Auditing Standards under Shari'ah

AUDITING STANDARD UNDER SHARI’AH @ Shari’ah Compliance Mechanisms

By: Prof. Dr. Mohd. Ma’sum Billah masum2001@yahoo.com applied-islamicfinance@yahoo.com

006-019-3699542 006 019-2790542

Introduction

Annual audit is mandatory for every company, regardless of size, that is registered under the Malaysia Companies Act, 1965. For this reason, the term ‘auditing’ is most commonly associated with the statutory audit of a company’s accounts or financial statements as provided under the Act[1]. The Act also stipulates that an external independent auditor referred to in the Act as ‘approved company auditor’ must perform a company’s annual audit[2].

An audit of financial statements increases the reliability of financial information for users (e.g.: managers, investors, creditors and regulatory agencies). An auditor plays an important role in this process by providing objective and independent reports on the reliability of information.[3] By adding the audit function in the business environment, the users of the financial statements have reasonable assurance that the financial statements do not contain material misstatements or omissions.

The auditing profession is currently operating in a very dynamic environment as numerous forces are affecting the responsibilities and activities of the public accountants. Lately, critics have charged that the current audit has failed to meet user expectations (e.g.: Enron case). Therefore it is important for the profession to reflect to the nature and ethics of auditing in hope that by practicing ethically this will restore the confidence of the public.

The purpose of this term paper is to explore auditing under the Shari’ah guidelines. Perhaps the best solution to the above critics is by developing an auditing standard and guidelines with reference to the Shari’ah rulings.

Central Idea – Essence Of Auditing

Annual audit has been made compulsory for every company, which is registered under the Companies Act, 1965. In contrast, a business registered as a sole proprietorship or partnership is not required to audit its annual statements annually. In addition, the act also requires that company’s annual audit must be performed by an external independent auditor. This is where the credibility of an auditor is enhanced through the public reliance on the professionalism of audit profession.

Traditionally, the essence of auditing is to provide financial control and risk management. Auditor is deemed to work on the interest of shareholders, by which he/she need to carry out a systematic process with the objective of accumulating and evaluating evidences regarding the management assertions contained in the financial statements[4]. Hence, the auditor’s assurance depends on the level of collaborative evidences found during the audit process.

However, there’s an increase in audit need since the corporate sector expanded in parallel to the changes in business activity. Thus, audit provides not only control on financial aspects but furnishes top management with analysis, appraisals, recommendations and advices regarding the company‘s performance and profitability as well[5]. Moreover, it identifies business opportunities, which will then contribute to adding value cross the business. Hence, the most important aspect is that audit serves as a method of corporate governance since audit analytical procedures provide extensive control on the correspondence between management assertions, its authenticity and financial reporting framework.[6]

An Overview Of The Audit Function For A Financial Statement Audit

Evidence

Evidence

Assertions

Adapted from: Auditing and Assurance services in Malaysia, William F.Messier, Jr. Margaret Boh, McGraw Hill, Malaysia Edition, 2002 pg 4

Objective

Of Auditing

Auditing plays an important role in the process of providing objective and independent reports on the reliability of information. Generally, by adding the audit function in business activity the users of the financial statements have reasonable assurance that the financial statements do not contain material misstatement. Hence, the users can rely on the assertions made by manager, while making any judgments or decisions.

As mentioned earlier, auditing profession is operating in a very dynamic environment. There are many forces, which influence the responsibilities and activities of an auditor. Thus, complying to general accounting and auditing standards in Malaysia as well as rulings issued by Shari’ah Supervisory Board while expressing a reasonable assurance to the financial statements become the most important objective of an audit. Apart from complying with the aforesaid standards, there are some other standards, which an auditor has to keenly keep under observation; i.e.: National Accounting Standard & Practice and Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI).[7]

This is to ensure that the activities carried are not in breach of the Shari’ah requirements. Ultimately, an audit on financial statements enhances the reliability of management assertions and enables auditor to communicate his true and fair opinion on the financial statement to the interested users or parties.

Organisations Affecting The Financial Statement Audit

Approved Reporting standards on requirements auditing for listed co.

Approved Ethics accounting standards

Responsibilities Of An Auditor

Auditing plays an important role in the principal-agent relationship, by which auditor has a responsibility of determining whether the financial reports prepared by the manager conform to the approved accounting standards and complied with Companies Act, 1965. In general, audit is to enable the auditor “ to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework”. This is stated in ISA 20, “Objective and General Principles Governing an Audit of Financial Statements” (Para.

2)[8]. Thus, auditor’s opinion towards the financial statements adds credibility to the report.

Auditing requires auditor to engage in a systematic process of accumulating and evaluating evidences, which relate to the management assertions in the financial statements. Auditor’s reliance on collaborative evidences will influence the auditor’s opinion towards the financial statements.

Performing professional duties entails a lot of ethical procedural activities. It requires some commitments towards the responsibility, which is shouldered by an auditor. Serving clients to the best and offer management some valuable advices have been highlighted as the primary responsibilities of auditors. This includes a discussion on the current system used by the client. Auditor, who observes and evaluates the management system and control used, may provide value-added advices to his client. For instance, auditor may suggest the use of UBS or MYOB accounting software to the client who is using manual accounting system.

To maintain the perception that auditors are credibly reliable in their profession, they should observe ethical values in their duty apart from providing the highest level of trustworthiness, integrity and truthfulness. All information should be disclosed and communicated to the related parties so that it will not reflect any wrong judgments. In addition, auditors should avoid themselves from taking any advantages of the client’s confidentiality of information, either for personal or third party’s interest.

The question of complying with professional ethics depends on the principle of religious legitimacy. Responsibility towards God should be put as the priority in one’s consideration followed by responsibility towards society, profession, superiors, client and he himself. Commitment towards Allah generates good ethical appearance, diligent and proper work with high quality, which complies with Shari’ah rules and principles. This applies especially to the auditor, who is Muslim in religion. The emphasis on Shari’ah adherence provides good audit work through the sincerity while performing professional duties.

Seeking Allah’s satisfaction becomes a due to good job fulfillment by way of being conscious to the accountability before Allah and the Day of Judgment. For instance, a good auditor will refrain himself from committing any corruption or convicting to any fraudulent activities such as accepting gift, favor or hospitality that would influence his judgment on the assertions contained in the financial statement.

Moreover, auditor is responsible to preserve his independence in either fact (mind) or appearance. Auditor should maintain his mental attitude of being fair and portray his independency. The Malaysian Institute of Accountant (MIA) By-Law on Professional Independence stated that, “ A member of public practice should be and be seen to be free of any interest that might detract from objectivity”[9].

This indicates that independence can be in term of mind as well as appearance. The earlier type of independence includes freeing an auditor’s mind from any factors, which will influence or affect his professional judgment. While the later type of independent refers to holding official position which disqualifies a person from being auditor for the that particular company as stated in Section 9(1) of the Company Act, 1965[10]. Apart, holding financial interest or having family relationship in the client’s company will disregard one to be the auditor of that company.

In addition, auditor should adhere to general accounting and auditing standards in Malaysia while conducting any audit work, even up to the process of evaluating evidences and providing reasonable assurance to the financial statements. Besides, auditor should observe their competency and due care in the profession. It can be attained through updating his technical services and keeping his knowledge up to date. In conclusion, in the expand of audit profession, auditor should continuously be aware and observe his function and responsibility towards God, society, profession and client in providing a true and fair view on the financial statements through serving client to the best and with the most ethical conduct, which would not contravene to the underlying principles.

In short, auditor’s responsibilities include: a) Determine whether the financial reports prepared by the manager conform to the approved accounting standards and complied with Companies Act, 1965. b) Add credibility to the report of financial statements. c) Engage in a systematic process of accumulating and evaluating evidences, which relate to the management assertions in the financial statements. d) Serve clients to the best and offering management valuable advices. e) Observe ethical values in their duty apart from providing the highest level of trustworthiness, integrity and truthfulness. f) Put emphasis on Shari’ah adherence to provide good audit work through the sincerity while performing professional duties. g) Preserve his independence in either fact (mind) or appearance. h) Adhere to general accounting and auditing standards in Malaysia while conducting any audit work, even up to the process of evaluating evidences and providing reasonable assurance to the financial statements.

Conclusion: Auditor should continuously be aware and observe his function and responsibility towards God, society, profession and client in providing a true and fair view on the financial statements through serving client to the best and with the most ethical conduct.

Overview Of The Agency Relationship Leading To The Need For Auditing

Principal Contract Agent

Adapted from : Auditing and Assurance services in Malaysia, William F.Messier, Jr. Margaret Boh, McGraw Hill, Malaysia Edition, 2002 pg 16

Shari’ah Rulings – Ethical Principles

Islam is a comprehensive religion. It provides guidance in all aspects of life including economics, social, political and cultural. Accounting and auditing are parts of economy, which are professions that are required by Shari’ah as Fard kifayah. Both accounting and auditing provide the concept of fairness as they show where the resources have been allocated. The realization of this concept is closely related to the code of ethics for accountant in performing their professional duties and responsibilities.

From the Islamic point of view, the ethics of accountants and auditors depend primarily on the principles of Islamic faith and Shari’ah. As ethics are integral part of Islamic Shari’ah, therefore, Islam strongly emphasizes on that and considers them as one of the objectives of legislation. In short, Islamic Shari’ah provides some foundations of auditors and accountants’ ethics.

The major Shari’ah foundations of auditors and accountants’ ethics are as the followings: -

1. Integrity[11]

Integrity is an act of honesty and having strong moral principle. In Islam, integrity is highly valued as it governs all acts. It requires accountants and auditors to perform their duties and responsibilities with competency and adequacy. Allah said in the Qur’an,

[pic] “Truly the best of men for the thee to employ is the man who is strong and trusty”. (Surah Al- Qasas: 26)

2. Principle of vicegerency of humanity on earth[12]

Man is the best creation of God (Allah) and Allah bestowed us with mind (al- aql). Thus, we serve as vicegerent of Allah. We are entrusted to develop the earth. However, it is important to be aware that the supreme authority belongs to Allah, and that man’s ownership of property is not absolute. We must always observe the orders and prohibitions of Allah regarding property. Objectives in Shari’ah are pervasive and this includes property. Thus, auditors have big roles in making sure that property and funds are not squandered and wasted uselessly or used in prohibited matters (e.g. usurious transactions) or traded unjustly or by denying the rights established in it for Allah.

Anything that is prohibited in Shari’ah should not be given neither verbal nor documentary support in anyway whatsoever. Allah said in the Qur’an;

[pic]

“Behold, thy Lord said to the angles: “I will create a

vicegerent on earth”.

(Surah Al Baqarah: 30)

[pic] “It is He who halt made you (His) agents, inheritors of the earth”.

(Surah Al An’am: 165)

3. Sincerity[13]

The Qur’an and Sunnah stress that in what ever we do, we must have good intentions. Good intentions will lead to good performances and commitments in work as they also promote sincerity and avoid hypocrisy. Auditors are not to perform work because of fame, flattery and boasting. Instead, he should regard his work as a religious commitment as well as a performance of his professional duty. This will eventually turn his duty into a form of worship. This is line with the fundamental established in Shari’ah that good intention turns a habit into worship. Subsequently, the auditor becomes worthy of reward from Allah.

4. Piety[14]

Piety is referred to strong believe in religion. It means fearing Allah to protect one’s self from adverse consequences with rules of Shari’ah. This is done by observing Allah’s commandment and forbids oneself from His prohibitions. Therefore, auditor has to fear Allah in performing his duty especially when dealing with property as it diverts man’s attention and leads him into transgression. As Allah said:

[pic] “Let there arise out of you a band of people inviting to all that is good, enjoying what is right and forbidding what is wrong”. (Surah Al- Imran: 104)

Then the Holy Prophet also mentioned that,

“Fear Allah wherever you are, and follow the evil with good to obliterate it, and deal with people in good conduct”.

5. Righteousness and making one’s work perfect[15]

According to this principle, one should perform his duties that have been assigned to him in the best manner and that is to attain perfection in his work. This can be achieved through academic qualifications, practical experience and acquisition of religious knowledge. Therefore, auditors must always strive to acquire the above. Allah promotes this principle in:

[pic] “And spend of your substance in the cause of God, and make not your own hands contribute to (your) destruction; but do good, for God Loveth those who do good”. (Surah Al Baqarah: 195)

Besides that, Prophet also mentioned that;

“Allah likes when someone performs his work to do it perfectly and Allah has described righteousness in everything”.

6. Allah-fearing conduct in everything[16]

This implies that Allah is constantly watching the acts of His servants. Therefore, it is Allah that the auditors should be afraid of regardless of the opinion of other people, which includes his superiors. This principle is absolute and will never change from time to time. Hence, auditors should always practise self-monitoring. And this may weaken unless it is tied to both faith and feeling that one is being observed by Allah. Allah said;

[pic]

‘Allah ever watches over you”

(Surah Al Nisa’: 1)

[pic]

For verily He knoweth what is secret and what is yet

more hidden”

(Surah Taha: 7)

7. Men’s accountability before Allah[17]

Since Allah is observing all the acts of auditors, therefore, he will be accountable to Him on the Day of Judgement for all his deeds. Thus, auditors should always be aware and to avoid doing things that may incur Allah’s punishment. The auditor should always remember that he is accountable before Allah, and before his society, profession, superiors and finally before himself.

[pic] “Then shall anyone who has done a atom’s weight of good, see it. And anyone who has done an atom’s weight of evil, shall see it”

(Surah Al Zalzalah: 7-8)

Shari’ah’s Code Of Ethics In Auditing

Auditing is one of the branches of accounting. It is associated with examination of accounting data. It is a professional service which people put high reliability on. Hence, audit needs to be performed in the most ethical manner since the auditors provide reasonable assurance to the company’s stakeholders. Therefore, based on the ethical principles highlighted in the Qur’an and Sunnah, the following ethical principles for accountant and auditors are derived[18]: -

1. Trustworthiness Accountants and auditors should be trustworthy and honest in conducting their professional duties. However, they are said to be trustworthy by conducting their responsibilities with high degree of integrity and honesty. One way to show their integrity is by protecting client’s interest, which is related to the confidentiality of the information of the clients. For example; they cannot use such confidential information for their personal gain and third party. Besides that, the auditors have to present and provide factual and truthful report so that others can rely on the information while making judgement and decision.

2. Legitimacy Besides being truthful and honest, auditors also have to comply with certain legal requirements and procedures including the Shari’ah rules and principles. They have to act and conduct according to the guidelines of Shari’ah principle. Moreover, they also have to comply with standards provided by professional bodies such as MASB.

3. Objectivity In conducting an audit work, auditors have to be objective. They have to perform their professional duties in fair, impartial and unbiased ways. They also have to be free from any conflict of interest in order to ensure their independence. Since independence is a fundamental characteristic and key point of auditing profession, auditors should be independent both mind and appearance. If the auditor is a member of the board of directors of the auditee company, then, he should not perform or conduct any audit work for that company.

This is because he could be involved in providing bias information, as now he is no longer an independent party.

4. Professional competence and diligence. Since auditing is a professional service, it should be conducted in professional ways. Therefore, auditors should show their credibility in realizing these duties. To ensure work are done in proper manner, they should be professionally competent and well- equipped in carrying out the task assigned. Hence, professional competence can be achieved or obtained through ways like formal education, training, experience and professional education. Besides that, they have to be due diligent in discharging their responsibilities as they are not only responsible to the stakeholders but ultimately also to Allah the Al-Mighty.

5. Faith-driven conduct Auditors should behave and conduct his duties in line with the faith values derived from Shari’ah rules and principles.

Auditor’s Report

The auditor’s report is the expression of opinion of the auditor whether the financial statements audited have been prepared in accordance with the auditing standards and applicable accounting principles. It is also important to note whether the financial statements comply with the statutory requirements.

The auditor’s report consists of:[19]

Title E.g. Reports of the Auditors

Addressee The report should be addressed mainly to the shareholders/members of the company audited (as required by the engagement and laws).

Introduction The report needs to identify the pages of financial statements that have been audited as well as the date and period covered. There should also be statements regarding the responsibilities of the management and the auditors. The management’s responsibility is towards the preparation of the financial statements. Meanwhile, the auditor’s responsibility is to express an opinion on the financial statements.

Scope Paragraph The reports should narrate that the audit was conducted in accordance with the relevant auditing standards and accounting principle, which do not contravene the Shari’ah Rules, and Principles. The report should also indicate that the audit was planned and performed to obtain reasonable assurance and not an absolute one. The audit also evaluates the overall financial statement presentation.

Opinion Paragraph The auditor’s report must state the auditor’s opinion as to whether the financial statements give a true and fair view in accordance with the appropriate standards that do not contravene with the Shari’ah rules and principles and statutory requirements.

Auditor’s Address and Signature The report should name the audit firm, personal name of auditor and address of the audit firm. The report should be signed.

Date of Report The auditor should date the report at the date when the audit was completed. The date should not be earlier that the date on which the statements are signed or approved by management.

Overview Of The Audit Process

Should be done in line with the Shari’ah Rules & Principles

Applications

Application of ethical conduct based on the principle of trustworthiness

An auditor should refrain oneself from engaging in any activity that would jeopardize the attainment of the institution’s religious and ethical objective. Therefore, an auditor should present and communicate favourable as well as adverse information honestly with complete transparency. He should not disclose confidential information acquired in the course of performing professional duties unless required to do so by the law. He also should not use the information acquired in the course of his duties for the advantage of himself or third parties.

Application of ethical conduct based on the principle of religious legitimacy

An auditor should always remember his responsibilities towards Allah, and towards his society, profession, superior and himself. Therefore, it is his responsibility to verify the religious legitimacy of everything relating to his duties. He should be aware of Shari’ah rules and principles relating to jurisprudence of financial transactions. Thus, he should receive formal, adequate training in jurisprudence of financial dealings. He must make sure that he performs his duties in conformity with such rules and principles. Anything that is not in conformity with Shari’ah should be considered illegitimate.

Application of ethical conduct based on the objectivity principle

An auditor should be independent in fact as well as appearance. Therefore, he should not involve himself in a situation whereby there is a conflict of interest. This is because it will threaten his judgement in expressing his opinion. He should also avoid from being influenced by others to ensure he could present information truthfully. In his course of duties, he should refuse any gifts or favours. Contingent fees (defining the fees as a percentage of the income number) should also be avoided as it might affect the independence and objectivity of the auditors.

Application of ethical conduct based on the professional competence and diligence principle.

An auditor has a responsibility to possess an appropriate level of academic and professional competence. He should uphold his competence by going through skills development constantly and keeping himself updated with the new developments in the auditing as well as accounting profession. Most importantly, he should acquire sufficient working knowledge of Shari’ah aspects relating to financial transactions.

Application of ethical conduct based on the principle of faith-driven conduct.

An auditor’s behaviour should always be in line with religious values derived from Shari’ah rules and principles. Particularly, he should consistently do self-monitoring (that is always be aware of the existence of Allah). He should be conscious that he is accountable before Allah on the Day of Judgement. Therefore, in his course of duties, he should be seeking Allah’s satisfaction and not to submit to the pressures of others. He also should show love and brotherhood as well as be merciful to the rest of the staffs and whomever he deals with.

Recommendations

Lately, critics have charged that the current audit has failed to meet user expectations. It is important for the profession to reflect to the nature and ethics of auditing in hope that by practicing ethically this will restore the confidence of the public. In order to uphold the integrity of auditors, a separate body should govern ethical principles governing the auditor’s professional responsibilities. Therefore, the best solution is to form the Shari'ah Supervisory Board to govern the ethics of auditors. The ethical principles that should be included are:

a) integrity b) trustworthiness c) confidentiality d) professional behaviour e) honesty f) righteousness g) fairness h) objectivity i) professional competence j) due care k) independence etc

The question of complying with professional ethics depends on the principle of religious legitimacy. Responsibility towards God should be put as the priority in one’s consideration. Commitment towards Allah generates good ethical appearance, diligent and proper work with high quality, which complies with Shariah rules and principles.

The emphasis on Shari’ah adherence provides good audit work through the sincerity while performing professional duties. Seeking Allah’s satisfaction becomes a due to good job fulfillment by way of being conscious to the accountability before Allah and the Day of Judgment.

Conclusion

Annual audit is mandatory for every company, regardless of size, that is registered under the Malaysia Companies Act, 1965. An auditing plays an important role in this process by providing objective and independent reports on the reliability of information.

Traditionally, the essence of auditing is to provide financial control and risk management. Auditor is deemed to work on the interest of shareholders, by which he/she need to carry out a systematic process with the objective of accumulating and evaluating evidences regarding the management assertions contained in the financial statements.

However, there’s an increase in audit need since the corporate sector expanded in parallel to the changes in business activity. Thus, audit provides not only control on financial aspects but furnishes top management with analysis, appraisals, recommendations and advices regarding the company‘s performance and profitability as well. Thus, complying to general accounting and auditing standards in Malaysia as well as rulings issued by Shari’ah Supervisory Board while expressing a reasonable assurance to the financial statements become the most important objective of an audit.

This is to ensure that the activities carried out are not in breach of the Shari’ah requirements. Ultimately, an audit on financial statements enhances the reliability of management assertions and enables auditor to communicate his true and fair opinion on the financial statement to the interested users or parties. To maintain the perception that auditors are credibly reliable in their profession, they should observe ethical values in their duty apart from providing the highest level of trustworthiness, integrity and truthfulness

----------------------- [1] Companies Act 1965, Malaysian Law Journal, 1999 Reissue, 1999, Pg 61 [2] Ibid, Pg 59 [3] Auditing and Assurance services in Malaysia, William F.Messier, Jr. Margaret Boh, McGraw Hill, Malaysia Edition, 2002, Pg 3 [4] Auditing and Assurance services in Malaysia, William F.Messier, Jr. Margaret Boh, McGraw Hill, Malaysia Edition, 2002, Pg 14 [5] Accountability, Corporate Social Reporting and the External Social Audit, Gray, R., D. Owen and K. Maunders (1991), iC.R. Lehman (ed.) Advances in Public Sector Accounting, Vol 4., 1991, pg 21.

[6] OP. cit, Pg 23 [7] Accounting and Auditing Organization for Islamic Financial Institutions, 1999, Pg 16 [8] International Standards on Auditing (ISA), ISA 20, Para 2 [9] Malaysian Approved Standards on Auditing, Malaysian Institute of Accountants, 1998 [10] Companies Act 1965, Malaysian Law Journal, 1999 Reissue, 1999, Pg 61 [11] Accounting and Auditing Organization for Islamic Financial Institutions, 1999, Pg 5 [12] Ibid, Pg 5 [13] Accounting and Auditing Organization for Islamic Financial Institutions, 1999, Pg 6 [14] Ibid, Pg 6 [15] Accounting and Auditing Organization for Islamic Financial Institutions, 1999, Pg 7 [16] Ibid, Pg 7 [17] Accounting and Auditing Organization for Islamic Financial Institutions, 1999, Pg 7 [18] Accounting and Auditing Organization for Islamic Financial Institutions, 1999, Pg 8-9 [19] Auditing and Assurance services in Malaysia, William F.Messier, Jr.

Margaret Boh, McGraw Hill, Malaysia Edition, 2002, Pg 503

-----------------------

Shareholders

Provides a financial report

Manager

Verifies the correspondence of the financial information in the report to the contract

Auditor

Issue audit report

Management

Auditor

Business Transactions

Obtain Evidence

Prepare Financial Statements

Test assertions to criteria

Users

Issues audit report

Malaysian Accounting Standards Board

Malaysian Institute of Accountants

Shari’ah Supervisory Board

Securities of Commissions

Financial statement audit

Financial statement users

Client acceptance & retention

Establish the terms of the engagement

Plan the audit

Consider internal control

Consider substantive tests

Complete the audit

Issue audit report