AUDITING OF ISLAMIC BANKS – A PRACTITIONER’S PERSPECTIVE
KHALID ABDULLAH JANAHI
On- and Off-Balance Sheet Issues
In the context of Islamic banking, there are currently no established criteria for the accounting treatment of customer deposits in respect of which the associated risks and rewards are borne by the investor.
Accordingly, the dilemma surrounding the treatment of such deposits or investment accounts, i.e., whether these should be included within the Islamic bank’s balance sheet or reflected off-balance sheet has, for some time, been the focus of attention of eminent Islamic scholars, jurists and professionals. However, the debate continues and no consensus has as yet been reached on the uniform treatment of investment accounts.
Additionally, formal accounting standards have not as yet been developed specifically for Islamic banks and financial institutions and therefore there are no formal rules and regulations governing the accounting treatment of investment accounts. Th e resolution of this matter is not an easy one, since, as discussed below, there are a number of tenuous issues arising from both methods of treatment.
Certain Islamic banks include investment accounts within their balance sheet, whilst others reflect such accounts as funds under management off-balance sheet. Th e classification of investment accounts, either on- or off-balance sheet is, at times, also determined by the regulatory environment in which the Islamic bank operates. Th e differing treatment adopted by Islamic banks in respect of their investment thus renders compatibility and comparability of financial statements of individual Islamic banks difficult, if not meaningless. Th e issue becomes further compounded in the case of multinational Islamic financial institutions, where, for example, the holding company, which does not have regulatory constraints, classifies investment accounts off-balance sheet, whereas its subsidiaries or branches operate in countries which require investment accounts to be included within the balance sheet.
Islamic banks which distinguish between on- and off-balance sheet investment accounts apply the risk-and-recourse criteria in classifying such accounts as either on- or off-balance sheet. Funds managed by Islamic banks without risk and recourse to the bank are reflected off-balance sheet and not co-mingled with the bank’s own assets and liabilities.
On the other hand, if investors place funds with the Islamic bank without recourse to the customer, these funds and their ultimate investment are co-mingled with the bank’s own assets and liabilities.
Islamic banks that include all investment accounts, irrespective of the risk and recourse criteria, within their balance sheet, co-mingle such investment accounts with their own assets and liabilities. However, certain banks, which have assets with maturities in excess of five years, tend to designate such assets as their own assets, financed by shareholders’ funds and not by investment accounts.
Such banks, however, exclude from their balance sheets investor funds, which are managed on a non-discretionary or “restricted” basis. These funds are accordingly reflected off-balance sheet.
Issues Associated with Classification of Investment Accounts On-balance Sheet
Following are some of the issues that may arise if discretionary investment accounts are reflected within an Islamic bank’s balance sheet irrespective of the risk-and-recourse criteria:
a) The inclusion of all investment accounts within the balance sheet of an Islamic bank may have the effect of considerably inflating its balance sheet and may consequently give rise to capital adequacy issues. As a result. Islamic banks may be required to increase their capital base in order to comply with internationally stipulated capital adequacy ratios.
b) Certain countries have regulatory requirements that restrict banks from extending credit facilities to non-licensed deposit-takers in excess of a stipulated percentage of the bank’s capital and reserves.
Inclusion of investment accounts on the balance sheet may result in Islamic banks encountering difficulties in complying with these regulatory requirements, since it is not unusual for customer funds to be invested in individually significant financing transactions. Islamic banks may therefore have to reduce the size of individual credit exposures and/or increase their capital base to an appropriate level in order to comply with regulatory requirements.
c) Since the assets and liabilities of the bank’s managed funds are to be co-mingled with those of the bank, elaborate internal accounting records, systems and procedures may need to be developed and maintained in order adequately to segregate the bank’s own assets and liabilities from those of its managed funds. Care may also need to be exercised in circumstances where the bank is investing in certain transactions jointly with its customers.
Issues Associated with Classification of Investment Accounts Off-balance Sheet
a) Issues associated with borrowing from, and lending, to managed funds
Islamic banks that classify investment accounts managed on a “without risk and recourse basis”, off-balance sheet, designate such accounts as “managed funds” or “funds under management”. These banks may at times borrow from, and lend to, their managed funds, such transactions occasionally reaching significant proportions.
Before expanding upon the issues associated with borrowing from, and lending to, managed funds, it would be useful to understand the circumstances under which Islamic banks may borrow from, and lend funds to, their managed funds.
Borrowing from the bank’s managed funds may be undertaken under the following circumstances:
(i) Islamic banks are constrained from raising funds in the conventional money market and therefore, at times, may resort to borrowing available funds from their managed funds.
(ii) In certain situations, an Islamic bank invests in assets which are denominated in currencies in which the bank may not have available financing resources. In order not to expose itself to foreign currency, the bank may borrow the required currency from its managed funds.
(iii) Under certain other circumstances, the Islamic bank may be faced with a situation in which it has undertaken a relatively high-risk, off-balance sheet investment for which it may not have available investor funds for that particular type of transaction.
The Islamic bank may therefore borrow funds at its own risk from off-balance sheet investors who wish to invest in comparatively low risk, liquid instruments and invest these funds in the off-balance sheet, high-risk transaction.
The Islamic bank may lend to its managed funds under the following circumstances:
(i) When the bank enters into significant financing transactions on behalf of its managed funds, it may not be able initially to obtain sufficient off-balance sheet funds to invest in the transaction. Consequently, the bank may initially provide the funds to cover the financing shortfall and subsequently repay itself as and when off-balance sheet funds for the particular transaction become available.
(ii) From time to time, the Islamic bank may lend to its managed funds in order to cover temporary shortfalls arising from investor withdrawals.
(iii)The bank may also lend to its managed funds under the scenario envisaged in (iii) above, whereby it may borrow funds from off-balance sheet investors wishing to invest in low-risk, liquid instruments and invest the funds in relatively high-risk, off-balance sheet transactions.
The following issues may arise as a result of borrowing from, and lending to, managed funds:
(i) Borrowing from, and lending to, the bank’s managed funds may have the effect of inflating an Islamic bank’s balance sheet, particularly if such borrowing and lending reaches significant proportions. The resultant inflation of an Islamic bank’s balance sheet may have adverse effects on its financial position, particularly in relation to capital adequacy issues.
(ii) Borrowing by an Islamic bank from its managed funds may raise certain arm’s length issues, particularly in respect of the rate at which it borrows these funds from its off-balance sheet investors. Since Islamic banks are prohibited from receiving or paying interest, in respect of which comparative market rates are readily available, it may be difficult to compare the rates of return paid by the bank on borrowing from its managed funds with the rates of return which the investors would have obtained in respect of alternative Islamically acceptable instruments and it is almost certain that at some stage the practice may be challenged accordingly.
(iii) Islamic institutions which rely to an extent on obtaining funds from their off-balance sheet investors to finance their own assets may be exposed to potential liquidity problems, particularly in the event of a significant level of withdrawal of investors’ funds. In the event of non-payment of such debts, the institution will almost certainly encounter legal problems with respect to fulfilment of its fiduciary duties towards the investors.
(iv) On the other hand. Islamic banks may also face liquidity issues in respect of potentially long-term commitments arising from financing off-balance sheet transactions for which the Islamic bank may be unable to attract sufficient investor funds to replace its own initial financing. Such a situation may also be construed to prejudice the interests of the shareholders of the bank, who, in substance, predominantly bear the responsibility of supporting the bank’s managed funds in view of the Sharia restrictions placed on Islamic banks in respect of raising external sources of funds to finance their managed funds.
(v) As a corollary to (iv) above, Islamic banks may expose themselves to credit risks, which are disproportionate to their corporate size, and consequently may incur potentially large financing losses.
b) Fiduciary Issues
Other issues arising from the treatment of managed funds off-balance sheet may have certain fiduciary connotations. It would, therefore, be appropriate at this juncture to perhaps elaborate on the concept of “fiduciary” before dealing with the issues associated therewith.
One of the most important responsibilities of an Islamic bank is the diligent performance of its fiduciary duties and obligations to its investors. Investors place a great deal of trust in Islamic institutions, since they provide funds at their own risk and without recourse to the Islamic bank. Quite often the investor permits the Islamic bank to invest his funds at the sole discretion of the bank.
Islamic banks, therefore, have an onerous duty to their investors and are thus required to perform their fiduciary role to the best of their ability and in the best interests of their investors. The fiduciary responsibility of an Islamic bank extends to include the exercising of due care and diligence to ensure that customer funds are invested in accordance and in compliance with the Islamic Sharia.
Following are some of the potential fiduciary issues that may arise:
(i) Islamic banks, in order to remain competitive with other conventional banks, may attempt to provide their investors with returns on investments which appear to be consistently comparable to prevailing market rates. In order to achieve this, some Islamic banks may establish off-balance sheet provisions or reserve accounts. When managed investments yield returns in excess of market rates, this provision account may be credited with such excesses, thereby aligning actual yields with market-comparable rates of return.
During leaner times, when the yields on investment fall below market rates of return, the provision account may be utilised to release funds sufficient to cover the shortfall, thereby artificially inflating returns to investors. The use of such techniques may result in the Islamic bank potentially compromising itself in the performance of its fiduciai7 duties, since investors may be under the misconception that their funds are actually yielding market rates of return. The situation might deteriorate if the provision account had been fully utilised, thus resulting in a decline in actual rates of return. Such a situation may reflect adversely on the reputation of an Islamic bank and consequently may cause investors to doubt its competence as a mudarib.
Another related issue arises when provisions are required to be established in respect of non-performing, off-balance sheet investments. The creation of such provisions off-balance sheet may have an adverse impact on investor return, which, as a consequence, may tend to decline.
In order to avoid such a situation. Islamic banks may adopt the route of establishing equivalent provisions on-balance sheet and assign such provisions to cover the off-balance sheet shortfall in provisions. On the other hand. Islamic banks may be reluctant to establish even on-balance sheet provisions to cover such shortfalls.
The adoption of such a treatment has the effect of masking the true quality and performance of the assets in which customers have invested their funds and may therefore potentially result in the bank breaching its fiduciary duties.
The allocation of on-balance sheet surplus provisions to cover the off-balance sheet shortfall in provisions may have wider implications, since this treatment may effectively reduce returns to the shareholders of the bank and may therefore be detrimental to their rights and interests.
Another example whereby the interests of shareholders may be adversely affected is when managed funds are not performing satisfactorily and the bank, in its capacity as mudarib, waives its management fees in order to maintain adequate returns to its investors. This practice may have a negative impact on the profitability of the bank itself and consequently may prejudice the interests of its shareholders.
(ii) Islamic banks are under constant pressure to maintain adequate returns to both their shareholders and their investors. This may result in the bank resorting to the transfer of assets either from, or to, its managed funds, sometimes at values other than the fair value of the asset. This practice is undesirable and could result in a breach in the performance of the bank’s fiduciary duties as well as jeopardise the interests of both its shareholders and investors.
(iii) Islamic banks, as a rule, enter into standard agreements with their off-balance sheet customers. These agreements, which require to be approved by the bank’s Religious Supervisory Board, formalise the relationships between the bank and its investors and set out the terms and conditions, as well as the rights and obligations, of both the bank and the investor. These agreements generally protect the interests of the bank and tend to provide the bank with a free hand in the investment of funds, obviously without recourse to itself.
However, certain investors stipulate the parameters within which they wish to invest their funds and accordingly specify the type and tenure of the investment in which they wish to place their funds.
The Islamic bank is, therefore, under a fiduciary obligation to comply with the terms and conditions of the agreement, as well as any restrictive covenants which the investor may stipulate. Accordingly, if the Islamic bank failed to comply with the terms and conditions of the agreement, as well as with the specific instructions of the investor, it would breach its fiduciary obligations to its off-balance sheet investors.
(iv) Islamic banks offer a wide range of mudarabas in which off-balance sheet customers may wish to invest their funds. Each mudaraba is structured differently and its salient features include the tenure of the mudaraba and the underlying assets in which customer funds will be invested. The Islamic bank is therefore under a fiduciary obligation to its customers to ensure that funds are invested in accordance with the objectives and the tenure of the mudaraba. Fiduciary issues arise when customer funds are invested in a manner that may be inconsistent with the stated objectives and the tenure of the mudaraba.
c) Sharia Compliance Issues
Having discussed fiduciary issues which arise mainly from the relationship between the Islamic bank and its off-balance sheet investors, it would be logical to proceed to Sharia compliance issues which external auditors of Islamic banks may be required to deal with. However, it should be noted that Islamic banks are required to comply with the covenants of the Sharia, irrespective of whether investment accounts are classified on-or off-balance sheet.
External auditors may come across Sharia compliance issues, which may arise from the following situations:
(i) Post facto review by the Religious Supervisory Board
In the recent past. Islamic financial institutions have structured and developed innovative Islamic financial instruments and transactions bearing in mind the compliance requirements of the Sharia. These institutions strive to obtain the approval of their in-house Religious Supervisory Boards before entering into new transactions or marketing new instruments.
However, at times, due to commercial considerations, approval for these transactions and instruments may be sought on a post facto basis and, as a result, it may be too late to address Sharia compliance issues which may arise from the review of these transactions and instruments by the Religious Supervisory Board.
(ii) Inadequate or incomplete submissions to the Religious Supervisory Board
Financing instruments and transactions may be submitted to the Religious Supervisory Board in their legal and commercial forms without sufficient details and explanations in respect of the underlying substance of these transactions. Consequently, the instruments and transactions may be approved by the Religious Supervisory Board without a full appreciation of the Sharia issues and implications associated therewith. These issues and implications, therefore, come to light at a later stage, most often during the course of the external audit. Management, then, have to address these issues to the Religious Supervisory Board in order to have them regularised.
(iii) The concept of the Sharia audit
An Islamic bank found to be in breach of its fiduciary duties, or in contravention of the covenants of the Sharia could potentially expose itself to litigation from its investors as well as from third parties. The external auditor of an Islamic bank, therefore, has an unwritten duty to verify that the Islamic bank is properly discharging its fiduciary functions as well as complying with the covenants of the Sharia and is consequently required to report upon any breaches which may occur.
In order to ensure that Islamic banks comply with the requirements of the Sharia as well as perform their fiduciary duties and obligations, close co-operation is required between Religious Supervisory Boards and external auditors. Currently, there are no formal rules and regulations to ensure compliance in these respects.
The introduction of the concept of the “Sharia audit” would ensure Sharia and fiduciary compliance and would also assign formal responsibility to ensure such compliance.
The Sharia audit could be performed either by the Islamic bank’s external auditors or by its Religious Supervisory Board.
The performance of the Sharia audit by the bank’s external auditors would ensure that adequate independence was maintained. However, the external auditors would be required to have the necessary competence and expertise to deal with Sharia and fiduciary compliance issues.
On the other hand, if the in-house Religious Supervisory Board of an Islamic bank were to carry out a Sharia audit, it would have to be sufficiently independent in order to ensure an effective audit. Additionally, the Religious Supervisory Board would also require the requisite skills and expertise to address and resolve the resultant accounting issues and implications. However, it should be noted that some Islamic banks have “Sharia internal auditors” who are also members of the bank’s Religious Supervisory Board. These “auditors” monitor Sharia and fiduciary compliance on an on-going basis and report their findings to the Religious Supervisory Board.
Under either of the above scenarios, an Islamic bank’s Religious Supervisory Board and its external auditors will require to liaise closely with each other on an on-going basis in order to ensure that potential Sharia and fiduciary compliance issues, which the Islamic bank may be exposed to, are addressed and resolved on a timely basis.
The establishment of rules and regulations, as well as a code of practice, for the performance of a Sharia audit would go a long way in effectively ensuring that Islamic banks comply with the covenants of the Sharia as well as perform their fiduciary duties and obligations to their investors.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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