In early May 2021, the Accounting and Auditing Organization for Islamic Financial lnstitutions (AAOlFl) published its auditing standard No. 6, which specifies its criteria for external audit of Sharia compliance at lslamic financial institutions (lFls). ln S&PGlobal Ratings’ view, this is a step forward for the industry and will reinforce governance and enhance market discipline. In this context, key aspects of market discipline include greater consistency in adhering to Sharia principles and a culture of rapid remedial action by noncompliant institutions, in response to wider market and investor demands.

Given the lack of standardization that the lslamic finance industry has been facing, the first problem AAOlFl

faced was, which standards should an audit exercise be performed against? In its No. 6 standard, AAOIFI addresses this by creating a hierarchy of the existing standards and regulations.

If opinions from these sources are ambiguous, the standard prioritizes the approvals and clarifications of the entity’s specific Sharia board. This is the obvious choice, given that these approvals and clarifications underpin

an IFI management team’s decisions and the institution’s functioning.

Internal Sharia audits are already performed on some IFIs, such as Islamic banks and takaful companies, but the findings are not published. Although they give stakeholders some assurance that they are compliant, they present an inherent conflict of interest. ln our view, internal auditing has not meaningfully supported enhanced transparency.

Enforcing external, independent audits, however, could change the game, especially if the detailed results were published, or at least shared with the IFI’s key

stakeholders. These would include holders of unrestricted investment accounts (URIAs).

AAOIFI does not specify if the standard will apply to market instruments issued by entities that are not subject to internal Sharia audit (for example, corporate or sovereign sukuk issuers). In our view, extending the practice of external audits to these instruments could also help strengthen their credibility.

Creating An External Audit Rulebook

AAOIFI’s aim, in publishing its auditing standard No. 6, was to preserve the stability of lslamic finance markets and provide some guidance on how to perform an external audit of an IFI’s Sharia compliance.

The new standard creates a hierarchy of the regulations, standards, and rulings against which the auditing exercise is to be performed. In order, these are:

- The Sharia standards issued by the AAOIFI.

The regulations issued by the institution’s regulator if these include Sharia requirements.