External Shariah audit in Islamic banks

The external Shariah audit is the latest development in the area of Shariah governance of the global Islamic banking industry. This is to maintain credibility of the Islamic banks' claim of Shariah compliance, which is often seen with scepticism by critics. Traditionally, full-fledged Islamic banks and also conventional banks with Islamic banking branches or windows appoint a Shariah supervisory board with the mandate to oversee Shariah compliance of the respective banks. An additional layer of assurance of Shariah compliance by an independent party will provide greater assurance to the Islamic banks' stakeholders.
In December 2016, the Central Bank of Kuwait issued 'Instructions on Shariah Supervisory Governance for Kuwaiti Islamic Banks', whereby the external Shariah audit is included as part of its comprehensive Shariah governance system. They have followed the footsteps of the central banks of Oman and Pakistan in including external Shariah audit as part of the Shariah governance framework of the Islamic banks. Several other jurisdictions, including Bahrain, are also likely to do the same. 
The international standard setter of Islamic financial institutions-the Accounting and Auditing Organisation for Islamic Institutions (AAOIFI)-recently issued an Exposure Draft specifically on external Shariah audit.
The responsibility of the external Shariah auditors is to form an opinion whether the products, contracts and conducts of an Islamic bank are in conformity with the resolutions passed by the bank's Shariah supervisory board and the Shariah board of the central bank, if there is any. The audit scope may also extend to compliance with international Shariah standards like the ones issued by the AAOIFI.
An external Shariah audit team must be comprised of a balanced number of experts in accounting, auditing, legal, Shariah and Islamic banking. The team members must possess an adequate level of experience and qualifications in the relevant fields. To maintain independence, the external Shariah auditors must not be employees of the bank or members of the bank's Shariah supervisory board or board of directors.  Reputable accounting and auditing firms can offer external Shariah audit service to the Islamic banks by teaming up with Islamic banking and Shariah experts. The service can be offered as part of the year-end financial statement audit or separately on a stand-alone basis. 
The AAOIFI and the Islamic Financial Services Board (IFSB) - another international standard setter of the Islamic financial institutions - already have included external Shariah audit as part of Shariah governance in their existing standards. While the IFSB has mentioned this as a recommended best practice that the Islamic banks can adopt, the AAOIFI made it an integral part of annual external audit of financial statements.    
The role of external Shariah auditors identified by the IFSB includes: annual Shariah compliance review; identifying significant breach in Shariah compliance, which has the potential to cause reputational risk; and if required by the supervisory authorities, reporting to them any material Shariah non-compliance identified when auditing the Islamic banks. However, following the philosophy of no one-size-fits-all, the IFSB has not detailed down the audit scope of external Shariah auditors. Instead, they have advocated the supervisory authorities to issue guidelines for external Shariah audit in their respective jurisdictions.  
In contrast, the AAOIFI has adopted an elaborate and prescribed approach towards external audit. The AAOIFI requires the external auditors of financial statements to have knowledge of Shariah rules and principles. This is to allow the external auditors to perform the dual role of auditing both financial statements and Shariah compliance. However, the external auditors are not required to have the same level of knowledge as that of a Shariah scholar, hence they are not expected to provide interpretation of Shariah rules and principles or to vet on the Shariah pronouncements of the Shariah supervisory board of the Islamic bank. 
Availability of human resource can be a challenge in implementing external Shariah audit. As done in other jurisdictions, this can be overcome by taking initiatives to train both the professional accountants and Shariah experts, to equip them with the necessary insights to conduct an effective external Shariah audit.
Globally, Islamic banking still faces many practical challenges and many issues are yet to be resolved due to various factors. Considering this, the purpose of implementing external Shariah audit should not be to find out the faults of the Islamic banks and take punitive actions against them, unless there is purposeful negligence towards Shariah compliance. Rather, the purpose should be identifying the areas and issues that hinder an Islamic bank from being fully Shariah compliant, and recommend improvement measures to the management and the regulators to gradually overcome the hindrances.  
The writer is a researcher at the International Shari'ah Research Academy for Islamic Finance (ISRA), Malaysia. He is also a member of the Association of Chartered Certified Accountants (ACCA) and AAOIFI Certified Islamic Professional Accountant (CIPA). 
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