Chapter 4

Tools and Techniques to Identify Incongruence in Sharī`ah Compliance

4.0. INTRODUCTION

The nature of Sharī`ah non-compliance risk refers to the structure of the product, the terms, the conditions governing the contracts/products/services, and the executions of the legal documentation/products that represent the stage of implementation. There are other related aspects that are within the Sharī`ah non-compliance scope such as marketing collateral, telemarketing, broadcasting, information technology infrastructure, and systems.

With regards to the means and instruments, there are a few that can be used in order to identify incongruence in Sharī`ah compliance.

4.1. TOOLS

4.1.1. Accounting/Islamic Financial Reporting Technique

Accounting is a very important instrument to identify incongruence with Sharī`ah by using different accounting tools or techniques such as the financial data, balance sheet, and so forth. The prohibited elements in Sharī`ah can be easily identified through this process. Accounting as an instrument along with the technique used can bring Sharī`ah compliance to the entire financial transactions and business activities that cover areas as follows:

• Accounting represents an official record of a financial transaction and traces the movement of assets and the type of payment at each stage of a transaction.
• Tracing and recording the different lawful and legitimate business activities.
• Allocating valid contracts and profit that exclude interest and uncertainty of contract conditions.
• Mutual consent with an ascertained degree of trust through transparency, fairness of representation, and equity between parties in terms of counter value or distribution.
• The balance sheet will show the asset and liability of the contracting parties and classify them as financial and non-financial transactions along with the source of funds and their use in the proper category that enables a proper examination.

4.1.1.1. Financial Statement/Balance Sheet (Asset and Liability)

The statement of net worth or balance sheet presents a snapshot of the client’s financial position at a particular date. It shows how the assets of the client are financed, which is either from his own savings and accumulations or from outside sources such as banks. The net worth section is the equity ownership the client possesses over his/her assets at that date. The balance sheet is divided into three broad sections as follows:

4.1.1.1.1. Assets

The assets section shows what the client possesses. The assets include:

• Liquid assets (cash and marketable securities)
• Certificates of deposit and Islamic bonds
• Investment assets (stocks, stock mutual funds, real estate, gold)
• Personal assets (auto, jewelry, art)
• Deferred assets (pension plan, Takaful coverage, and inheritances)

Below are more details about the aforementioned types of assets:

4.1.1.1.2. Liabilities

The liabilities section shows what the client owes, which includes the following:

• Short-term debt-financing credit cards
• Intermediate-term debt financing (car)
• Lone-term debt financing (mortgages)

The liabilities section is the “minus side” of the client’s statement of net worth. It provides a listing of items that will result in an outflow of financial resources in the future.

MAIN CATEGORIES OF LIABILITIES There are two main categories of liabilities:

ANALYZING LIABILITIES Liabilities show the debt or the future financial obligation. They determine the level of the debt and its Sharī`ah compliance according to the tolerable level of debt. Debt financing due between one and five years, such as auto debts, and debt financing due in more than five years, such as mortgages, are long-term debt financing. The liabilities will show the portfolio of debt that one individual or entity may have. The analysis of the liability will show whether debt portfolio is Islamic debt or otherwise.

4.1.1.2. The Cash-Flow Statement

The cash-flow statement provides information about the movement of cash. It provides inflows and outflows of cash.

The cash inflow and outflow provide details about the source of income, that is, where the cash is coming from. This will help to determine the Sharī`ah compliance status of the cash. The cash outflow also shows where the money is going in trading the process of spending and disbursement. This also helps to give the status of the Sharī`ah compliance of the usage. In short, the cash flow traces the source of fund and the channel of spending, where Sharī`ah compliance can be granted or Sharī`ah non-compliance risks can be identified.

4.1.2. Legal Technique

Legal technique as a form of assessment and examination plays a very significant role in identifying incongruence with Sharī`ah. The legal approach is based on the examination of the structure of the contract and the assessment of the product terms and conditions to ensure Sharī`ah compliance status. The legal assessment includes the terms and conditions stipulated in the agreement and the way the contract is executed, respectively. The careful examination of the clauses in the contract will identify any potential violation of Sharī`ah rules while providing an assurance that the process is consistent between Sharī`ah and legal requirements.

Islamic finance rides on some acts, legal requirements, and guidelines. The non-compliance of the transaction with the legal acts and regulation will trigger Sharī`ah non-compliance risk because those rules and regulations are integrated and based on Sharī`ah requirements.

4.1.3. Sharī`ah Technique

4.1.3.1. Sharī`ah Parameter References (SPR) of Bank Negara

The parameters issued by Bank Negara are regarded as the main reference for the Islamic financial institutions. These references are known as SPR, and they are used in structuring the products and services of the Islamic financial institutions. The rules and principles along with the terms and conditions are derived from these principles endorsed by the Sharī`ah Advisory Council of Bank Negara. The Sharī`ah reference parameters as of now are as follows: Murabahah, Ijarah, Mudarabah, Musharakah, and Istisna. Any deviation from these references is an indication of Sharī`ah non-compliance. However, these parameters are in the process to be converted into Sharī`ah standards.

4.1.3.2. Resolutions of Sharī`ah Advisory Council (SAC) of Bank Negara

The resolutions of the Sharī`ah advisory of Bank Negara along with their guidelines and circulars establish a status of Sharī`ah compliance. Any deviation on their resolution will trigger a Sharī`ah non-compliance risk.

4.1.3.3. Islamic Ruling (Resolutions of the Sharī`ah Committee of the Bank)

The resolutions of the Sharī`ah committee of the IFI pertaining to products and services represent the Sharī`ah compliance status that the IFI should subscribe to. The Islamic financial institution should carry out the banking activities according to the resolutions of the Sharī`ah committee. Failing to do so, Sharī`ah non-compliance will be triggered. The resolutions can identify incongruence in legal documentation from Sharī`ah perspective. This instrument is used by the Sharī`ah board to examine the documents of the present product to eliminate any element that is not consistent with Sharī`ah rules and principles. The resolutions will be the point of reference used by relevant division of Sharī`ah audit and Sharī`ah review in their audit and review through the whole process.

4.1.3.4. AAOIFI Sharī`ah Standards

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Sharī`ah standards represent a benchmark for Sharī`ah compliance because AAOIFI has a global representation and most of the experts in Islamic finance are part of the global institution that issue standards in Sharī`ah, for accounting, auditing, governance, and code of ethics. The AAOIFI standards are not binding; hence every jurisdiction has the option to subscribe to the AAOIFI standards or not. However, when there is no resolution in specific jurisdiction on a particular issue in Islamic finance, or the jurisdiction is silent about it, AAOIFI becomes the benchmark and the proper reference to refer to. In some jurisdictions, such as Bahrain, Syria, Jordan, and Sudan, their respective authorities have enforced the AAOIFI standards in their market. Hence, any deviation from AAOIFO standards triggers the Sharī`ah non-compliance risk.

4.1.3.5. Islamic Ruling (Fatwa and Resolutions at the International Level)

The resolutions that have been issued at the international level such as resolution of the international fiqh academy represent a sound reference for Sharī`ah compliance status because of the global acceptance and international endorsement. Hence, these resolutions and fatwa can guide the IFI toward a Sharī`ah compliance status.

4.1.3.6. Sharī`ah Screening

In 1995, the SC’s SAC established the methodology to undertake Sharī`ah screening process for listed companies. The methodology comprises quantitative and qualitative assessments. The Sharī`ah screening is an appropriate tool to identify a Sharī`ah non-compliance risk. The methodology of the Sharī`ah Advisory Council of Malaysia on stock screening enables it to monitor the Sharī`ah non-compliance risk within the specific tolerated benchmark.

According to the Securities Commission of Malaysia, the focus of the examination will be on the primary activities of a company with regard to the goods and services offered. This is because these primary activities bring returns for the companies that are subsequently distributed to its shareholders. Such activities need to be identified to see whether they are consistent with Sharī`ah principles. If they are not, then that particular company’s securities are excluded from the list of Sharī`ah-compliant securities.

• The criteria can be used to analyse whether securities of a particular company can be deemed Sharī`ah compliant or not.
• The decision was made on four basic primary criteria to analyse listed securities.
• These criteria were established after referring to the sources of Sharī`ah and general Sharī`ah principles.
• The criteria were formulated according to the activities of a particular company.1

First Criterion: Riba as the Primary Activity of the Company The primary activity of the company is based on riba as practised by conventional financial institutions, including commercial banks, merchant banks, and finance companies. This criterion is based on the Quranic verses 275–276 in Surah al-Baqarah:

Those who devour riba will not stand except as one whom the evil one by his touch hath driven to madness. That is because they say: “Trade is like riba,” but God hath permitted trade and forbidden riba. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for God to judge; but those who repeat (the offence) are Companions of Fire: they will abide therein (forever). God will deprive riba of all blessing, but will give increase for deeds of charity: for He loveth not creatures ungrateful and wicked.

Second Criterion: A Company Whose Primary Activity Is Gambling This criterion will include companies running casinos, gaming, and others. This criterion is based on the Quranic verses:

O you who believe! Intoxicants, and gambling, (dedication of) stones, and (divination by) arrows, are an abomination of Satan’s handiwork: eschew such (abomination) that ye may prosper.

Third Criterion: The Primary Activity of a Company Is the Production and Sale of Goods and Services That Are Prohibited in Islam This criterion will include the following:

• Processing, producing, and marketing of alcoholic drinks.
• Supplying non-halal meat like pork, and so forth.
• Providing immoral services like prostitution, pubs, discos, and so forth.

Fourth Criterion: Gharar (Uncertainty) This criterion includes companies whose primary activity is gharar (uncertainty), such as conventional insurance trading. The basis of the prohibition on gharar is a hadith of the Prophet s.a.w.:

Verily, the Prophet s.a.w. prohibits gharar transactions.

The Product Approval of Securities in Mixed Companies The methodology used in the approval of mixed securities is based on setting a specific benchmark to measure a certain degree of the prohibited elements. This Sharī`ah position takes into consideration umum al balwa and ghararyasir, which can justify listing the company with a mix of permissible and prohibited elements. According to the Securities Commission Sharī`ah Advisory Council, companies with a certain degree of prohibited elements that do not exceed the benchmark set by the SAC can be included in the list of Sharī`ah-compliant securities.2

Quantitative and Qualitative Approach in the Screening Process in Capital Markets There are two methods used in the screening process: the quantitative approach and the qualitative approach.

Summary of Revised Screening Methodology of Securities Commission Malaysia In view of the current development and sophistication of the Islamic finance industry, the screening methodology has now been revised by adopting a two-tier approach to the quantitative assessment that applies the business activity benchmarks and the newly introduced financial ratio benchmarks while maintaining the qualitative assessment.

This revision is in line with the SC’s initiatives to further build scale in the Sharī`ah-compliant equity and investment-management segments as well as expand the Islamic capital market’s (ICM) international reach, as outlined in the Capital Market Master plan.

Quantitative Assessment Business activity benchmarks: 5 percent and 20 percent.

• Financial ratio benchmarks: 33 percent.

Business Activity Benchmarks The 5 percent benchmark would be applicable to the following business activities:

• Conventional banking
• Conventional insurance
• Gambling
• Liquor and liquor-related activities
• Pork and pork-related activities
• Non-halal food and beverages
• Sharī`ah non-compliant entertainment
• Interest income from conventional accounts and instruments
• Tobacco and tobacco-related activities
• Other activities deemed non-compliant according to Sharī`ah

The 20 percent benchmark would be applicable to the following activities:

• Hotel and resort operations
• Share trading
• Stockbroking business
• Rental received from Sharī`ah non-compliant activities
• Other activities deemed non-compliant according to Sharī`ah

The contribution of Sharī`ah non-compliant activities to the overall revenue and profit before tax of the company, will be calculated and compared against the relevant business activity benchmarks.

Financial Ratio Benchmarks The financial ratios applied are as follows.

CASH OVER TOTAL ASSETS Cash will only include cash placed in conventional accounts and instruments, whereas cash placed in Islamic accounts and instruments will be excluded from the calculation.

DEBT OVER TOTAL ASSETS Debt will only include interest-bearing debt, whereas Islamic debt/financing or Sukuk will be excluded from the calculation. Both ratios, which are intended to measure riba and riba-based elements within a company’s balance sheet, must be lower than 33 percent.

The Sharī`ah-compliant status of the company may be affected in the following manner:

• Companies with mixed activities in which are currently assessed under the 10 percent or 25 percent benchmarks may be affected because their activities are now assessed under the 5 percent or 20 percent benchmarks.

An example is given next.

• Companies with high level of conventional debt may be affected because currently there is no screening based on the total conventional debt of the company.

An example is given next.

Formula for Sharī`ah Screening

4.2. TECHNIQUES

In addition to the preceding tools, there are other techniques that are used to identify the Sharī`ah non-compliance risk in Islamic financial activities. These are as follows:

4.2.1. Observation

Observation is a methodology in data collection used in qualitative research. Its aim is to be close to the subject matter under observation and be familiar with it. It forces the person involved to have a clear understanding about the company’s behavior. Observation can be used in Sharī`ah non-compliance risk.

4.2.2. Sampling

Sampling is used to examine the relevant legal documentations of the products and services used by the Islamic financial institution. The size of the sample is determined according to the soundness of the internal control system of the Islamic financial institution: smaller sample size if the internal control system is sound; larger sample size if the internal control system is weak.

4.2.3. Interview

Interview is an effective technique that tests the level of competence, skill, and knowledge of the human capital in the Islamic financial institution. It can cover many areas related the Sharī`ah non-compliance risk in the financial activities of the Islamic financial institution.

4.2.4. Testing

Testing can be applied on existing system software; it may have more than one objective. The first one is to test the skills of the officer in using the system in a competent manner. The second is to test the liability of the system itself, to ensure its Sharī`ah compliance status.

NOTES

1. www.sc.com.my (official website of the Securities Commission Malaysia).

2. Resolution of the Securities Commission Sharī`ah Advisory Council, 2nd ed. (Kuala Lumpur, Malaysia: Sharī`ah Advisory Council of the Securities Commission, 2009), 145.

3. Ibid., 150.