2-DAY COURSE ON ISLAMIC BANKING AND CAPITAL MARKET: PRODUCTS & INSTRUMENTS 22 -23 MAY 2007

1. 2-DAY COURSE ON ISLAMIC BANKING AND CAPITAL MARKET: PRODUCTS & INSTRUMENTS22 -23 MAY 2007 Dr. Syed Musa Alhabshi Principal Consultant Amanie Business Solutions Sdn Bhd Accounting, Auditing and Governance for Islamic Financial Services Suite A-D, 14th Floor, Bangunan Angkasa Raya Jalan Ampang, 50450 Kuala Lumpur Tel:  +603 2034 2545 Fax: +603 2034 2546 http://www.amanie.com.my

2. 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

3. FINANCIAL REPORTING FRAMEWORK USER GROUPS SHARI’AH PRINCIPLES ISLAMIC FINANCIAL INSTITUTION FINANCIAL REPORTING OBJECTIVES ACCOUNTING PRINCIPLES

4. 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

5. 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.

6. 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

7. 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.

8. Accounting Standards • General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial Institutions • Murabaha and Murabaha to the Purchase Orderer • Mudaraba Financing • Musharaka Financing • Disclosure of Bases for Profit Allocation between Owners' Equity and Investment Account Holders and Their Equivalent • Salam and Parallel Salam • Ijarah and Ijarah Muntahia Bittamleek • Istisna'a and Parallel Istisna'a • Zakah • Provisions and Reserves • General Presentation and Disclosure in Financial Statements of Islamic Insurance Companies

9. Accounting Standards • Disclosure of Bases for Determining and Allocationg Surplus or Deficit in Islamic Insurance Companies • Investment Funds • Provisions and Reserves in Islamic Insurance Companies • Foreign Currency Transactions and Foreign Operations • Investments • Islamic Financial Services offered by Conventional Financial Institutions • Contributions in Islamic Insurance Companies (New) • Deferred Payment Sale • Disclosure on Transfer of Assets (New) • Segment Reporting  (New)

10. Auditing Standards • Objective and Principles of Auditing • The Auditor's Report • Terms of Audit Engagement • Testing by an External Auditor for Compliance with Shari'a Rules and Principles by an External Auditor • The Auditor's Responsibility to Consider Fraud and Error in an Audit to Financial Statements (New)

11. Governance Standards &Code of Ethics Governance Standards • Shari'a Supervisory Board: Appointment, Composition and Report • Shari'a Review • Internal Shari'a Review • Audit and Governance Committee for Islamic Financial Institutions Ethics • Code of Ethics for Accounting and Auditors of Islamic Financial Institutions • Code of Ethics for the Employees of Islamic Financial Institutions

12. Nature of Financial Reporting Financial Accounting Statements No. 1 & 2 • Objective of Financial Accounting of Islamic Banks and Financial Institutions • Emphasizes the importance of contractual rights and obligations and Shari’ah compliance • Concepts of Financial Accounting for Islamic Banks and Financial Institutions • Addresses the issue of prohibited earnings & expenditures as well as ensuring reasonable rates of returns to depositors

13. 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.

14. 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 principles • measurement principles • disclosure & presentation principles

15. Role of Financial Reporting & Accounting Information FINANCIAL REPORTS Economic Decision Usefulness Reporting Accountability Relevance Reliability Economic Agent Economic Consequences Stewardship function Representational Faithfulness

16. 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

17. Information for Decision Making • Legitimate Decision • Lawful Transactions • fulfilling contractual conditions and requirements • Lawful goods & Services • nature, type and purpose of goods and services • Competitive price & fair value • market mechanism and market structures • Equitable Distribution • reasonable rates of returns to shareholders and depositors

18. 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.

19. 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

20. Impact of Shari’ah Contractual Conditions of Transactions on Reporting Process Distinguishing contractual relationships render a distinct reporting process to address the lacunae of entity-based reporting

21. Types of Financial Statements • Balance Sheet • Income Statement • Statement of Owner’s Equity • Cash Flow Statement • Statement of Restricted Investments • Statement of Sources & Uses of Zakah • Statement of Sources & Uses of Qard Fund

22. 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

23. Shariah Governance: By Whom? For Whom? REGULATORS SC & BNM SUPERVISION & SHARIAH ADVISORY COUNCILS INVESTMENT ACCOUNT HODERS & SHAREHOLDERS IFI SHARIAH SUPERVISORY BOARD & SHARIAH COMMITEE EXTERNAL AUDITORS BOARD OF DIRECTORS AUDIT & GOVERNANCE COMMITEE

24. 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

25. 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.

26. Duties & Responsibilities of Shariah Committee • Advise BOD on business operations to be Shariah compliant • Endorse Shariah Compliance Manual • Endorse & Validate pertinent documents • Assist related parties (such as auditors, legal counsel, consultants) that seek advice on Shariah Matters • Advise IFI to seek clarification or endorsement of unresolved or endorsed by SAC • Provide written Shariah Opinion • Assist SAC on reference for advice • Shall report to the BOD (act as independent body of IFI)

27. Shariah Compliance Behavior

28. 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.

29. 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

30. 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)

31. 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

32. Audit Report & Shari’a Opinion • Independent samples and tests conducted by both auditor and SSB Audit opinion • the financial statements as a whole are free from material misstatement based on accumulated audit evidence, refers to the whole audit process and comply with Islamic Shari'a Rules and Principles

33. 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 …

34. 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

35. 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

36. Reporting & Communication Channels Audit & Governance Committee Express Shariah Opinion on IFI True & Fair Opinion Shariah Board/Shariah Committee Internal Audit External Auditor Formulate Policy Shariah Endorsement ATTEST Shariah Review INTERNAL CONTROL SYSTEM Islamic Financial Institution Testing for Shariah Compliance Internal Shariah Review

37. 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).

38. 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

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

40. 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

41. 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

42. Anatomy of Asset Risk Exposures Financing or Investment?

43. Income Distribution to PER, IRR, SHF & IAH Income Attributable to IAH Income distributed to Shareholders & Investment Account Holders Based on PSR Less: Transfer of Profits to IAH PER Less: Transfer of Profits to SHF PER Income Distributable to IAH Income Attributable to SHF & Other Deposit funds Less: Transfer of Profits to IAH IRR Return on Unrestricted IAH Return on Equity

44. ANATOMY OF FUNDING RISK EXPOSURES

45. 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

46. FINANCIAL REPORTING, AUDITING & GOVERNANCE FRAMEWORK AUDIT COMMITTEE SHAREHOLDERS AAOIFI IFSB INVESTMENT ACCOUNT HOLDERS SHARI’AH SUPERVISORY BOARD ISLAMIC FINANCIAL INSTITUTION OTHER STAKEHOLDERS GOVERNANCE COMITTEE REGULATORY AUTHORITIES

47. Multi-Disciplinary Perspectives on Role of Shariah Review, Audit & Governance Prudential Guidelines & Standards Promulgated By IFSB to Ensure Risk Management & Disclosure Framework Related to Capital Adequacy, Corporate Governance & Market Discipline Shari’ah Goals, Opinions & Rulings Propounded by Shari’ah Scholars Financial, Statements, Reports and other Useful Information Required by AAOIFI & Relevant International Financial Reporting, Auditing & Governance Standards SHARIAH COMPLIANCE BEHAVIOR Regulatory requirements by Central Banks, Monetary Authorities or Supervisory Agencies

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

49. THANK YOU & WASSALAM