accomplishment oI audit responsibilities. This appears to be
Iundamental in the case oI Shariah review units that have to deal with large volumes oI
transactions in conducting ex-post assessments.
Third, the independence oI action oI SSC and Shariah reviewers and their ability to
withstand pressures Irom management can be assured only as long as Shariah bodies
Iunctionally report, and are accountable, to an individual or entity with suIIicient authority to:
(a) saIeguard their independence, (b) achieve a broad audit coverage, (c) ensure adequate
consideration oI audit reports, and (d) generate appropriate action on audit recommendations.
This role is generally perIormed by independent directors involved in the audit
committee. In the case oI those IIFS with concentrated shareholding, this role may be
assumed by minority shareholders` directors. However, Iollowing the practice oI external
auditors in some jurisdictions, Shariah reviewers may be required to report Iraud or
unexplained breaches oI rules directly to supervisory authorities. The latter option could be
diIIicult to implement in countries where supervisors may regard matters oI shariah
compliance to be outside their competence
24
.


24
WaIik Grais and Matteo Pellegrini. 2006. 'Corporate Governance and Shariah Compliance in Institutions
OIIering Islamic Financial Services. World Bank Policy Research Working Paper 4054, November.


5.0 CONCLUSION
With the rapid expansion oI Islamic fnance in Malaysia, the establishment oI a
comprehensive and holistic governance structures and processes should be continually
enhanced to remain dynamic and relevant at all times. The Shari`ah governance Iramework in
Malaysia has evolved with the changing market conditions, whereby the governance structure
at both the overall Islamic fnancial system and the individual Islamic fnancial institutions
have been enhanced and strengthened to ensure the observance oI Shari`ah. The eIIective
implementation oI the new Shari`ah governance Iramework will Iurther promote
stakeholders` confdence and the integrity oI the Islamic fnancial industry thereby reducing
Shari`ah non-compliance risks and contribute towards maintaining fnancial stability.
Furthermore, the scope oI Shari`ah auditing should be broader than the conventional
audit but it is limited to Iinancial statements audit. Most IFIs audit compliance oI products
only. Cost consideration oI extending scope, new entrants and thereIore need to compete by
developing new products, need to educate staII beIore scope expansion, perceived to be
diIIicult. Not in Iavor oI social and environmental or perIormance audit as considered not
within scope, lack oI awareness as workload may increase without adequate resources, proIit
motivated.



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