issues in contemporary accounting & finance

Issues in Contemporary Accounting & Finance

Issues in Contemporary Accounting & Finance Editors Siti Zaidah Turmin Mohammad Noor Hisham Osman Zulkarnain Muhamad Sori Ahmed Razman Abdul Latiff 2015

Universiti Putra Malaysia Press Serdang • 2015

Contents

© Universiti Putra Malaysia Press 2015 First Print 2015 All rights reserved. No part of this book may be reproduced in any form without permission in writing from the publisher, except by a reviewer who wishes to quote brief passages in a review written for inclusion in a magazine or newspaper. UPM Press is a member of the Malaysian Book Publishers Association (MABOPA) Membership No.: 9802 Perpustakaan Negara Malaysia

Preface Chapter 1

Introduction Siti Zaidah Turmin, Mohammad Noor Hisham Osman, Zulkarnain Muhamad Sori and Ahmed Razman Abdul Latiff

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Chapter 2

Web-based Business Reporting Practice: A Review of Asia Literature Siti Zaidah Turmin, Fatima Abdul Hamid, Nazli Anum Mohamad Ghazali and Mohammad Noor Hisham Osman

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Chapter 3

Corporate Governance Characteristics and Internet Financial Reporting: Evidence from Gulf Co-Operation Council Countries Hasan O. Bin-Ghanem and Akmalia M. Ariff

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Chapter 4

The Corporate Social Responsibility Disclosure: A Study of Listed Companies in Malaysia Chan Yan Khay and Ong Tze San

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Cataloguing-in-Publication Data

ISSUES IN CONTEMPORARY ACCOUNTING & FINANCE / EDITORS SITI ZAIDAH TURMIN, MOHAMMAD NOOR HISHAM OSMAN, ZULKARNAIN MUHAMAD SORI, AHMED RAZMAN ABDUL LATIFF Includes index ISBN 978-967-344-500-4 1. Accounting. 2. Finance. I. Siti Zaidah Turmin. II. Mohammad Noor Hisham Osman. III. Zulkarnain Muhamad Sori. IV. Ahmed Razman Abdul Latiff. 657 Cover design: Typesetting: Nor Azizah Sabirin @ Isa Type face: Times New Roman PS Type size: 11/ 14.5

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Direct orders to Universiti Putra Malaysia Press 43400 UPM Serdang Selangor Darul Ehsan Tel: 03-89468851/ 89468854 Fax: 03-89416172 E-mail: [email protected]

Chapter 5

Factors Affecting Auditor Independence Zaidi Mat Daud, Chai Fong Ying and Ridzwana Mohd Said

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Chapter 6

Perceptions of Auditor Independence: The Case of Provision of Non-Audit Services Zulkarnain Muhamad Sori, Yusuf Karbhari and Siti Zaidah Turmin

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Printed by

Chapter 7

Shariah Committee, Shariah Governance in Islamic Financial Institutions Sabarina Mohammed Shah and Mohammat Sabri Hassan

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Chapter 8

Shariah Committee and Shariah Governance Framework: Some Evidence Zulkarnain Muhamad Sori, Shamsher Mohamad and Mohamad Eskandar Shah Mohd Rashid

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Chapter 9

The ‘Gatekeeper of Financial Truth’ in Malaysian IFIs: Some Evidence Shamsher Mohamad, Zulkarnain Muhamad Sori and Eskandar Shah

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Governance, Performance and Risk Management Issues in Malaysian Islamic Financial Institutions Gulzhan Musaeva, Mohamad Eskandar Shah Mohd Rashid, Shamsher Mohamad and Zulkarnain Muhamad Sori

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Chapter 10

The Editor Index

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Preface

This book integrates empirical studies and conceptual discussion in the field of accounting and finance in Malaysian and international setting. The aim of this book is to share findings of empirical results as well as conceptual discussion and to provide reading and reference materials on various accounting and finance topics to undergraduate and postgraduate students, researchers, practitioners and policymakers through relevant information provided. This book consists of ten chapters. Specifically, it is presented into three parts, namely corporate internet reporting and social responsibility reporting, auditor independence and corporate governance and Islamic finance. We would like to take this opportunity to express our sincere gratitude to all contributors for their articles and UPM Press for assisting in publication of this book. Last but not least, we are also grateful to the Dean of Faculty of Economics and Management, UPM, Prof. Dr. Zulkornain Yusop, and the Head of Accounting and Finance Department, Dr. Amalina Abdullah for their full support throughout the process of publishing this book. Siti Zaidah Turmin Mohammad Noor Hisham Osman Zulkarnain Muhamad Sori Ahmed Razman Abdul Latif 2015

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Chapter 1 Introduction Siti Zaidah Turmin, Mohammad Noor Hisham Osman, Zulkarnain Muhamad Sori and Ahmed Razman Abdul Latiff

Over the last 10 years, Malaysian capital market has made significant progress in instilling an efficient and well-regulated marketplace together with a proper institutional framework for the regulation of the accounting profession. The shareholders and stakeholders interests are safeguarded through high quality corporate financial reporting and corporate governance. It is the aim of the book to provide evidence and research findings on relevant issues. The book is divided into three parts that consists of 11 separate chapters of academic research works. The chapters covered ranging from issues on corporate internet reporting practice, corporate social responsibility, corporate governance, auditor independence and Islamic finance.

PART I: CORPORATE INTERNET REPORTING AND SOCIAL RESPONSIBILITY REPORTING Corporate internet reporting is a new communication medium that is vital for the corporate sector in presenting and disseminating financial and non-financial information to their stakeholders. CHAPTER 2: Webbased Business Reporting Practice: A Review of Asia Literature by Siti Zaidah Turmin, Fatima Abdul Hamid, Nazli Anum Mohamad Ghazali and Mohammad Noor Hisham Osman comprehensively review past literatures and document researches on the practice of this new business reporting medium in Asia region. The discussions focused on the practice


Introduction

by corporations in Bangladesh, India, Hong Kong, Singapore, Indonesia as well as Thailand. Most of the literatures revealed that corporate sectors are not using the full potential of web-based reporting in communicating corporate information to their stakeholders, thus, needing significant improvements by the corporations to fully utilize the potential of the Internet in its practice. CHAPTER 3: Corporate Governance Characteristics and Internet Financial Reporting: Evidence from Gulf Co-Operation Council Countries by Hasan O. Bin-Ghanem and Akmalia M. Ariff further explored the issue of corporate internet reporting by investigating the influence of board of directors and audit committee characteristics on the level of Internet Financial Reporting practices of listed financial companies in Gulf Cooperation Council countries. Content analysis approach and an un-weighted index is used to measure the level of internet financial reporting. The results indicate that only board sub-committee is significantly associated with Internet financial reporting. This study also documents that audit committee meetings and financial expertise significantly affect Internet financial reporting. Furthermore, not all board of directors and audit committee attributes influences the extent of IFR. Looking at another perspective of corporate reporting, CHAPTER 4: The Corporate Social Responsibility Disclosure: A Study of Listed Companies in Malaysia by Chan Yan Khay and Ong Tze San examines the relationship between corporate attributes and firm-specific factors and corporate social responsibility disclosures by the Malaysian listed technology companies between the year of 2009 to 2013. The study documented a positive relationship between percentage of Board Audit Committee and firm size with corporate social responsibility reporting of the companies. However, the percentage of independent director in board, board leadership structure and return on equity are found to be negatively related to corporate social responsibility reporting.

PART II: AUDITOR INDEPENDENCE AND CORPORATE GOVERNANCE

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Auditor independence has always been a major concern to the business community and it has been regarded as the ‘gatekeeper of financial truth’. CHAPTER 5: Factors Affecting Auditor Independence by Zaidi Mat Daud, Chai Fong Ying and Ridzwana Mohd Said investigate the relationship between factors of audit tenure and the switching behaviour of auditors, non-audit services, size of audit firms as well as client’s audit committee and auditor independence. Results of the questionnaire survey conducted upon private sector auditors working in audit firms reveals that significant relationship between the tenure and switching behaviour of audit on client, non-audit services provided for the audit client, size of audit firms, and audit committee of client and auditor independence in Malaysia. CHAPTER 6: Perceptions of Auditor Independence: The Case of Provision of Non-audit services by Zulkarnain Muhamad Sori, Yusuf Karbhari and Siti Zaidah Turmin examine the effects of the joint provision of audit and non-audit services on perceived auditor independence from the perspective of senior managers of audit firms, loan officers and public listed companies in Malaysia. This study is conducted in two stages. The first stage involved the use of a postal questionnaire to seek information from auditors, loan officers and senior managers of public listed companies on the impact of joint provision of audit and non-audit services on auditor independence. The second stage entailed a series of interviews with senior managers of audit firms, banks and publicly listed companies to solicit more detailed information on the issue of interest. Based on the study, it was found that majority of the respondents agreed that the provision of non-audit services to audit clients by the audit engagement team would threaten independence. Furthermore, the joint provision of audit and nonaudit services to audit clients by audit staff is revealed as the most threat to auditor independence. On the other hand, the majority of the respondents agreed that auditor independence would not be threatened if the provision of audit and non-audit services were to be provided by staff from a separate department and entity. Also, the majority of the respondents agreed that auditor independence would be safeguarded if auditors were to provide full disclosure in client accounts following the provision of non-audit services.


PART III: ISLAMIC FINANCE The role of Shariah Committees has taken new importance and perspective in the light of recent turmoil in the financial markets. Effective Shariah governance that inculcates transparency, trust, ethical behavior, credibility, underlying faith and belief and ethics will provide credibility to the IFIs that will help spur a healthy growth of the Islamic finance industry. CHAPTER 7: Shariah Committee, Shariah Governance in Islamic Financial Institutions by Sabarina Mohammed Shah and Mohammat Sabri Hassan offers comprehensive discussion on the issues of shariah committee and shariah governance upon Islamic financial institutions worldwide. Discussions include types of Shariah Committee structure worldwide as well as governance issues affecting the Islamic financial institution. Regardless of the challenges faced by Islamic financial institutions under its existing environment, the Shariah Committee members are bounded by their accountability to first and foremost, Allah SWT and the ummah. Inevitably, the Shariah Committee effectiveness in discharging their roles is crucial to the survival of the Islamic financial institutions. In anticipation of the importance of an effective Shariah Committee thus, there is a need to bridge the wide expectation gap from stakeholders. Shariah committee independence has been highlighted by the Shariah Governance Framework as an important credential for an effective functioning of Shariah committees. Zulkarnain Muhamad Sori, Shamsher Mohamad and Mohamad Eskandar Shah Mohd Rashid in CHAPTER 8: Shariah Committee and Shariah Governance Framework: Some Evidence examined Shariah committee independence of local Islamic financial institutions as perceived by the shariah committee members of the Islamic financial institutions. Shariah committee chairman and members were interviewed to collect the required information. The results identified Shariah committee independence safeguards and threats, and implied better effectiveness through clearly defined meaning of independence and guidelines or code of best practices as a guide for the committee and related parties.

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Introduction

CHAPTER 9: The ‘Gatekeeper of Financial Truth’ in Malaysian Islamic Financial Institutions: Some Evidence by Shamsher Mohamad, Zulkarnain Muhamad Sori and Eskandar Shah discusses on the various challenges faced by Shariah committees in general and in Malaysian Islamic Banks in particular. Different from their conventional counterparts that focus only on maximizing wealth of shareholders, IFIs protect the interests of all stakeholders (including shareholders) and initiatives to maximize wealth are permitted by guides that ensure no form of any injustice to all stakeholders. Specifically, the chapter highlighted issues related to effectiveness of Shariah Committees such as independence, confidentiality, competence, consistency and information disclosure Finally, although not a near equivalent of conventional banking in terms of size, the global Islamic banking industry has grown at a very rapid pace in the last three decades. Malaysia has been at the forefront of this development since early 1980s and has earned a reputation of a global hub for Islamic banking. Due to the significant contribution of the Malaysian IFI towards the economy, CHAPTER 10: Governance, Performance and Risk Management Issues in Malaysian Islamic Financial Institutions by Gulzhan Musaeva, Mohamad Eskandar Shah Mohd Rashid, Shamsher Mohamad and Zulkarnain Muhamad Sori surveys and analyses the published works on Islamic banking in Malaysia, covering period from 1989 to 2013, with the goals of evaluating their contribution and usefulness to various stakeholders and charting the future directions for research that could sustain Malaysia’s global leadership position in Islamic banking. The surveys and analyses are sourced from reputable English-language resources on the topic of Islamic banking in Malaysia. The paper starts with a brief introduction followed by a summary of published papers and identification of gaps, and concludes by charting the possible directions for future research in the Malaysian Islamic banking sector in view of the planned government initiatives as the benchmark.

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Web-based Business Reporting Practice: A Review of Asia Literature

Chapter 2 Web-based Business Reporting Practice: A Review of Asia Literature Siti Zaidah Turmin, Fatima Abdul Hamid, Nazli Anum Mohamad Ghazali and Mohammad Noor Hisham Osman

INTRODUCTION The widespread and exponential use of Internet technology in Asia is undeniable. According to the Asia Internet Usage Statistics and Population Statistics, nearly half of internet users in the world as at 30 June 2014 (i.e. 45.7%) are from the Asia region. This portion seems considerable as compared to 54.3% of internet users for the rest of the world. Besides, the Internet penetration in Asia for 2014 was 34.7%, thus it is not far behind the world average Internet penetration of 42.3%. In corporate world, the Internet is accepted as an extremely important new technology (Porter, 2001). The use of Internet technology that is aligned with the organisation’s goals is considered as a precondition for a company’s success (Porter, 2001). The Internet facilitates communication in the business world. This includes investor relations activities to inform investors of traditional paper-based annual report, replacing and enhancing the traditional way of stakeholders’ communication, revolutionizing external and disseminating information to a wider range of people instantly. The communication process between the corporate sector and stakeholders via the medium of the Internet is known as web-based business reporting. Jones and Xiao (2004) in providing definition of webbased business reporting, mentioned that “company websites can include the traditional annual reports together with additional financial and nonfinancial information in multiple formats”. Web-based business reporting

is seen as an important way for the corporate sector in presenting and disseminating business information to the stakeholders. The significance of web-based business reporting in corporate activities has been recognized by the Organisation for Economic Co-Operation and Development (OECD) (2004: 56) as mentioned in their statements, “channels for the dissemination of information can be as important as the content of the information itself”. Among the advantages of web-based business reporting compared to traditional paper-based reporting are innovative presentation of information, (Jones and Xiao, 2004), dynamic multimedia formats (Debreceny, Gray and Rahman, 2002), wider and easier access to information for larger groups of users without selection ((Ettredge, Richardson and Scholtz, 2001), creating interest to potential investors and boosting corporate image (Ettredge et al., 2001), ability of providing timeliness (Pratt, 1996) and more interactive information with unlimited space (Joseph, 1995) as well as the faster and lower cost of information dissemination (Geerings, Bollen and Hassink, 2003).

Practice of Web-Based Business Reporting in Asia Despite majority of web-based business reporting studies being focused on the US and European countries (Bogdan, Pop, Popa and Scorte, 2009), Asia region were not excluded. Motivated by the growing popularity of this new modern reporting medium in the Western countries, researchers started to venture into this field of research in Asia parts. The study by Blanning (1999), which focused on the context of the Republic of Singapore, was among the earliest research in the area of Internet reporting in Asia. Blanning (1999) conducted a study to closely examine the earlier stage of Internet adoption for corporate presence among Singaporean organisations. Specifically, Blanning (1999) examined the use of Internet technology and the Web among four types of organisation – hotels, publishers, logistics agencies and libraries. In general, it was found that the Internet has been used by Singaporean organisations for the purpose of establishing an external corporate presence among their customers, suppliers, distributors and potential business partners. Particularly, Internet technology has been utilised as a channel for e-commerce by hotels and

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publishers, providing better logistic services by logistics companies and satisfying the specific information needs of the library visitors throughout the Republic by the libraries. In this Republic, Service Providers played a big role whereby those organisations were found to establish and place their corporate web pages through the Service Provider. In other words, the corporate websites of those organisations were accessed through the Service Providers’ homepage. Therefore, it can be said that at the time this study was conducted, the use of Internet technology by organisations being examined was still limited and yet to disclose any of their financial information over the websites. Poon, Li and Yu (2003) performed a study to better understand the current implementation of voluntary web-based business reporting practice in Hong Kong. The sample used was 100 companies listed on the Hong Kong Stock Exchange, whereby those companies constituted the Hang Seng Index, which was known as the barometer of the Hong Kong stock market. Out of this number, most of the companies (94 companies, 94%) have websites with the vast majority of the websites (87 websites) containing financial information. The implementation of web-based business reporting was found to be popular across all types of activity sector. This was proven by three sectors (utilities, hotels and other sector) revealing one hundred percent, while the remaining sectors (consolidated enterprises, industrials, properties and finance) revealed more than 80% in the percentage of web-based business reporting firms in the sector. Annual reports, interim reports and annual or interim results in the pdf format were the most commonly found financial items, consistent with Lymer and Tallberg (1997) who previously mentioned the popularity of unaudited interim reports disclosed on company websites. Other information disclosed included real time share price movement and historical dividends per share, but with a low level of disclosure (28% and 16% of companies, respectively). In tandem with Brennan and Hourigan (1998), the study found many company websites without hyperlink pages, thus, indicating that the format and content of financial information were not specifically designed for the websites.

In Thailand, motivated by the lack of studies on Internet reporting in developing countries, an attempt was made by Davey and Homkajohn (2004) to examine the extent and quality of web-based business reporting practiced by Thai corporations. The sample of the study was the top 40 companies listed on the Thailand Stock Exchange. Web-based business reporting was measured based on the four categories of content, timeliness, technology and user support attributes. The results of the study revealed that almost all companies in the sample (37 companies, 92.5%) have websites with most of the companies (30 companies) disclosing financial reports on the websites. The web-based business reporting scores of companies ranged from 18% to 64% with 41.78% being the average score.1 In general, the user support category received the highest scores, while the category of technology received the lowest scores. The vast majority of the websites (92%) were in the English language due to the background of the companies being export oriented. More specifically, Davey and Homkajohn (2004) found that the majority of websites (30 companies, 81%) contained the pdf format of complete financial statements and annual reports, which included interim reports. However, low disclosure was found with regards to share price history (35%) and dividend history (10%). As for timeliness of information, press releases were revealed as the most commonly found item (89%), followed by stock quotes and vision statements. However, none of the companies were found to report the unaudited latest quarterly results, irrespective of its function as the most up to date interim report. Moreover, on the date of study, only one third of the companies (11 companies) were found to update the news on the websites. Concerning the technology, pdf format downloadable annual report was the most commonly found attribute (31 companies). As most companies were found to provide annual reports in pdf format, this result was predictable. Other attributes that were quite commonly found were direct e-mail contact and mailing lists (75%). Nevertheless, audio or video files and downloadable and processable files

1 Three companies that received top scoring were Electricity Generating Public Company Limited, Shinawatra Satellite Public Company Limited and Shinawatra Computer and Communication Public Company Limited.

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were not found in any of the websites. Pertaining to the user support category, link to home page was the attribute most frequently found in company websites (86%). However, the study found a lower percentage of websites with site map (54%) or site search (43%). Moreover, based on the results of a very few companies (2 companies) that needed more than three clicks to access the financial information, the study acknowledged the easiness of access of the vast majority of websites. Also, based on formatting, outline, font type and size, graphics and terminology, the study considered that 62% of the websites were well developed. Davey and Homkajohn (2004) further concluded that Thai listed companies did not take full advantage of computer technological features to add value to their corporate disclosure, thus, their communication with stakeholders through the practice of online corporate reporting lagged behind the developed countries. In addition, the substantial variation in the practices of companies in terms of content and timeliness of web-based business reporting and its insufficient formal guidance by the Thailand regulatory bodies raised issues of comparability and reliability of web-based business reporting practices by Thai listed companies. In Bangladesh, the increased use of Internet by corporations for business reporting purposes attributed by the expansion of securities market motivated Hossain Khan, Muzaffar and Mahmood (2006) to conduct a study on the current state of web-based business reporting by Bangladeshi companies. The study was conducted on 60 companies listed on the Chittagong Stock Exchange, which consist of eight different sectors2. Basically, websites were examined based on the categories of company profile, product information, shareholder information, press releases, performance reporting, human resources and marketing. The study found that less than half of the companies (24 companies, 40%) have websites, a percentage that is considered lower compared to its Asian counterparts (94% in Hong Kong and 93% in Thailand). These websites were solely and actively used to promote companies as well as their products and services. However, very few companies exists that use websites to

present corporate information to stakeholders, such as investor relations, press releases, performance reporting, human resource and marketing3. In respect of the use of websites, the study found the use of graphics, hyperlinks and trend data by some companies. However, the ability of data downloading and non-financial performance measures were found to be completely non-existent in the companies’ websites. In conclusion, Hossain Khan et al. (2006) considered the Internet reporting practices by Bangladeshi companies as not achieving the level of an acceptable standard, thus, requiring adequate preparation, proper regulation and control as well as an effective structure to ensure better functioning. A year later, the issue of Internet reporting was studied again by Dutta and Bose (2007), but with a focus on examining the extent of Internet reporting practiced by the Bangladeshi companies. This study used a wider sample of 268 companies listed on the Dhaka Stock Exchange and Chittagong Stock Exchange, which consist of 15 sectors. Therefore, this study can be seen as an expansion of the previous study by Hossain Khan et al. (2006). Dutta and Bose (2007) measured the extent of Internet reporting based on five groups of attributes that constitute a total of 65 items, namely, financial information, corporate governance, social and environmental, investor relations and presentations. In determining the Internet reporting scores of each company, the study used a dichotomous index whereby an item was awarded a score of 1 if it is disclosed and a score of 0 if otherwise. The results revealed that less than half of the companies (104 companies, 39%) have websites with companies from the banking, leasing and finance sector being the highest. Thus, the percentage was not much different from the previous study by Hossain Khan et al.

2 Including sectors of banking and insurance, pharmaceuticals and chemicals, cements and ceramics, textiles and clothing, leasing and finance, food and allied products, ICT and others.

3 In detail, 2 companies in pharmaceutical and chemical sector have disclosure of investor relations, press release, financial performance reporting and human resources on the websites and three of them were also found to have disclosure of marketing information. Only one company under the bank and insurance sector was found to have disclosure of press release, performance reporting human resources and marketing. For the leasing and finance sector, all companies disclosed press releases and marketing information, but only half disclosed human resources data. Marketing information was also disclosed by all companies in the ICT sector. However, only two ICT companies were found to disclose press releases, while only one company disclosed information concerning investor relations. Other sectors, which consisted of companies in leather, property development, paper products, fuel and power, revealed disclosure of performance reporting and human resource by one company, press release by two companies and marketing information by three companies.

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(2006). The Internet reporting scores of companies ranged from 1 point to 25 points with a mean of 9 points, thus, indicating a low level of Internet reporting practice. In addition, medium variation was found with regards to the Internet reporting disclosure level among companies in the study, as indicated by the standard deviation of 6.75. Subsequently, content analysis conducted by Dutta and Bose (2007) showed that most of the attributes were disclosed by the companies. Specifically, nearly two thirds of the company websites (64 websites, 61.54%) disclosed financial information with press release being the most frequent attribute found (44%), followed by past years’ balance sheet and profit and loss account (28%) and current year’s annual report (24%). A larger number of websites was found relating to corporate governance disclosure (74 websites, 71.15%). The most common attribute found was directors’ information (63%), followed by executive officers’ information (39%) and shareholding structure (23%). However, only 40 websites (38%) were found to disclose social and environmental attributes with disclosure of donations being the top (16%) followed by employee training and environmental policy statement (14% of each item). As for investor relations attributes, the level of disclosure appeared to be very low with less than 10% of companies being found to have most of the items.4 However, all websites were in the English language with not a single website providing information in Bangla. In terms of presentation, a link to press release, which was provided by 45 companies (43%), was most commonly found, followed by pdf format of annual reports (29%), internal search engine (28%) and site map (27%). Surprisingly, 15 companies (14%) were found to provide downloadable and processable data on the websites, having increased significantly compared to the study by Hossain Khan et al. (2006) in which it was totally absent. This number was relatively large, as compared to its nonexistence in the study of Davey and Homkajohn (2004) in Thailand. Thus, Dutta and Bose (2007) concluded that Internet reporting practiced by Bangladeshi listed companies was in its infancy 4 Only eight websites were found to have frequently asked questions, seven websites (6.73%) disclosed items of name, phone number and postal address of investor relations office and three websites disclosed the e-mail address of the investor relations officer. Disclosure of financial calendar was totally absent (0%).

stage with the establishment of corporate websites for corporate reporting purpose for companies in the banking, leasing and finance sector, while other sectors were lagging far behind this sector. Furthermore, similar to Davey and Homkajohn (2004), Bangladeshi companies were mentioned by Dutta and Bose (2007) as not using the full potential of the Internet in communicating corporate information to their stakeholders. At the same time, the evaluation of corporate Internet reporting practiced by Bangladeshi corporations was also conducted by Bhuiyan, Biswas and Chowdhury (2007) in which 273 public listed companies on the Dhaka Stock Exchange were examined to identify the existence of corporate websites as well as the information disclosed on the websites. However, compared to Dutta and Bose (2007), who used 65 items under five major groups of Internet disclosure index, Bhuiyan et al. (2007) used 54 items of attributes of Internet disclosure index that were grouped into a wider classification of seven major themes. These comprised general information, accounting and financial information, corporate social responsibility and human resources information, corporate governance information and contact details to investor relation and related conveniences that are associated with disclosure content and material processable format as well as user support, which is associated with presentation format. The study found that one third of the companies (91 companies, 33.33%) have websites, which was slightly lower compared to 40% of companies by Hossain Khan et al. (2006) and 39% of companies by Dutta and Bose (2007). This difference might be attributed to the different samples used in these studies. However, in line with Dutta and Bose (2007), companies in the banking sector were well ahead in establishing websites (31 banks, 78%). The internet disclosure scores ranged from 5.56 to 51.85 with 21.33 as a mean and 12.89 as a standard deviation, thus, indicating a huge discrepancy of website disclosure among companies. In general, Bangladeshi companies emphasized the content rather than the presentation in practicing Internet reporting. Specifically, general information was in the top position for content disclosure with company history and background being the most common item disclosed. Corporate social disclosure (CSR) and human resource information as well as accounting and financial information

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constituted the second and third position with employment opportunity and financial highlights being the most frequent items to be found for both themes, respectively. Information on authority was at the top for corporate governance, while contact information received the highest concentration by companies to be disclosed under investor relations and related convenience. However, both themes under presentation (material processable format and user support) showed similar scores for Internet disclosure index. For the material processable format category, the study found that all websites were presented in English, which is in line with Dutta and Bose (2007). However, none of the companies provided financial data in a processable format, which is in line with Hossain Khan et al. (2006), but inconsistent with Dutta and Bose (2007). Again, this difference is perhaps attributable to different companies being used as a sample in these studies. A similar result was revealed for audio and video files with not even one company having this attribute. For the category of technological advantages and user support, links to related sites, search engine, site map, feedback and frequently asked questions were found in less than half of the websites. Based on the results, Bhuiyan et al. (2007) concluded that Bangladeshi corporations were without exception, impacted by the evolution of Internet technology and changes of information flow between firms and stakeholders. Internet reporting in Bangladesh was considered as an emerging issue (Bhuiyan et al., 2007), thus, needing significant improvements by the corporations to fully utilize the potential of the Internet in its practice. Again, the practice of web-based business reporting in Bangladesh was studied by Hossain Khan, Muzaffar and Nazmul (2008). However at this time, Hossain Khan et al. (2008) made an attempt to closely examine the extent of Internet reporting by Bangladeshi companies based on the attributes of financial reporting websites, which consisted of 27 items. In addition, the evaluation of Internet reporting was also examined based on a focus group conducted with different experts and regulatory institutions. This differentiates this study from their previous study in 2006. A smaller sample of 30 companies listed on the categories of A

and B5 of the Chittagong Stock Exchange were used. It was revealed by the study that 40% of the companies have websites with three quarters of them (9 companies, 75%) disclosing financial statements on the websites. Corporate information was the most frequently found item with all companies disclosing it, followed by vision statement (92%), chairman’s message and financial highlight summary (83%). Conversely, no company was found to have environmental reporting and quarterly statements on their websites. Despite the high percentage of disclosure, Hossain Khan et al. (2008) observed differences between annual reports in the digital version and the paper-based version. In addition, the auditors’ report and signatures in the digital annual reports were found to be copied from the printed version without the existence of the auditor’s digital signature on any website, thus, contributing to the issue of information security and manipulation of online corporate information. In respect of the presentation of information, the use of pdf format (80%) in disclosing annual reports was four times more than the use of html format (20%). Nevertheless, none of the companies presented annual reports using XBRL,6 showing that it was not yet initiated in Bangladesh. Furthermore, the study acknowledged several negative responses from the respondents concerning Internet financial reporting in Bangladesh, which included unreliable sources of information, inadequate content of information, less usefulness and outdated information. Therefore, Hossain Khan et al. (2008) concluded that the practice of Internet reporting in Bangladesh was irrelevant in satisfying users’ need of information. It was suggested by Hossain Khan et al. (2008) that the use of the digital signature of responsible authorities in the websites, providing a full set of information with predictive and feedback value for decision making purposes, practising XBRL technology and disclosing more timely information can improve the practice of Internet reporting of those companies. 5 Companies under the A and B categories of the Chittagong Stock Exchange include the first and second class of companies, which are segregated based on performance of dividend percentage, compliance of securities related rules and other capital market parameters. 6 XBRL is an electronic language for financial reporting. By using XBRL, financial statements can be prepared in a variety of formats, thus, enhancing the usability of the financial statements.

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In Indonesia, an attempt to examine the quality of web-based business reporting was made by Budisusetyo and Almilia (2008). However, the focus of the study was limited to the banking sector listed on the Jakarta Stock Exchange. Using 23 listed banks as the sample, the quality of web-based business reporting was measured based on the attributes of Internet reporting index, which were grouped into content, timeliness, technology and user support7. The result revealed that the majority of the banks (19 banks, 83%) have websites. The web-based business reporting scores of those websites ranged between 22% to 64.50% with an average score of 44.34%. With regards to the content, all websites were found to have financial reports in different forms, whereby more than half of the websites (13 websites. 68%) contained annual reports and quarterly reports. In terms of language used, all websites were presented by using the Indonesian language, thus, contrary to the study in Bangladesh by Dutta and Bose (2007) in which they prefer to use English instead of their local language. The category of timeliness revealed a high number of companies disclosing unaudited latest quarterly results and vision statement (18 companies, 95%) as well as press release (17 companies, 89%). As for technology, direct e-mail contact and mailing list were found to be commonly used with close to two thirds of websites (74%) having these attributes. In contrast, very few banks used presentation slides (3 banks, 16%) and downloadable files (1 bank, 5%). Consistent with the study by Davey and Homkajohn (2004) in Thailand, the use of audio or video files was completely non-existent. However, the study revealed an encouraging level of use for attributes of user support with very close to two thirds of banks in the sample (14 banks, 74%) providing frequently asked questions, site maps and site search on their websites. In conclusion, Budisusetyo and Almilia (2008) mentioned that the considerable variation of web-based business reporting disclosure across the sample banks was due to the different reasons that banks had in establishing Internet presence in their corporations. However, similar to Davey and Homkajohn (2004) and Dutta and Bose (2007), Budisusetyo and Almilia (2008) claimed that

listed Indonesian banks were not utilising the full technological advantage offered by the Internet in practising web-based business reporting. In India, the first research on Internet reporting was conducted by Verma (2010). By using a sample of two hundred companies of BSE-200 Index from nineteen industry sectors, Verma (2010) examined the level and extent of financial and non-financial disclosure on corporate websites based on the Internet disclosure index of 135 items. The items were grouped into one category of financial reporting index and six categories of non-financial reporting index, namely, corporate governance information, corporate social responsibility and human resource information, marketing information, investor relations communication, right to information act, and technological aspects and user support. The results of the study indicated a wide variation of web disclosure of the companies without standardisation of the content and presentation of the disclosure. In general, disclosure of the non-financial reporting index received the mean score of 46.52, which was much higher than the mean score of 14.16 for the financial reporting index. Specifically, disclosure for the category of technological aspects and user support was the highest, followed by financial reporting index, corporate governance information, investor relations’ communication and corporate social responsibility and human resource information. However, the categories of marketing information and right to information act revealed the lowest score of disclosure. Looking at industry wise classification, it was found that companies in the sectors of information technology, diversified and transport service outperformed other sectors in average web disclosure. Companies in the diversified sector were the highest in the disclosure of financial reporting index, followed by the financial sector and chemical and petrochemical sector. However, the information technology sector was in first place with regards to the web disclosure of the non-financial reporting index, followed by the diversified sector and transport services sector. Furthermore, statistical analysis of ANOVA (sig. value of 0.001) confirmed the significant impact of industry sector upon the level of web disclosure of companies, thus, proving that the reporting practices followed by companies were determined by the industry standard and level of competition. Thus, Verma (2010) concluded that Internet reporting was used as a tool by corporations in India for the purpose of differentiation, image management and attracting stakeholders.

7 A similar study can be accessed through the electronic copy of SSRN entitled ‘Exploring Financial and Sustainability Reporting On the Web in Indonesia’ by Budisusetyo and Almilia (2008).

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CONCLUSION Web-based business reporting is currently a widespread phenomenon as it is used by most of private corporations as well as public sector entities around the world to communicate information with stakeholders. Motivated by the enormous popularity of web-based business reporting practice in the western region, this paper focused on providing reviews of the literature on the practice of web-based business reporting in the Asia region. This paper is expected to contribute to the understanding and knowledge in relation to the web-based business reporting practice by the corporation at the international level, specifically in the Asia region. Further, the understanding on the practice of web-based business reporting will reflects to several issues that might need further investigation. This will includes issues of determinants of web-based business reporting as well as comparative studies of web-based business reporting’s nature among different region in the world. In addition, it might be useful for future researchers to conduct study on the issues of reliability and security of information provided by this new medium of reporting.


Debreceny, R., Gray, G.L. and Rahman, A. (2002). The determinants of Internet financial reporting. Journal of Accounting and Public Policy. 21(4-5): 371394. Dutta, P. and Bose, S. (2007). Web-based Corporate Reporting in Bangladesh: An Exploratory Study. The Cost and Management. 35(6): 29-45. Ettredge, M., Richardson, V.J. and Scholtz, S. (2001). The presentation of financial information at corporate Web sites. International Journal of Accounting Information Systems. 2 (3): 149-168. Geerings, J., Bollen, L.H.H. and Hassink, H.E.D. (2003). Investor relations on the Internet: a survey of the Euronext zone. The European Accounting Review. 12(3): 567-579. Hossain Khan, M.A., Muzaffar, A.T. and Mahmood, A.S. (2006). The Use of Internet for Corporate Reporting: A Discussion of the Issues and Surveys of Current Usage in Bangladesh. Hossain Khan, M.A., Muzaffar, A.T. and Nazmul, A.K. (2008). Corporate Financial Reporting on Internet: Global Developments and an Appraisal of Practices in Bangladesh. Business and Economics Working Paper Series. American International University-Bangladesh.

REFERENCES

Jones, J.P. and Stanwick, S. (2001). Electronic-Based Financial Reporting. Ohio CPA Journal. 60(3): 31-34.

Asia Internet Usage Statistics and Population Statistics. http://www. internetworldstats.com

Jones, M.J. and Xiao, J.Z. (2004). Financial reporting on the Internet by 2010: a consensus view. Accounting Forum. 28(3): 237-263.

Blanning, R.W. (1999). Establishing a Corporate Presence on the Internet in Singapore. Journal of Organisational Computing and Electronic Commerce. 9(1): 83-99.

OECD Principles of Corporate Governance. (2004). Organisation for Economic Co-operation and Development.

Bogdan, V., Pop, C.S., Popa, D.N. and Scorte, C. (2009). Voluntary Internet Financial Reporting and Disclosure. A New Challenge for Romanian Companies. Annals of the University of Oradea: Economic Science. 3(1): 770778. Budisusetyo, A. and Almilia, L.S. (2008). The Practice of Financial Disclosure on Corporate Website: Case Study in Indonesia. Working Paper. SSRN.

Poon, P.L., Li, D. and Yu, Y.T. (2003). Internet Financial Reporting. Information Systems Audit and Control Association. 1. Porter, M.E. (2001). Strategy and the Internet. Harvard Business Review. March: 62-78. Verma, D. (2010). Web-based Business Reporting in Indian Corporate Sector. Journal of Knowledge Management Practice. 11(1).

Davey, H. and Homkajohn, K. (2004). Corporate Internet Reporting: An Asian Example. Problems and Perspectives in Management. 2: 211-227.

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Corporate Governance Characteristics and Internet Financial Reporting

Chapter 3 Corporate Governance Characteristics and Internet Financial Reporting: Evidence from Gulf Co-Operation Council Countries Hasan O. Bin-Ghanem and Akmalia M. Ariff

INTRODUCTION This study focuses on Internet Financial Reporting (IFR) practices among financial companies in the Gulf Cooperation Council (GCC) countries and analyses whether characteristics of board of directors and audit committee influence the level of IFR. Through IFR practices, information about companies’ performance and activities can be made available in relatively cheap, fast, interactive, and varying formats (Pervan, 2006). Despite their benefits, IFR practices are generally voluntary and unregulated (Dutta & Bose, 2007). Due to that, issues on the reliability of the disclosed information to outsiders (Botti, Boubaker, Hamrouni, & Solonandrasana, 2014) are often highlighted since IFR policies remain at the discretion of managers (Kelton & Yang, 2008). Given the prevalence of IFR, more research is needed to better understand the dynamics of why some firms engage in voluntary IFR whilst others do not (Oyelere & Kuruppu, 2012). Corporate governance mechanisms may be important in explaining the variations in the levels of IFR across companies as well as countries. Kelton and Yang (2008) state that corporate governance mechanisms are involved in monitoring and determining a firm’s overall information disclosure policy. In this vein, Ajinkya, Bhojraj, and Sengupta (2005) suggest that promoting stronger governance resulted in more transparent disclosure. Prior studies that examine the role of corporate governance in IFR practices have tended to focus on developed countries (e.g., Gandı´a,

2008; Kelton & Yang, 2008; Botti et al., 2014) or a single-country study (e.g., Elsayed, El-Masry, & Elbeltagi, 2010; Kiew-Heong, Saleh, & Abessi, 2011). While their findings are important, the lack of focus on developing countries hamper the overall understanding on the effect of corporate governance on IFR. Setting robust corporate governance standards in less mature economics is more important especially in encouraging foreign investment and assisting in economic growth (Hubbard & Wood, 2013). As such, it is imperative to understand the relationship between corporate governance and IFR from the perspective of developing countries, such as the GCC. In the GCC setting, there is so much interest in investment opportunities with its rapid economic growth fuelled by booming oil revenues (Basuony & Mohamed, 2014). As such, the issues of IFR and corporate governance are both important. With respect to IFR, it is expected that GCC companies, having great incentive to expand their activities globally as well as to raise their capital internationally, choose the Internet to disclose more information to wider potential stakeholders. In the context of corporate governance, given the dominant financial intermediation role of banks in GCC countries, effective corporate governance in financial companies is fundamental for establishing sound financial systems (Saidi, 2011). We aim to provide evidence on the role of corporate governance in influencing IFR practices in the GCC countries. We posit that board of directors and audit committee characteristics influence IFR. By using a sample of 152 GCC listed financial companies, the descriptive results show that the average IFR score is 58 percent. The regression analysis show that board sub-committee, audit committee meetings, and audit committee financial expertise are significantly associated with IFR. Our findings add to the literature by examining the effect of comprehensive governance mechanisms on IFR in the context of the emerging economies of the GCC countries. The unique features of our setting make the investigation more crucial to advance and enhance the practice of both corporate governance and IFR. More specifically, we provide evidence on the institutional environment, related to corporate governance, that can promote firms to practise higher quality IFR.

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The remainder of the study is as follows. Section 2 provides the literature review, while hypotheses development is outlined in section 3. Section 4 discusses the research methodology and section 5 and 6 present the finding and conclusion.

practices, based on, among others, agency, signalling, and innovation diffusion theories (e.g., Marston & Polei, 2004; Garg & Verma, 2010; Ali-Khan & Ismail, 2014). More related to our study are studies that have linked IFR with the dimensions of corporate governance especially in Arab countries (e.g., AbuGhazaleh, Qasim, & Roberts, 2012; Samaha, Dahawy, Abdel-Meguid, & Abdallah, 2012). In the GCC countries, to the researchers’ knowledge, only one study is relevant. Alanezi (2009), who examined IFR and its determinants among 179 companies listed in the Kuwait Security Market, found that 56% of the sampled companies presented their financial reports on their Websites. The results portrayed that there were significant and positive relationships between IFR and firm size, auditing type, as well as industry type. However, the study failed to provide evidence on the impact of any of the corporate governance attributes on IFR. This is possibly because he examined a limited number of governance mechanisms and measured IFR based on dichotomous variable. Alanezi (2009) advocated future research to consider other variables of corporate governance, such as board of director and audit committee. Also related to our study are studies that have focused on cross-country sample in analyzing corporate governance as potential determinants of IFR. For example, Ojah and Mokoaleli-Mokoteli (2012) discovered that corporate governance structure, as well as physical, and institutional infrastructures were important determinants of a country’s adoption of IFR for sample companies from 44 developed and developing countries. A comparative study of of corporate information transparency on the Internet among listed companies from Mexico and Spain was performed by Turrent and Ariza (2012). The results revealed that strength and application of law, GDP per capita, inflation, and firm-level variables, such as ownership concentration and Chairman of the Board-Chief Executive Officer (COB-CEO) duality, were among the factors that contributed to the most disclosure with regards to corporate transparency. However, there were insignificant relationships between Internet corporate information transparency and other variables, such as board size and composition, firm size, leverage, and profitability.

LITERATURE REVIEW Firm is considered as using IFR when it provides on the web a comprehensive set of financial statements or some financial highlights from its financial statements or partial or summarized financial statements (Oyelere, Laswad, & Fisher, 2003). IFR practices allow information to be provided instantaneously to a global audience (Abdelsalam, Bryant, & Street, 2007) and enable disclosure of up-to-date information (Kelton & Yang, 2008). The role of IFR in improving the availability of financial information offers several capital market benefits such as encouraging investment (Aly, Simon, & Hussainey, 2010), reducing information asymmetry (Puspitaningrum & Atmini, 2012), and leading to increased overall transparency and public awareness (Kelton & Yang, 2008; AliKhan, Ismail, & Zakuan, 2013). Review of descriptive studies on IFR showed that IFR is a global practices. Studies that focused on IFR practices of companies within a country (e.g., Homayoun, Rahman, & Bashiri, 2011; Dolinšek, Tominc & Skerbinjek, 2014; Lipunga, 2014) and in more than one country (e.g., Smith & Pierce, 2005; Shukla & Gekara, 2010) indicate that more companies in many countries acknowledge the Internet as one of the most important channel for communication of financial information. However, the findings of studies differ from one country to another. For example the average level of IFR is 65% for Malaysian companies (Ali-Khan & Ismail, 2011), and 70% for Jordanian companies (Al-Htaybat, 2011). In the context of GCC countries, researches indicated that IFR is still at an embryonic stage in the GCC, even though there are considerable opportunities in corporate communication and reporting through the Internet (Momany & Pillai, 2013; Basuony & Mohamed, 2014). In an effort to explain the differences in IFR practices across companies, a number of studies have attempted to analyse the determinants of IFR 22

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Overall, the results from prior studies suggested that corporate governance demands of information, in both content detail and speed of delivery, are important in determining the adoption of IFR (Ojah & Mokoaleli-Mokoteli, 2012). However, their findings regarding the relationship between corporate governance characteristics and IFR were mixed and inconclusive. Further, analysis using cross-country sample is rather limited. For that reason, we extend the literature by examining a set of governance mechanisms to understand their role in enhancing IFR, in developing countries of the GCC.

However, the evidence on the role of board size in determining the level of IFR is inconclusive. For example, some studies (e.g., Kiew-Heong et al., 2011; Samaha et al., 2012) found the board size is positively associated with IFR, while other studies found insignificant association (e.g., Erer & Dalgic, 2011; Turrent & Ariza, 2012). In the GCC, boards lack a diversified composition and represent the direct interests of the controlling owners. Therefore, we suggest that a larger board in this setting may reduce the controlling and monitoring capacities and thereby affect IFR practices inversely. Board independence is another important element of board of directors efficiency (Klein, 2002). According to agency theory, a greater proportion of outside directors have a greater incentive to alleviate agency problems in order to develop their reputation as monitoring experts (Fama & Jensen, 1983). Pertaining to IFR, Kelton and Yang (2008) suggested that the monitoring of managerial opportunism was enhanced by high percentage of independent directors on the board, which in turn, reduces management’s chance of withholding information. Nevertheless, empirical evidence has not reached clear conclusions on the relationship between board independence and IFR. Some studies discovered a positive relationship (Erer & Dalgic, 2011; Kiew-Heong et al., 2011) suggesting that independent directors play a complementary role in information disclosure (Samaha & Dahawy, 2010). However, other results were found to be either negative (Abdelsalam & Street, 2007; Samaha et al., 2012), or insignificant (Puspitaningrum & Atmini, 2012; Samaha et al., 2012). Based on agency theory, we expect that independent directors play an effective monitoring role leading to increase in the demand for additional disclosure, such as IFR. Frequency of board meetings provides a metric for the intensity of board activity (Lipton & Lorsch, 1992; Vafeas, 1999), and hence, proxies for effectiveness of board. The intensity of board activities is likely to contribute to the effectiveness of oversight functions, which leads to higher incentive to disclose more information, allowing stakeholders to become aware of their efforts (Lipton & Lorsch, 1992; Kiew-Heong et al., 2011; Sánchez, Domínguez, & Álvarez, 2011). This suggests that when frequent meetings are held, managers are under pressure to better

HYPOTHESES DEVELOPMENT Corporate disclosure mitigates the information asymmetry problem and agency conflicts between management and outside investors. In addition, the review of prior literature suggest that corporate governance demands of information, in both content detail and speed of delivery, are important in determining the adoption of IFR.

Board of Directors Characteristics and IFR A central institution in the internal governance of a firm is the board of directors, which provides a key monitoring function in dealing with agency problems in the firm (Lefort & Urzúa, 2008). Boards can be effective mechanisms to monitor top management on behalf of dispersed shareholders (Ghosh, 2006), and thus, influences the disclosure transparency (Homayoun & Rahman, 2010). We focus on four board characteristics i.e. size, independence, meetings, and committees. Board size is crucial for effective board governance in board structures (Nkundabanyanga, Ahiauzu, Sejjaaka, & Ntayi, 2013). Small boards are able to enhance the directors’ sense of participation and to allow them to communicate freely and frequently with senior executives, thus encourages faster information processing (Zahra, Neubaum, & Huse, 2000) and improve decision making. Whereas, large board would lead to less effectiveness in terms of management control, and results in increased conflict and agency problems between the members of the board that may delay critical decisions (Cormier, Ledoux, Magnan, & Aerts, 2010). 24

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fulfil their disclosure obligations, and therefore, they are less likely to retain information (Botti et al., 2014). Nonetheless, Kiew-Heong et al. (2011) failed to associate between board meetings and IFR in Malaysian companies. In light of the above arguments, we suggest in an environment where information asymmetry is high, such as the GCC, more board meetings are likely to enhance internal governance and extent of financial reporting via Internet. Board sub-committees (i.e., the nominating, audit, and compensation committees) perform specific tasks in the decision control process (Fama & Jensen, 1983), and improve internal control systems (Klein, 1998). In this vein, it has been argued that establishing board sub-committees can lead to excessive managerial monitoring (Conger, Finegold, & Lawler, 1998), and determine the effectiveness of the board monitoring activities regarding information asymmetries (Vafeas, 1999). In the GCC countries, codes of corporate governance recommend companies to adopt such subcommittees in order to assist the board to carry out its tasks effectively. Hence, it is interesting to examine, for the first time, the effect of board committees on the IFR practices. As such, we argue board of director that have three sub-committees (nominating, audit, and compensation) is likely to affect IFR. Therefore, this study explores the impact of board characteristics on IFR as a medium for disseminating information in GCC. Based on the above discussion, the testable hypotheses are as follows: H1: There is an association between IFR and board of directors that have smaller size, more proportion of outside members, more frequent meeting, and three sub-committees (nominating, audit, and compensation). H1a: There is a negative association between board size and IFR. H1b: There is a positive association between board independence and IFR. H1c: There is a positive association between board meeting and IFR. H1d: There is a positive association between board sub-committees and IFR.

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Audit Committee Characteristics and IFR Effective audit committees enhance the quality and the credibility of annual audited financial statements, by assisting the work of the board of directors that are charged with safeguarding and advancing the interests of shareholders (Fama & Jensen, 1983; Islam, Islam & Bhattacharjee, 2010). Kelton and Yang (2008) indicated that key characteristics of the audit committee have a powerful effect on the ability of the audit committee to perform a complementary role in improving oversight and by monitoring the financial reporting process, leading to increased disclosure transparency via IFR. We focus on four characteristics of audit committee i.e. size, independence, meetings, and expertise. Size of the audit committee should be sufficient in order to improve the quality of internal controls and to help the committee to discharge its duties effectively (Zhang, Zhou, & Zhou, 2007). Large audit committee tends to enhance the audit committee’s status and power within an organization (Kalbers & Fogarty, 1993) and is more likely to uncover and resolve potential problems in the financial reporting process (Bedard, Chtourou, & Courteau, 2004). However, only Kiew-Heong et al. (2011) investigates the effect of size of audit committee on IFR and reports an insignificant influence. Therefore, there is still a need for more investigation of the effect of audit committee size on IFR practice in other setting, such as in the GCC. As such, we argue that audit committee size is likely to affect the IFR. Audit committee independence plays a role in reducing conflict of interest between managers and outside investors (Akhtaruddin & Haron, 2010). The effectiveness of an audit committee depends on their independence (Dhaliwal, Naiker, & Navissi, 2010) as independent audit committees are more active and effective in their performance and in disclosing information to stakeholders (Raghunandan, Read, & Rama, 2001). Empirically, there is evidence that independent audit committees are associated with higher disclosure quality (Karamanou & Vafeas, 2005; Barros, Boubaker, & Hamrouni, 2013). However, studies (Kelton & Yang, 2008; Kiew-Heong et al., 2011) that have explored the association between audit committee independence and IFR failed to identify any

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significant result. Bronson, Carcello, Hollingsworth, and Neal (2009) argue that the benefits of audit committee independence are limited unless the audit committee is completely independent. As such, we argue that if the audit committee are truly independent, they should be able to reduce managerial discretion over financial reports through IFR. Expertise of audit committees’ members contributes to audit committee effectiveness (Akhtaruddin & Haron, 2010) in performing their oversight roles in the financial reporting process more effectively (Zhang et al., 2007). Puspitaningrum and Atmini (2012) proposed that audit committee members must have financial literacy in order to function effectively. Beasley, Carcello, Hermanson, and Neal (2009) claimed that the effective oversight by the audit committee required its members to have knowledge on accounting concepts and auditing process to enhance their understanding of the financial reporting process. Empirically, Kelton and Yang (2008) discovered that firms with a greater percentage of financial experts on the audit committee were more likely to pursue disclosure transparency with IFR. However, Kiew-Heong et al. (2011) failed to provide such relationship in Malaysian companies. Accordingly, we suggest that audit committee members with financial expertise are more likely to increase the demand IFR. Audit committee meeting enhance its effective operation because effective audit committee is found to meet regularly (Xie, Davidson, & Dadalt, 2003). According to Karamanou and Vafeas (2005), audit committees that meet more frequently would have more time to perform the role of monitoring the corporate reporting process efficiently. Empirical evidence showed a positive relationship between the frequency of audit committee meetings and the decision to disclose forward-looking information in the annual report (O’Sullivan, Percy, & Stewart, 2007), voluntary disclosure of management reports on internal controls (Bronson, Carcello, & Raghunandan, 2006), and voluntary disclosure (Allegrini & Greco, 2013). Focusing on IFR, the importance of audit committee meeting frequency is supported by Kelton and Yang (2008) and Cormier et al. (2010). However, Kiew-Heong et al. (2011) failed to provide such relationship in Malaysian companies. We thus expect the IFR to be better in firms with more frequently audit committees meeting.

Based on the above arguments, this study examines the effect of audit committee characteristics on the level of IFR. Based on the above discussion, the testable hypothesis is formulated as follows:

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H2: There is an association between IFR and audit committee that has larger size, more proportion of outside members, more percentage of financial experts, and more frequent meeting. H2a: There is a positive association between audit committee size and IFR. H2b: There is a positive association between audit committee independence and IFR. H2c: There is a positive association between audit committee financial experts and IFR. H2d: There is a positive association between audit committee meeting and IFR.

RESEARCH METHODOLOGY Research Sampling The sample consists of financial companies from the GCC countries namely: Bahrain, Oman, Qatar, Saudi Arabia and the United Arab Emirates. Financial sector is selected as it is one of the most economically viable diversification options in the economy of the GCC countries. It is the second highest contributor to the countries’ GDP, after the oil and gas sector (Al-Obaidan, 2008; Al-Hassan, Oulidi, & Khamis, 2010). Table 3.1 Composition of sample Sample Attributes Bahrain Oman Qatar KSA UAE Total Total number of financial companies listed 23 30 17 44 59 173 in the GCC Less: Companies without website addresses (0) Companies with inaccessible websites (3) (3) Companies with incomplete corporate (2) (1) (2) (1) (12) (18) governance data Final sample 21 26 15 43 47 152 Note: KSA = Saudi Arabia, and UAE = United Arab Emirates

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Secondary data method is employed to gather data for the year 2012. Data for the dependent variable are collected from the companies’ website. Data for independent variables are derived from the annual reports of the companies. Referring to Table 3.1, the sample initially includes all the 173 financial companies listed on the Stock Exchanges of the five countries. However, 21 out of the 173 companies are excluded because their websites are inaccessible, under construction, or contain incomplete data. The final sample consists of 152 companies i.e. 21 from Bahrain, 26 from Oman, 15 from Qatar, 43 from Saudi Arabia, and 47 from the United Arab Emirates.

independence (BRDIND) is measured as a ratio of independent to total number of directors on the board. Board meeting (BRDMEET) is measured by the number of board of directors meetings held during the financial year end of 2012. Committees of board (BRDCOMT) is measured by giving 1 for companies that have three committees – nominating, audit and compensation – and 0 otherwise. Audit committee characteristics are represented by four variables following the measurement approaches in studies such as Kelton and Yang (2008) and Kiew-Heong et al. (2011). Audit committee size (ACSIZE) is measured as the number of directors on the audit committee. Audit committee independence (ACIND) is measured as a ratio of independent to total number of directors on the audit committee. Audit committee expertise (ACFINEX) is measured by the percentage of financial experts on the audit committee. Audit committee meeting (ACMEET) is measured as the number of audit committee meetings during the year end 2012. Other independent variables are included in the model to reduce the impact of potentially omitted variables and endogeneity (Ntim, Opong, Danbolt, & Thomas, 2012). We control for firm characteristics that are size, profitability, leverage, and auditor. Following prior studies (e.g. Debreceny & Rahman, 2005; Abdelsalam et al., 2007), we measure firm size, profitability, and leverage by the natural logarithm of the book value of the total firm assets, the return on assets (ROA), and the ratio of total debt to total assets, respectively. Auditor (BIG4) is a dummy variable of 1 if the sample companies are audited by a Big 4 accounting firm, and 0 otherwise. We include dummy variables to control for country differences (COUNTRY).

Dependent Variable The dependent variable is the extent of IFR in the websites of the companies. An index is developed based on previous work (e.g., Xiao, Yang, & Chow, 2004; Kelton & Yang, 2008; Al-Htaybat, 2011; Ali-Khan & Ismail, 2011) but it is closely similar to the index that is used by Desoky (2009) in analysing IFR in Egypt. Indices used in Arab countries are relevant to our study because these countries experience similar characteristics with the GCC nations. Following the approach in Abdelsalam et al. (2007) and Al-Htaybat (2011), we deleted items that are not found in any website or items applicable to only some particular GCC countries and added items commonly found in the websites of the companies but not included in our preliminary index. To increase the validity of the index, verifications and comments from three experts in financial reporting were considered. Our IFR index incorporates a total of 35 items. We employed unweighted scoring approach (Abdelsalam et al., 2007; Kelton & Yang, 2008) by giving a score of “1” for the presence and “0” for the absence of each item of content. The total score for each company is measured as the percentage of the actual score awarded to the maximum possible score.

The research model

Independent Variables

The regression model, which is utilized to test the relationship between corporate governance characteristics and IFR, is estimated as follows:

Board of directors’ characteristics are represented by four variables based on measurements that are previously used by prior studies (e.g., Elsayed et al., 2010; Samaha et al., 2012; Botti et al., 2014). Board size (BRDSIZE) is the total number of directors on the board. Board

IFRT = α0 + β1 BRDSIZE + β2 BRDIND + β3 BRDCOMT + β4 BRDMEET + β5 ACSIZE + β6 ACIND + β7 ACMEET + β8 ACFINEX + β9 FSIZE + β10 ROA + β11 LEV + β12 BIG4 + β13 COUNTRY1 + ... + β16 COUNTRY4 + ε. (1)

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Where: IFR BRDSIZE BRDIND BRDCOMT BRDMEET ACSIZE ACIND ACMEET ACFINEX FSIZE ROA LEV BIG4

Table 3.2 cont’d

: : : : : : : : : : : : :

The level of Internet Financial Reporting (IFR), Board size, Board independence, Board committees, Board meeting, Audit committee size, Audit committee independence, Audit committee meeting, Audit committee expertise, Firm size, Profitability, Leverage, and Audited by big 4 accounting firms

RESULTS AND DISCUSSION Descriptive Statistics As illustrated in Table 3.2, the mean level of IFR is 0.58 with a median of 0.60. On average, a company discloses 58% of the 35 items included in the index. The highest and lowest scores of IFR are 91 per cent and 9 per cent, respectively. The wide range of 82% in the level of IFR indicates a substantial variation in the IFR across the sample companies. None of the companies disclose 100% of the 35 index items applicable to them, thereby highlighting the opportunity for further improvement in IFR practices. Table 3.2 Descriptive Statistics of Variables Variables

Min

Max.

Mean

Median

Range

Std.Dev

IFR

0.090

0.910

0.582

0.600

0.820

0.198

BRDSIZE

5.000

14.000

8.461

9.000

9.000

1.790

BRDIND

0.000

1.000

0.577

0.560

1.000

0.264

BRDCOMT

0.000

1.000

0.724

1.000

1.000

0.449

BRDMEET

2.000

11.000

5.599

6.000

9.000

1.562

ACSIZE

2.000

6.000

3.388

3.000

4.000

0.737

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ACIND

0.000

1.000

0.820

1.000

1.000

0.271

ACMEET

2.000

12.000

4.822

4.000

10.000

1.794

ACFINEX

0.000

1.000

0.491

0.500

1.000

0.204

FSIZE

6.880

11.000

8.863

8.510

4.120

0.977

LEV

0.030

1.000

0.625

0.672

0.970

0.237

ROA

-0.100

0.100

0.025

0.021

0.200

0.033

Note : IFR = The level of IFR, BRDSIZE = Board size, BRDIND = Board independence, BRDCOMT = Board sub-committees, BRDCOMT = Board meeting, ACSIZE = Audit committee size, ACIND = Audit committee independence, ACMEET = Audit committee meetings, ACFINEX = Audit committee financial expertise, FSIZE = Firm size, LEV = Leverage, and ROA = Profitability.

Table 3.2 shows that the board size ranges from 5 to 14 members, with an average of 8 members. This average is in line with studies conducted by Arouri, Muttakin, and Hossain (2011) and Kiew-Heong et al. (2011) who report that the board size in banks in the GCC and Malaysian firms is about 9 and 8 members, respectively. The proportion of independent directors ranges from 0% to 100%, with an average of 57.7%, indicating that there a balance between insiders and dependent directors. This average complies with the GCC Corporate Governance Code, which recommends that at least one third of the board be comprised of independent directors. In terms of board sub-committees, the descriptive statistics results (untabulated) indicate that a majority 72.3% (110) of financial companies listed in the GCC have three board sub-committees: audit, remuneration and nomination, which shed light on the importance of establishing such committees among financial companies listed in the GCC. Finally, board meetings held during the year ranges from 2 to 11 meetings, with an average number of board meetings of 6 times per year. This average complies with the GCC Corporate Governance Code, which recommends at least four board meetings per year. Table 3.2 shows that the audit committee size ranges from 2 to 6 members, with an average of 3 members. This is in line with a study conducted by Kiew-Heong et al. (2011) who reported that the size of audit committees of Malaysian firms ranges from 2 to 8, with a mean of 4. The 33



statistics shows that the proportion of audit committee independence is between 100% and 0%, with an average of 82%. This complies with the GCC Corporate Governance Code, which recommends that independent directors should dominate the audit committee. Table 3.2 reveals that the sampled companies held between 2 to 12 meetings in the year, with an average of 5. Finally, the audit committee financial expertise ranges from 0% to 100%, with an average of 49%. This average indicates that some companies comply with the GCC Corporate Governance Code, which recommends that at least one member of the audit committee have financial expertise. With respect to the control variables, the mean and median firm sizes are $6.88 and $8.51, respectively, with a minimum value of $6.88 and a maximum value of $11. As for leverage, the mean and median values are 62.5% and 67.2%, respectively. The sample has an average profitability level of 2.5%, with a minimum value of -10%, maximum value of 10%, and a median value of 2.1%. In terms of audit firm size, the results (untabulated) indicate that that the majority 89.5% (136) of financial companies listed in the GCC are audited by a local audit firm affiliated with one of the BIG4.

Table 3.3 Regression Results

Regression Results Results of Pearson Correlation analysis (untabulated) indicate that directors with large number of members on the board (BRDSIZE), three committees – nominating, audit and compensation of board (BRDCOMT), and frequency meeting held during the financial year (BRDMEET) are positively significantly correlated with IFR. Additionally, only audit committee expertise (ACFINEX) is positively significantly correlated with IFR. Correlation result suggests that multicollinearity is not a problem because the level of correlation does not exceed 0.90 (Hair, Black, Babin, & Anderson, 2010). The regression results are shown in Table 3.3.

34

Variables Constant BRDSIZE BRDIND BRDCOMT BRDMEET ACSIZE ACIND ACMEET ACFINEX FSIZE ROA LEV BIG4 COUNTRY Adjusted R2 F Change Sig. F Durbin-Watson

Exp Sign + + + + + + + + + + +

Coefficients -0.004 0.030 0.203*** 0.009 -0.002 0.020 -0.020*** 0.268*** 0.062*** -0.193 0.059 -0.033

t-stat

Sig

-1.222 -0.705 0.533 7.339 1.227 -0.147 0.412 -3.248 4.778 4.342 -0.944 1.137 -1.022 Included

0.224 0.482 0.595 0.000 0.222 0.884 0.681 0.001 0.000 0.000 0.347 0.258 0.308

0.653 18.738 0.000 2.200

Note: *** Significant at 1%, ** Significant at 5%, * Significant at 10%.

For board of directors’ characteristics, the results of Table 3.3 indicate that only board sub-committee (BRDCOMT) is significantly associated with IFR. However, the coefficient for board size (BRDSIZE), board independence (BRDIND), and board meeting (BRDMEET) are insignificant. The result for board size is contradicted to agency theory, which suggests that a small board can be an effective mechanism to monitor the performance of corporate executives with less conflict. The result, however, is in line with prior studies by Kelton and Yang (2008) and Alanezi (2009). The insignificant result for the association between the proportion of independent directors on the board and IFR is also inconsistent with agency theory, which suggests the presence of directors improves a firm’s compliance with disclosure requirements as they are free from management interests. This could potentially be caused by selection procedures in developing countries, which is more likely to not 35



be truly independent (Barako, Hancock, & Izan, 2006). In the GCC, board independence seems to be established just as a formality, to obey the rules. Empirically, our result is consistent with the findings in previous studies (e.g., Puspitaningrum and Atmini (2012), and Samaha et al. (2012). Consistent with our expectation, Table 3.3 shows that the presence of board sub-committees has a positive influence on IFR (t = 7.339, p = 0.000). This finding suggests that the companies that have audit, nominating, and compensation committees disclose more information on their websites than those who do not have these sub-committees. This result is consistent with empirical studies on disclosure such as Ştefănescu (2012) and Hassan (2013). In terms of board meetings, our result does not support the argument that having less time to meet as a group on the board leads to less transparency (Laksmana, 2008). The insignificant result, however, is consistent with Kiew-Heong et al. (2011) who found that board meetings are not associated with IFR among Malaysian listed companies. With respect to audit committee characteristics, Table 3.3 shows that audit committee size (ACSIZE) and audit committee independence (ACIND) are not significantly associated with IFR. However, audit committee meetings (ACMEET) and audit committee financial expertise (ACFINEX) significantly affect IFR. The insignificant findings for audit committee size and audit committee independence confirm Kiew-Heong et al. (2011) who found that neither audit committee size nor independence explain IFR. Our study finds a significant but negative relationship between audit committee meetings and IFR (t = -3.248, p = 0.001), consistent with Barros et al. (2013) who explained that the negative impact of audit committee meeting might be because an audit committee that meets frequently drives a signal of continuous monitoring to the market, reducing the need for public information disclosure in annual reports. Table 3.3 display a positive relationship between audit committee financial expertise and IFR (t = 4.778, p = 0.000), suggesting that companies with a greater percentage of financial experts on the audit committee are more likely to disclose IFR. The finding is consistent with the result of prior studies (e.g., Kelton & Yang, 2008; Kiew-Heong et al., 2011).

With respects to the control variables, the results in Table 3.3 show that only firm size (t = 4.342, p = 0.000) has a significant relationship with IFR. This result is consistent with agency theory, and signalling theory, and is in line with many empirical studies on IFR (e.g., Evans, Henderson, & Trinkle, 2011; Puspitaningrum & Atmini, 2012). However, profitability, leverage, and auditor type are not significant. The results also indicate that country of origin is likely to influence the level of information on the Internet. The results support the findings by Debreceny and Rahman (2005) and Bonsón and Escobar (2006) on the influence of country of origin on the level of disclosure. Overall, our study provides evidence that not all board of directors and audit committee attributes influence the extent of IFR in GCC listed financial companies.

36

CONCLUSION This study examines whether characteristics of board of directors and audit committee explains the variation in the level of IFR. We performed analysis on a sample of 152 financial companies publicly listed in the stock market of the GCC countries in 2012. Our focus on the GCC countries is motivated by the lack of empirical evidence in this particular region as opposed to the exhaustive evidence from the developed market in many of the prior IFR studies. The results show that only board sub-committee is significantly associated with IFR. However, board size, board independence, and board meeting are found to be insignificant. In addition, this study documents that audit committee meetings and audit committee financial expertise significantly affect IFR. However, the results show that audit committee size and independence are insignificant. In the light of the major challenges faced by the financial companies in the GCC (Chahine, 2007; Al-Obaidan, 2008) and the implementation of policies to stimulate financial liberalization and financial restructuring in the banking sector in the GCC (Maghyereh & Awartani, 2012), Internet reporting emerges as an effective method of marketing a company to shareholders and investors (Dolinšek et al., 2014). IFR assists in increasing investors’ awareness and 37



keeps them well-informed with the latest financial information that helps in rationalizing their investment decisions in the securities market. As IFR serves as a tool that can assist the GCC companies in expanding their activities and raising their capital internationally, our findings provide insights into the need for effective corporate governance mechanisms, such as board of directors and audit committee, in ensuring better quality IFR practices. This study is subject to several limitations. Firstly, the sample is drawn only from the GCC listed financial companies. Future research could consider a wide range of companies as a sample or extend this study to other emerging markets. Secondly, this study suffers from measurement issues involving the development of the variables. Results obtained are only valid to the extent of the disclosure index used and time period investigated. Future research could extend the index by examining a new set of information items. Thirdly, some corporate governance factors are excluded due to the limitations involving data unavailability. For example, we do not have data on the education level and the international experience of board of directors and audit committee, and information technology committee. Future research could consider such attributes that may influence IFR.

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The Corporate Social Responsibility Disclosure: A Study of Listed Companies in Malaysia

Chapter 4 The Corporate Social Responsibility Disclosure: A Study of Listed Companies in Malaysia Chan Yan Khay and Ong Tze San

BACKGROUND In September 2006, Bursa Malaysia brought out a CSR framework for public listed companies, which focused on areas in the environment, marketplace, community and workplace. Bursa Malaysia has always advocated CSR as being key to sustainability because sustainability supports stakeholder value creation, and the sustainability activities that integrate environmental and societal concerns into business strategies and performance could drive a superior operating performance and as a trademark of good management and corporate governance (Bursa Malaysia, 2012). Most Malaysian companies have engaged in, or are performing, some level of sustainability activities, through meeting compliance requirements, volunteering for relief efforts, and donating money, amongst other things; however, the formal reporting of these sustainability activities is still very low. In addition, many companies are not actively engaged in corporate sustainability efforts due to their lack of understanding of sustainability. This passive involvement is also caused by a lack of empirical and convincing evidence about the benefits of sustainability development. It must be noted that Malaysian companies were badly affected during the financial crisis in the year 1997 to 1998. The crisis had lead economy downturn with negative economic growth Malaysia. Based on Malaysia Economic Report, Gross Domestic Product (GDP) dropped from around

RM230, 000 millions year 1996 to RM100, 000 millions year 1998. Foreign direct investment in the year 1996 reported around USD$7400 millions also decreased to around USD$2800millions in the year of 1998. Numbers of investor had withdrawn their money from Malaysia market. Confidence level of investors had decreased drastically. In order to improve business performance, corporate governance is necessary to a country. In the year 1998, Malaysia implemented reformation in corporate governance. Malaysia has its own Code of Corporate Governance to restore and sustain investor confidence level to assure security of a financial crisis or corporate scandals. Code serves as benchmarks and for monitoring purpose on implementation of those practices by companies. Malaysia Code of Corporate Governance (MCCG) was issued in March 2000 as a significant milestone in corporate governance reformation in Malaysia. On the other hand, with effective date from December 31, 2007, public listed companies in Malaysia are required to disclose CSR activities or practices by the listed issuer and its subsidiaries even there is no CSR activities, companies required to state in the annual report. The requirement was incorporated into the Listing Requirements of Bursa Malaysia (Appendix 9C, Part A, paragraph 29). CSR Disclosure is another initiative to improve confidence of investors to invest in Malaysia. However, the CSR Disclosure by Malaysian companies is still at infant stage (Saleh, 2009) and only limit to public listed companies as requested by Bursa Malaysia. To date, public listed companies in Malaysia do not have accounting standards in CSR Disclosure but they disclose CSR activities purely in voluntary basis. Since CSR Disclosure is so important, yet companies do not have the initiative to disclose. Therefore, it is important to find out what factors influencing the disclosure of CSR information in their annual report. The objectives of the study: (a) To measure the level of corporate social responsibility disclosure of Malaysian public listed companies. (b) To examine the relationship between corporate governance attributes and the level of corporate social responsibility disclosure of Malaysian listed companies. 47



Research Framework

Firm Size

Dependent variable

Previous studies in 1990s, firm size found to influence CSR disclosure (Belkaoui et al. 1989; Roberts 1992; Williams 1999; Patten 1991). However, studies in 2000 onwards such as Hossain et al. (2006) and Mohd (2011) reported that size of the firm does not affect the level of corporate social and environmental disclosure. Mohammad et al. (2010) also included total assets and total sales as controllable variables. This study will examine the relationship between firm size and CSRD. Total assets and total sales/ revenue obtained from annual reports will be the measure on firm size.

Corporate Social Responsibility Disclosure is the dependent variable for this study. Since the passed financial crisis, Malaysia is adapting the corporate governance practices to sustain investors. Practicing corporate social responsibility disclosure is one the important steps sustaining and attracting more investors. Therefore, this study will obtain data from technology industry of Bursa Malaysia for the past five years into evaluate the corporate governance attributes and corporate social responsibility disclosure level and their relative importance. Independent directors There is study mentioned that independent directors lead to better corporate social responsibility (Sahinet et al., 2011). Independent director is one of the corporate governance attributes that play important roles. Malaysian Code of Corporate Governance 2012 had recommended in order in strengthening composition, the board should establish a Nominating Committee which should comprise exclusively of non-executive directors, a majority of whom must be independent. The role of independent directors in brief is to provide independent oversight over the company. This study will review the effectiveness of independent directors in taking out their duties relative to CSRD. Board Leadership, Board Audit Committee, Return on Equity The Board Leadership Structure (BLS), Percentage of Board Audit Committee (BAC) and Return on Equity (ROE). According to Rouf (2011), prior studies had identified board leadership structure significantly associated with the level of disclosure; previous researches used profitably as a determinant of disclosure in corporate annual reports; Audit Committee was found as positively significant in determining disclosure level. Therefore, information on the mentioned control variables will be obtained and examine from annual reports.

Figure 4.1 Conceptual Framework

48

49


H1: The extent of social responsibility disclosure will be positively related to the percentage of the independent directors on the board. H2: The extent of social responsibility disclosures is positively related with the board leadership structure. H3: The extent of social responsibility disclosures is positively related percentage of independent director in Board of Audit Committee. H4: Firm size is positively associated with the extent of social responsibility disclosures.

LITERATURE REVIEW The concept of corporate social responsibility (CSR) has becoming greater within the last two decades. Literature shows that definitions of CSR by and large fall into two general schools of thought - business is obliged to maximize profits within the boundaries of the law and minimal ethical constraints (Friedman, 1970; Levitt, 1958); and those that advocate a broader range of obligations towards society (Carroll, 1991; Drucker, 1993). The community generally expects businesses to move away from their limited economic focus and be more socially responsible. (Yam, 2012) Based on previous study, different categories been identified to classify CSRD practices into five areas – environment, energy, community involvement, products and employees/human resources. (Saleh, 2009; Thompson et al., 2004; Abu-Baker et al., 2000) Besides, there are also some other studies had tested and found other areas in CSRD. (Amran et al., 2007; Ramasamy et al., 2004; Rashid et al., 2002). The majority of studies on CSRD, especially in the emerging capital markets, use content analysis and following previous studies, they will also utilize annual reports as a principle focus of the firm’s disclosures (Saleh, 2009). There are many ways businesses demonstrate their CSR initiatives. For example, a company may embed social elements into products to demonstrate CSR towards customers. To reduce its adverse impact on the environment, a firm may reduce carbon emissions in its business operation. To the community, some firms may make monetary contributions to improve education facilities. (Yam, 2012) 50


For example, study done by Saleh (2009), the content analysis employed presumes that content categories identified in the written messages of the annual reports have evidence, meaning that they can be classified into six categories of themes for content analysis – environment, energy, human resources, products, community involvement, and others respectively. These can be compared with customers, employees, community, environment, minority stakeholders. However, if more than one category is subject to content analysis, a more complex level of measurement may be achieved through the summing of the results for each category. Thus, according to the previous study by Hamid (2004) on content analysis of CSRD in the emerging capital markets, this study will use four types of CSRD, namely employee relations, community involvement, product dimensions, and environmental performance. Measuring attributes of CSRD scores is adopted from Al-Tuwaijri et al. (2004), who used quantitative disclosure measures, which have assigned weights to different disclosure items based on the perceived importance of each item to various user groups. This study reports and analyses CSRD through content analysis for Malaysian companies listed in Bursa Malaysia. This study is different from prior studies on CSRD in a Malaysian context as the report examines the relationship between corporate attributes and firm-specific factors and corporate social responsibility disclosures for latter trend on a specific industry.

METHODOLOGY Research Methods This study is a content analysis research where data were collected at a single point of time from year 2009 till year 2013. This research adopts a quantitative research approach where sufficient quantitative data were collected through information disclosed in annual reports of public listed companies in technology industry. The focus of analysis in this study was targeting on CSR disclosures of each firm under four indicators – employee, community involvement, product and environment. This selection criterion is consistent with previous studies on corporate social responsibility 51



reporting Thompson et al., (2004) found that a higher proportion of large and medium-sized companies disclosed social information compared to small companies. The time span was selected for two reasons: First, CSRD is in its infancy period in the emerging capital market Thompson et al., (2004). Second, Bursa Malaysia listing requirement had announced public listed companies to include description of CSR activities in annual with effective year 2007. Data collection is done from the twenty two techonology companies’ annual reports through the Bursa Malaysia’s website. Statistical Package for Social Science (SPSS) of version 20 was used to analyze the data obtained from main market of Bursa Malaysia total of twenty two Malaysian public listed companies in technology industry that participated in this research.

In this study, Regression model and Test of Hypothesis Regression technique will be used to analyze data. The following equation created to test the relationship between CSR Disclosure as dependent variable with independent variables of firm specifics characteristics. The regression technique used to test H1 is as follows:

Disclosure Index Construction and Application Content analysis approach used to explore the number of companies that reported their CSR activities. Items selected for inclusion were based on their relevance to the Malaysian context, and these were classified into four indicators of CSRD namely: (1) employee; (2) community involvement; (3) product and (4) environment. Each indicator has sub-item disclosures that are adjusted based on whether the items are disclosed. Firms that disclose any information for the given indicators receive ‘1’ whereas firms that do not disclose any information for the given indicators receive a ‘0. This paper uses an unweighted approach for disclosure scoring. This approach is most appropriate when no importance is given to any specific user-groups (Akhtaruddin, M. et al., 2009). The method of initially computing the disclosure score for each company can be expressed as follows:

Where, DCOR = the aggregate disclosures score; dj = 1 if the jth item is disclosed or 0 if it is not disclosed; and n = the maximum score that a company can obtain.

52

TCSRD Ni j t TCSRD

= = = =

Total social responsibility disclosure score for jth firm at the time t, ith item for jth firm year a + β1PIND + β 2 TA + β 3 TSE + β 4 BLS + β 5 PROE + β 6BAC + ʓe Expected sign (+) (+) (+) (+) (+) (+), TCSRD = Total corporate social responsibility disclosure score received from eachcompany PIND = Percentage of independent directors to directors on board. = Total assets of the firm. TA = Total Sales or Revenue of the firm. TSE = Board leadership structure, 1 for duel or 0 non-dual BLS = Percentage of Return on equity as net profit to total Assets ROE = Percentage of independent directors in Board audit committee, BAC

a ʓ

= total constant, and = the error term

1 for yes or 0 No

Sampling The sample in this study consists of all Malaysian public listed companies categorised under technology industry. A total of 22 companies are listed in main board of Bursa Malaysia,for the the year 2008 to 2012. Technology industry is selected due to its constant innovation, exponential growth, and rapid expansion into unfamiliar markets. It is anticipated that technology companies may be innovative in disclosuring their corporate social responsibility activities.

53



Research Administration

Figure 4.2 CSRD Index of sample companies

Table 4.1 explains the operational definitions of variable, source of information and expected signs and relationship in the between variables. Table 4.1 Opearational and relationship Independent Operational definition Variable TCSRD Total CSR disclosure index β1PIND Ratio of independent directors to the total number of directors on the board β 2 TA Total assets represent the size of firms. β 3 TSE β 4 BLS β 5ROE β 6BAC

Total sales / revenue represent the size of firms. Dichotomous, 1 or 0 Percentage Return on equity as net profit to total assets Percentage of independent directors in Board Audit Committee

Source of information

Expected sign and relationship Company annual reports Index Company annual reports (+) PIND has a significant positive relationship with the level of CSRD Company annual reports (+) TA is associated positively with the level of CSRD. Company annual reports (+) TSE is Associated positively with the level of CSRD. Company annual reports (+)BLS is positively related to the level of CSRD. Company annual reports (+) PROE is associated positively with the level of CSRD. Company annual reports (+) BAC is associated positively with the level of CSRD.

Data Analysis Profiles of Companies The total numbers of public listed company in technology industry is only thirty six companies. However, there are only twenty two out of thirty six companies that have been operated more than five years since year 2009. Figure 4.2 showed the numbers of CSR activities done according to years and companies. There increase numbers of CSR activities year by year. However, it is still slow moving in CSRD from year to year.

54

Companies

2009

2010

2011

1. Amtel Holdings Berhad

4

3

3

2. CBSA Berhad

7

8

6

3. D & O Green Technologies Berhad

6

8

9

4. Dataprep Holdings Berhad

6

7

6

5. Digistar Corporation Berhad

2

5

6. ExcelForce MSC Berhad

4

7. ETI Tech Corporation Berhad

4

8. Formis Resources Berhad 9. GHL Systems Berhad

2012 2013 Grand Total 4

9

23

7

7

35

10

11

44

6

4

29

6

5

7

25

6

9

10

10

39

6

7

6

7

30

3

6

8

7

6

30

6

6

6

6

6

30

10. Green Packet Berhad

8

9

13

13

13

56

11. Globetronics Technology Berhad

11

12

13

14

13

63

12. HeiTech Padu Berhad

9

13

13

13

14

62

13. Industronics Berhad

6

9

9

6

9

39

14. KESM Industries Berhad

6

5

5

4

5

25

15. Thetaedge Berhad

5

10

10

12

14

51

16. Malaysian Pacific Industries Berhad

12

14

13

13

13

65

17. Mesiniaga Berhad

7

11

13

11

11

53

18. Notion Vtec Berhad 19. Pentamaster Corporation Berhad

11 5

10 8

11 10

10 8

10 12

52 43

20. Unisem (M) Berhad

14

13

13

13

14

67

21. ViTrox Corporation Berhad

9

10

10

10

10

49

12 157

9 188

9 202

9 197

10 215

49 959

22. Willowglen MSC Berhad Grand Total

Descriptive Analysis Referring to Table 4.2, there are total of one hundred ten datas collected for this study. Fourteen is the highest numbers of a company would disclose their CSR activities based on the four dimension – employee, community, product and environmnet and the minimum CSRD for a company is two activities. Frequencies distribution and percentage distributions were used to summarizes the data about the CSR Disclosure from year 2008- 2012. 55


468860144.20266

TOTAL SALE/ REVENUE

110

7342000.00 1539126000.00 241409616.2818

352674326.44219

BOARD AUDIT COMMITTEE

110

.50000

1.00000

.8316675

.16528313

RETURN ON ASSETS

110

-.35272

1.52775

.0652120

.18976129

Valid N (listwise)

110

Pearson Analysis

All the independent variables have multicolinearity less than 0.6 in Table 4.3. Notice that Pearson correlation coefficient was specifically used to determine whether there is a problem of multicolinearity (r > 0.7) exists between independent variables. This had proven that every independent variables are not related that could enable the study to go on investigate. However, the control variables have multicolinearity of 0.921 means that both control variables in highly correlated stage. Total asset and total sales is correlated because these two variables represent firm size.

56

1.000

21533408.00 1851621000.00 347101683.8909

-.047

110

.227

TOTAL ASSETS

-.309

.44148682

-.262

.0255810

.065

.64957

-.268

-4.03513

1.000

110

-.189

RETURN ON EQUITY

.019

.502

-.034

.50

-.045

1

-.068

0

1.000

110

-.172

BOARD LEADERSHIP STRUCTURE

-.087

.12959278

.009

.4412317

1.000

.75000

.921

.16667

.065

110

.527

% INDEPENDENT OVER TOTAL DIRECTORS

1.000

3.177

-.046

8.72

.524

14

1.000

2

.036

110

1.000

TOTAL CSR DISCLOSURE

TOTAL CSR DISCLOSURE % INDEPENDENT OVER TOTAL DIRECTORS TOTAL ASSETS TOTAL SALE/ REVENUE BOARD LEADERSHIP STRUCTURE RETURN ON EQUITY BOARD AUDIT COMMITTEE

Std. Deviation

TOTAL SALE/ REVENUE

Mean

% INDEPENDENT TOTAL ASSETS OVER TOTAL DIRECTORS

Maximum

TOTAL CSR DISCLOSURE

Minimum

Table 4.3 Pearson analysis

N

BOARD RETURN BOARD AUDIT ON LEADERSHIP STRUCTURE EQUITY COMMITTEE

Table 4.2 Descriptive Statistics

-.068


57



Multivariate Tests Results In Table 4.4, the value for Wilks’ Lambda is 0.277, with a probability value of 0.000 means that p is less than 0.005. When p value is less than 0.05, we can conclude that there is a statistically significant relationship between CSRD with percentage over total directors, board leadership structure, the return on equity and percentage independent director in board audit committee. In this case, this result is matched with previous studies that all the independent variables are contributing and affecting the dependent variable, CSRD. Table 4.4 Multivariate tests Effect Pillai’s Trace Wilks’ Lambda Hotelling’s Trace Intercept

Value

F

Hypothesis Error df Sig. Partial Eta df Squared

0.961 381.536b

6

92

0

0.961

0.039 381.536b

6

92

0

0.961

24.883 381.536b

6

92

0

0.961

Roy’s Largest Root 24.883 381.536b Pillai’s Trace 1.039 1.693 Wilks’ Lambda 0.277 1.872 Hotelling’s Trace 1.655 2.076 Roy’s Largest Root

6 72

92 582

0 0.001

0.961 0.173

72

506.339

0

0.193

72

542

0

0.216

12

97

0

0.504

industry in Malaysia are at infancy stage and there is limited data to assess the CSRD in Malaysia. Table 4.5 Tests of between-subjects effects

% INDEPENDENT OVER TOTAL DIRECTORS TOTAL ASSETS TOTAL SALE/ REVENUE

Type III Sum of Squares

df

Mean Square

F

Sig.

Partial Eta Squared

.210

12

1.050 1.050 .411

.115

11192162354680000000

12

7.085 7.085 .000

.467

6175655952595540000

12

6.763 6.763 .000

.456

3.666

12

1.243 1.243 .266

.133

1.023

12

.656

12

BOARD LEADERSHIP STRUCTURE RETURN ON EQUITY BOARD AUDIT COMMITTEE

.409

.409 .957

.048

2.286 2.286 .013

.220

R Squared = .456 (Adjusted R Squared = .388)

CONCLUSION Contribution of the Research

For this study, only significant of percentage of independent directors in Board Audit Committee 0.013, total assets 0.0000 and total sales/ revenue 0.0000 meet the criteria of significant less than 0.17. The results indicate that only independent director in Boards Audit Committee and firm size is affecting the CSRD (Table 4.5). There is possibility that due to technology

Technology Industry in Malaysia is still at early stage comparing with other industries listed in Bursa Malaysia. Technology industry plays important role to stakeholder as technology covers broad fields affecting people, biodiversity, water, air and many more. Therefore, they are liable to contribute in CSR activities. Research done will get to investigate how far technology industry willing to contribute back to its stakeholders. This empirical study provides some useful insights into the area of corporate governance, particularly using technology industry as research context. Companies will be more careful in their corporate governance aspects which will directly affect their financial performance. Through the findings of this study, companies are urged to be more proactive in their

58

59

TCSRD

1.018

8.228

c

a. Design: Intercept + TCSRD b. Exact statistic c. The statistic is an upper bound on F that yields a lower bound on the significance level.

Test of Between-Subjects Effects


corporate governance structure and promote genuine governance within their corporations.

Implications This research is an extension of research done overseas and extension to previous research done in Malaysia. Independent directors, board leadership structure and board audit committee are corporate governance attributes and characteristics variables been included in finding level of CSRD. The purpose of this study is to examine whether factors such as Independent Directors, Board Leadership Structure (BLS), Board Audit Committee (BAC), Return on Equity and firm size will influence the disclosure of social responsibility information in annual reports. Apparently, the proposed concept of research is all the independent variables including the control variables are positive related to CSRD. The study used the disclosure index with four dimensions to measure CSRD on a sample of twenty two listed companies in technology industry in Malaysia. Only Hypothesis 3 and Hypothesis 5revealed that CSRD is positively related percentage of independent director in Board of Audit Committee and firm size for technology industry of Malaysia. The results showed that CSRD is negatively related with independent director, board leadership structure and return on equity.

Suggestions for Further Research This research can be further extended by collecting information of CSRD in annual reports and social reports of public listed company in Malaysia. This will enhance the reliability of the study. Future study can test more variable that related to corporate governance attributes and CSR initiatives. Comparative study should be carried out with other industries. Enlarging data samples will be able more represents all the public listed company.

60


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65

66

EMPLOYEES BENEFITS PROFILES OF EMPLOYEES SHARE OPTION FOR EMPLOYEES AWARDS & RECOGNITION TO EMPLOYEE OTHERS

3 4 5

67

0.0%

0

0

10

11

9

15

2

21

6

0

0

11

17

15

4

2

12

0

22

17

14

n

0.0%

45.5%

50.0%

40.9%

68.2%

9.1%

95.5%

27.3%

0.0%

0.0%

50.0%

77.3%

68.2%

18.2%

9.1%

54.5%

0.0%

100.0%

77.3%

63.6%

2010 %

0

14

9

11

15

4

21

10

1

0

10

17

13

7

2

12

0

22

19

15

n

0.0%

63.6%

40.9%

50.0%

68.2%

18.2%

95.5%

45.5%

4.5%

0.0%

45.5%

77.3%

59.1%

31.8%

9.1%

54.5%

0.0%

100.0%

86.4%

68.2%

2011 %

0

14

9

12

15

1

21

11

1

1

8

16

13

5

3

13

0

22

17

15

n

0.0%

63.6%

40.9%

54.5%

68.2%

4.5%

95.5%

50.0%

4.5%

4.5%

36.4%

72.7%

59.1%

22.7%

13.6%

59.1%

0.0%

100.0%

77.3%

68.2%

2012 %

1

16

9

12

16

3

21

13

1

1

10

18

13

7

5

12

0

22

18

17

n

4.5%

72.7%

40.9%

54.5%

72.7%

13.6%

95.5%

59.1%

4.5%

4.5%

45.5%

81.8%

59.1%

31.8%

22.7%

54.5%

0.0%

100.0%

81.8%

77.3%

2013 %

Notes: n = numbers of firms disclose on the given category ; %= number of firms disclose as percentage of total firms in the sample (22)

22.7%

5

22.7% 31.8%

ENVIRONMENT 1 POLLUTION CONTROL

59.1%

9.1%

95.5%

36.4%

0.0%

0.0%

7

5

3 PRODUCT QUALITY

2 PREVENTION/REPARATION PROGRAMME 3 CONSERVATION AND RECYCLED MATERIALS 4 AWARD IN ENVIRONMENT PROGRAMME

2 13

2 PRODUCT SAFETY

21

8

0

0

40.9%

59.1%

9

36.4%

8

4.5%

18.2%

68.2%

0.0%

100.0%

63.6%

45.5%

2009 %

13

1

4

15

0

22

PRODUCT 1 PRODUCT DEVELOPMENT

6

5 PUBLIC HEALTH & SAFETY PROJECT

SCHOLARSHIP PROGRAMME & INTERNSHIP SPONSOR FOR SPORT ACTIVITIES SUPPORTING NATIONAL PRIDE

3 4

CASH DONATION PROGRAMME CHARITY PROGRAMME

1 2

7

6

COMMUNITY INVOLVEMENT

TRAINING & EDUCATION

2

14

10

EMPLOYEE HEALTH & SAFETY

1

n

CSR disclosure dimensions

APPENDIX A: Corporate Social Responsibility Disclosure (CSRD) in Malaysian Companies’ Annual Reports

Issues in Contemporary Accounting & Finance The Corporate Social Responsibility Disclosure: A Study of Listed Companies in Malaysia

Factors Affecting Auditor Independence

Chapter 5 Factors Affecting Auditor Independence Zaidi Mat Daud, Chai Fong Ying & Ridzwana Mohd Said

credibility of the audit profession is argued to be dependent upon the users’ perceptions of auditor independence (Desira and Baldacchino, 2005). This study aims to examine this issue since perceptions may have changed after the recent financial scandals involving local companies and reforms in corporate governance. Thus, the findings may provide further understanding concerning the factors that potentially undermine auditor independence in Malaysia and complement the work of Abu Bakar and Ahmad (2009).

RESEARCH OBJECTIVE INTRODUCTION Auditor independence has always been a major concern to the business community, and, once again, has been brought to the forefront due to the recent collapse of many giant corporations around the world, such as Enron, World.com and Parmalat. Not only have these events caused substantial financial loss to the respective companies, but they have also ruined the reputation of the audit profession. Thus, these financial scandals and corporate failures have been proven to have a detrimental effect on the public’s perception of auditors (Abu Bakar and Ahmad, 2009). Malaysia is no exception to this issue. Several local companies have been associated with financial scandals and have received media attention, such as Transmile, Megan Media and Port Klang Free Trade Zone (PKFZ). Although these scandals may not be solely attributed to the failure of the auditors, it is also widely believed that these scandals took place because the auditors compromised their independence by accommodating their clients’ interests during the audit. The work of auditors is translated in the form of an audit opinion. If users believe that an auditor is independent of a company, they will display high confidence in the auditor’s opinion. Once an auditor is perceived to lack independence, the audit work loses credibility and the value of the auditing function is severely impaired, if not lost (Firth, 1980). Thus, the

This study aims to investigate the factors that affect perceived auditor independence in Malaysia. Specifically, the following objectives are addressed: • • • •

To investigate the relationship between audit tenure and the switching behaviour of auditors, and auditor independence. To investigate the relationship between non-audit services and auditor independence. To investigate the relationship between the size of audit firms and auditor independence. To investigate the relationship between the client’s audit committee and auditor independence.

AUDITOR INDEPENDENCE Auditor independence is important to both the audit profession and the public in general. For the general public, ‘a lack of auditor independence is putting at risk the investment of ordinary people’ (Gettler et al., 2002). For the audit profession, auditor independence represents professional status and public stewardship (Kleinman and Palmon, 2001), and, as Gill et al., (2001) stated: ‘independence is the cornerstone of the auditing profession and without independence the auditor’s opinion is suspected’ (p.55). As the Public Oversight Board’s Panel on Audit Effectiveness (POB, 2000) noted:

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‘Independence is fundamental to the reliability of auditors’ reports. Those reports would not be credible, and investors and creditors would have little confidence in them, if audits were not independent in both fact and appearance. To be credible, an auditor’s opinion must be based on an objective and disinterested assessment of whether the financial statements are presented fairly in conformity with generally accepted accounting principles’ (p.109).

Another major point in the above statement is that auditors must be independent not only in fact, but also in appearance. Independence in fact, can be defined as the auditor’s state of mind, and his or her ability to make objective and unbiased decisions (Dykxhoorn and Sinning, 1982). Independence in appearance refers to ‘the perception by a reasonable observer that the auditor has no relationship to the audit client that suggests a conflict of interest’ (Pierce, 2006). In short, independence in appearance indicates whether the auditor appears to be independent, whereas independence in fact would be less significant if the users do not perceive that independence exists.

FACTORS AFFECTING AUDITOR INDEPENDENCE A review of the literature concerning the factors affecting auditor independence revealed that numerous studies have been conducted over the last two decades (Beattie et al., 1999; Bakar et al., 2005; Alleyne et al., 2006; Abu Bakar and Ahmad, 2009; Fawzi and Atala, 2012). These studies indicated that tenure and the switching behaviour of audit on client, non-audit services, size of audit firms and audit committee are among the important factors that determine auditor independence.

Audit Tenure and Switching Behaviour Audit tenure has been identified in prior studies as one of the factors affecting auditor independence. (Abdul Naser et al., 2006; Fawzi and Atala, 2012). Abu Bakar and Ahmad (2009) defined an audit firm’s tenure as the length of time the audit firm has been serving or filing the audit needs of a given client and which have a certain impact on the risk of 70


compromising auditor independence. For example, lack of innovation and less rigorous audit procedures may arise after a long duration serving a given client. The lengthy audit tenure with the same client may cause the auditor to develop a ‘cosy relationship’ that can sway the auditor to make assumptions that will affect the evaluation of current evidence (Abdul Nasser et al., 2006). Under this circumstance, auditors will find it difficult to maintain their integrity and objectivity, and, thus, audit failures are unavoidable (Bazerman et al., 1997). The issue of audit tenure is more complex for small audit firms than for big audit firms. Big audit firms normally have a large variety of clients, and, thus, they can afford to lose some of their clients, especially if they are dealing with distressed clients. However, smaller audit firms, with limited clients, may fear losing their tenure, especially when dealing with risky clients. This may influence the firm to compromise its objectivity and independence (Abdul Naser et al., 2006). Empirical studies on audit tenure showed mixed results. For example, a study by Teoh and Lim (1996) found that tenure does not have a significant impact on auditor independence. In another study, by Alleyne et al. (2006), it was found that most auditors are less keen to shorten the tenure, as they believe that a long association with their client allows them to be more familiar with the client’s operation, and, hence, save time. In a recent study by Abu Bakar and Ahmad (2009), it was found that the longer the duration of service provided to the same client, the more easily auditor independence is impaired.

Non-Audit Services (NAS) Providing NAS has always been the central issue to auditor independence and is subject to controversy. Some people opine that NAS performed by auditors help to improve the audit function and enable directors to be held accountable, as they feel that with inside knowledge of the business, the auditors work more efficiently in their non-audit work, such as acquisitions, due diligence, and tax advice to benefit management and shareholders (The Star, 2008). On the other hand, prior research has suggested that audit firms should be prevented from offering such services as it may impair

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auditor independence. Teoh and Lim (1996) argued that a fee dependency problem will arise when the income of an auditor is heavily dependent on a major client and could have a negative impact on auditor independence. A study by Defond et al. (2002) on this issue revealed that auditors agree that NAS could impair auditor independence when the firm’s NAS revenue is substantial from that audit client. Bakar et al. (2005) examined the perceptions of loan officers regarding several potential factors that may impair auditor independence, including the provision of NAS. Their findings showed that the majority (86%) of the respondents agreed that the provision of NAS has the potential to impair auditor independence. A later study by Sikka (2009) also presented findings that were consistent with prior studies. He found that NAS provided by auditors impaired auditor independence in terms of the quality of audit work and the attitude towards audit planning as a consequence of the auditors relying too heavily on the fees from a client.

Size of Audit Firms The literature indicated that the size of the audit firm is one of the important factors that affect auditor independence (Muhammad Sori et al., 2006). Prior studies suggested that there is a positive relationship between size of audit firm and auditor independence. It is also suggested that larger audit firms are often considered to be more independent than smaller audit firms as the former are perceived to be able to resist pressure from management. Normally, these large audit firms have many competent employees, sound financial resources and facilities for continuing operational activities. Practically, these visible characteristics would reduce their dependence on certain clients. Muhamad Sori et al. (2006) found that the senior managers of public listed companies have a high degree of confidence with respect to the quality of the audit by the Big Four audit firms as they are perceived to be more independent than non-Big Four Firms. This is because the intention of a big audit firm is to maintain its reputation, which is an invaluable and intangible asset in the market (Muhamad Sori et al., 2006).

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Audit Committee The existence of an audit committee is important for enhancing the perception of auditor independence in Malaysia (Teoh and Lim, 1996). An audit committee plays an important role when auditors provide extensive NAS to their clients, and it is responsible for overseeing the financial reporting and auditing procedure. The audit committee is responsible for the oversight function of the board and internal control to reduce the management threat to auditor independence (Muhamad Sori et al., 2009). Abu Bakar and Ahmad (2009) found that there is a positive relationship between the audit committee and auditor independence. According to studies by Muhamad Sori et al. (2009), Alleyne et al. (2006), and Abu Bakar and Ahmad (2009), the existence of an audit committee is perceived to strengthen corporate governance because the majority of the members are non-executives and independent, and they cannot be easily influenced by the executive members. Zhang and Zhang (2009) stated that the company’s audit committee is responsible for overseeing the auditors’ work in terms of approving all audit and nonaudit services, receiving all new auditing and accounting information from the auditors, and serving as the bridge for communication between the auditor and the client company. The authors also indicate that the auditors need to report to the audit committee, and, thus, the board members of the company being audited must include a financial expert and independent members. Muhamad Sori et al. (2009) found that the presence of a wellfunctioning and independent audit committee would safeguard the auditor independence since audit committees are responsible for approving the audit fees and are comprised of independent and non-executive directors. In contrast, Gul (1989) found that audit committees do not significantly affect the perceptions of auditor independence.

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RESEARCH FRAMEWORK AND HYPOTHESES

RESEARCH METHODOLOGY

Figure 5.1 shows the research framework of the study. This study attempts to investigate the factors affecting auditor independence, and to examine the relationship between the four proposed factors and auditor independence.

Questionnaire Design and Data Collection

Figure 5.1 The research framework

Based on the prior studies mentioned above, the following hypotheses are proposed: Hypothesis 1: There is a significant relationship between the tenure and switching behaviour of audit on client and auditor independence. Hypothesis 2: There is a significant relationship between non-audit services and auditor independence. Hypothesis 3: There is a significant relationship between size of audit firm and auditor independence. Hypothesis 4: There is a significant relationship between audit committee and auditor independence.

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In this study, the data were gathered by distributing a set of questionnaires to the respondents. The questionnaire was adopted from the study of Abu Bakar and Ahmad (2009) to ensure the validity and reliability of the constructs. In addition, it was piloted with accounting students of a public university. The questionnaire was divided into two sections. The first section consisted of questions pertaining to the respondents’ profile, while the second section consisted of statements relating to the factors that influence auditor independence. The target respondents were private sector auditors working in audit firms. In order to increase the response rate, the questionnaire was sent to the respondents through email and by mail. The audit firms surveyed were randomly selected from the database of audit firms registered with the Malaysian Institute of Accountants (MIA). Based on the defined target population, 180 samples were randomly selected from audit firms located in the different states of Malaysia. A total of 75 usable responses were received, representing 41.7% of the response rate. Regression Model The study used multiple regression analysis to investigate the relationship between variables. Data from the questionnaires were extracted and entered into the SPSS software for analysis purposes. The regression equation model is shown below: Y = ∞ + β1 X1 + β2 X2 + β3 X3 + β4 X4 + ε ∞ - Intercept Y - Auditor independence X1 - Tenure and switching behaviour of audit on client X2 - Non-audit services X3 - Size of audit firms X4 - Audit committee ε - Error term

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DATA ANALYSIS

Table 5.2 cont’d

Reliability Test

Monthly Income

Below RM2000 RM2001-RM3000 RM3000-RM4000 RM4001-RM5000 Above RM6001

17 34 14 4 6

22.7 45.3 18.7 5.3 8.0

Length of Service

Less than 3 years 3-6 years 7-10 years Above 10 years Entry Level Middle Level Senior Level

65 3 6 1 64 5 6

86.7 4.0 8.0 1.3 85.3 6.7 8.0

The results of the analysis below show that the Cronbach’s Alpha value of all the variables are more than 0.5, which means that all the variables are reliable for analyses. Thus, the reliability of the study instruments are satisfactory. Table 5.1 Reliability Test Variables

Cronbach’s Alpha

N of items

Tenure and switching behaviour of audit on client Non-audit services Size of audit firms Audit committee

0.558

4

0.616

5

0.852 0.750 0.521

5 5 4

Auditor Independence

Descriptive analysis Table 5.2 Respondents’ Profile Demographic Gender

Respondent Male Female

Frequency Per cent 38 50.7 37 49.3

Age

21-25 years old 26-30 years old 31-35 years old 36-40 years old

57 12 4 2

76.0 16.0 5.3 2.7

Race

Malay Chinese Indian Others

2 70 2 1

2.7 93.3 2.7 1.3

Highest Level of education Degree 39 Professional Qualification 34 Master Degree 2

52.0 45.3 2.7

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Job Position

The table shows that the male and female respondents consisted of 50.7% and 49.3%, respectively. The majority of the respondents were between 21 to 25 years old (76%), whereas the minority of the respondents were between 36 to 40 years old. The Chinese respondents made up 93.3%, followed by 2.7% Malay and Indian respondents, respectively, and 1% from other race. From the perspective of the highest education level in the field of accounting, approximately 52% of the respondents had a bachelor’s degree, and 45.3% and 2.7% of the respondents had a professional qualification and master’s degree, respectively. The majority of the respondents (45.3%) earned a monthly income of between RM2001RM3000, while the monthly income of the other respondents was between RM4001 to RM5000, (5.3%). The length of service in an audit firm of most of the respondents was less than three years (86.7%). The length of service of the rest of the respondents (1.3%) exceeded 10 years. From the perspective of a current job position, the majority of the respondents (85.3%) were in the entry level, followed by the senior level (8%) and middle level (6.7%). Regression Analysis The results of the ANOVA analysis indicates that the model as a whole (which includes the tenure and switching behaviour of the audit on client, 77



non-audit services, size of audit firms, and audit committee) is significant where the p-value of 0.000 is less than 0.05. Table 5.3 Coefficients Unstandardized Coefficients Std. B Error

Model

1

t

Sig.

(Constant)

6.204

.328

18.908

.000

Tenure and switching behaviour of audit on client

.564

.239

2.358

.021

Non-audit services

-.980

.216

-4.537

.000

Size of audit firms

-.788

.187

-4.210

.000

Audit committee

.545

.140

3.884

.000

Based on the Table 5.3, the equation developed based on the correlation between the independent and dependent variables is as follows: Y= 6.204 + 0.564 X1 – 0.980 X2 – 0.788 X3 + 0.545 X4 Y = Auditor independence X1 = Tenure and switching behaviour of audit on client X2 = Non-audit services (NAS) X3 = Size of audit firms X4 = Audit committee The equation shows that auditor independence is expected to be constant at 6.204 when there is no other factor affecting it. Auditor independence is expected to increase by 0.564 when the tenure and switching behaviour of audit on client increases by 1; decrease by 0.980 when the NAS provides an increase of 1; decrease by 0.788 when the size of the audit firms increases by 1; and increase by 0.545 when the audit committee increases by 1.

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FINDINGS AND DISCUSSION According to the regression results in Table 5.3, the p-value for the tenure and switching behaviour of audit on client is 0.021, which is less than 0.05. This indicates that the tenure and switching behaviour of audit on client has a significant relationship with auditor independence. The result suggests that the longer the duration of service given to the client, the more the direct influence on auditor independence. Hence, the respondents implied that auditors would be more professional, independent, and familiar with the company’s business environment. However, the result contradicts the studies conducted by Fawzi and Atala (2012), and Abu Bakar and Ahmad (2009) in that serving a given client over a longer duration will impair the independence of the auditor. One of the reasons for switching audit firms is the increase in total assets and the financial risk of the company (Abdul Nasser et al., 2006). This result is similar to that of the study by Alleyne et al. (2006), which also concluded that the auditors are less keen to shorten the tenure. Meanwhile, the p-value of 0.000 in Table 5.3 indicates the significant correlation between NAS and auditor independence. It shows a negative relationship between these two variables based on the beta value of -0.980. The result demonstrates that the more NAS provided to the same audit client, the more it will directly threaten auditor independence. The result demonstrates that the increase in the NAS provided to the same audit client directly threatens auditor independence. This can be due to the conflict in the role of the audit team when performing the audit service and non-audit service simultaneously to the given audit client, which may impede the independence of the auditor. For example, during the audit, the audit team needs to provide a true and fair view when determining fraud in the financial statements of the company; however, at the same time, they also provide some NAS to the management of the particular client in terms of taxation advisory, management advisory, financial and investment advisory, and information technology advisory. Under this circumstance, this contradicts the objective and role of the audit team itself.

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This result is in line with the prior studies of Abu Bakar and Ahmad (2009), Muhamad Sori et al. (2006), and Francis and Ke (2006) in which it was found that auditor independence was significantly threatened when the audit and NAS were jointly provided by the audit engagement team. In addition, they indicated that there were indifferences between the opinions of the loan officers and accountant (Muhamad Sori et al., 2006), auditors (Abu Bakar and Ahmad, 2009), and investors (Francis and Ke, 2006) in terms of the relationship being tested. In addition, Sikka (2009) supported the findings in that the impairment of auditor independence is the NAS provided by auditors as a conflict of interest occurs when the auditor performs the statutory role as well as undertakes the NAS work. However, the finding contradicts the study of Defond et al. (2002), which found that the NAS provided and fees collected have no significant effect on auditor independence. For the factor relating to the size of audit firms, the results in Table 5.3 demonstrate that big audit firms can threaten auditor independence. The p-value of 0.000 indicates that there is an association between the size of audit firm and auditor independence. Hence, the majority of the respondents who have less than three years work experience (86.7%) expressed that smaller audit firms can also act independently as they rely on the auditor’s working experience and professional ethics. On the other hand, not all big four audit firms are able to resist client pressure as some jobs may be undertaken by fresh graduate auditors who lack experience in managing client pressure. This result is in line with Abu Bakar and Ahmad (2009), and Fawzi and Atala (2012) in that audit firm size is one of the reasons for the impairment of auditor independence. However, the result of this study contradicts the findings of Alleyne et al. (2006). The authors concluded that large audit firms were perceived as being more independent, compared to smaller audit firms, as larger firms were seen as being less financially dependent on certain clients. Therefore, they are able to resist client pressure. On the other hand, the results of this study are inconsistent with the findings of Muhamad Sori et al. (2006) in that Big Four firms are perceived to be superior compared to non-Big Four firms, as Big Four auditors are better able to resist management pressure in conflict situations. Different target

respondents could be the main reason for the result of this research, which contradicts prior empirical studies. Lastly, the p-value of 0.000 indicates the existence of correlation between the audit committee and auditor independence. A beta value of 0.606 indicates that there is a positive and significant relationship between these two variables, where the existence of the audit committee is very important for ensuring and safeguarding auditor independence. The result is consistent with that of Muhamad Sori et al. (2009) in that the researchers found that an active and functioning audit committee could significantly preserve auditor independence with a condition that committee members are truly independent, knowledgeable, diligent and committed to improve good governance. In addition, the present study also supports the findings of Abu Bakar and Ahmad (2009), and Alleyne et al. (2006) who found that the audit committee is perceived to influence auditor independence.

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CONCLUSION The study examines the perception of Malaysian auditors concerning auditor independence. It has identified the factors that impair the auditor independence and the relationship between it and the auditors. The results have established that the tenure and switching behaviour of audit on client, NAS provided for the audit client, size of audit firms, and audit committee of client have a significant relationship and influence auditor independence in Malaysia. Thus, all the proposed hypotheses are accepted. This study contributes to the literature on the perceptions of auditor independence in a developing economy. In addition, it also provides evidence to regulators in developing countries about the factors affecting auditor independence. The results contribute not only to a better understanding and provide recent evidence from the viewpoint of those target respondents for auditors in Malaysia to improve their professional practice, but also the awareness of the audit client and the public concerning the importance and impact of auditor independence. In addition, the findings can be utilised to educate users and those who prepare financial reports about the contextual factors surrounding the role of auditors, and the possible threat and enhancement factors affecting



auditor independence. Furthermore, the results of this study may also assist the relevant policymakers in their effort to attain the international auditing standard. This is because the regulators and policymakers in Malaysia generally review and adapt the audit legislation of developed countries during the standard setting process as the audit environment in Malaysia differs from that of the developed countries. The current study only examines the perception of auditors and ignores the point of view of other parties, such as investors and loan officers. Future research is recommended to extend the current investigation by including the parties mentioned and other factors that may influence auditor independence, such as the level of competition, size of audit fees, ethics and regulations on auditors.

DeFond, M., Wong, T. J., & Li, S. (2002), “The impact of improved auditors independence on market concentration in”, Journal of Accounting and Economics, 28, 269-305. Desira, J. and Baldacchino, P.J. (2005), “Jurors’ and self-perceptions of the statutory auditors in Malta”, Managerial Auditing Journal, 20 (7), 691-706. Dykxhoorn, H. J. & Sinning, K. E. (1982). Perceptions of auditor independence: Its perceived effect on loan and investment decisions of German financial statements users, Accounting, Organisations and Society, 7(4), 337-347. Fawzi, A.S., & Atala, Q. (2012), “Jordanian Shareholders’ Perception Of External Auditor Independence,” Interdisciplinary Journal Of Contemporary Research In Business, 4(3). Firth, M. (1980). Perceptions of Auditor Independence and Official Ethical Guidelines. The Accounting Review 55(3), 451-466. Francis, J. R., & Ke, B. (2006). Disclosure of fees paid to auditors and the market valuation of earnings surprises. Review of Accounting Studies, 11(4), 495-523.

REFERENCES Abdul Nasser, A.T., Abdul Wahid, E., Syed Mustapha Nazri, S.N.F. and Hudaib, M. (2006), “Auditor-client relationship: the case of audit tenure and audit switching in Malaysia”, Managerial Auditing Journal, 21 (7), 724-737. Abu Bakar, N.B, & Ahmad, M. (2009), Auditor independence: Malaysian accountants’ perception, International Journal of Business and Management, 4 (12), 129-141. Alleyne, P.A., Devonish, D., & Alleyne, P. (2006), “Perceptions of auditor independence in Barbados”, Managerial Auditing Journal, 21 (6), 621-635. Bakar, N.B.A, Rahman, A.R.A. & Rashid, H.M.A (2005), Factors Influencing Auditor Independence: Malaysian Loan Officers’ Perceptions, Managerial Auditing Journal, 20 (8), 804-823. Bazerman, M.H., Morgan, K.P., & Loewenstein G.F. (1997), The impossibility of audit independence, Sloan Management Review. Beattie, V., Brandt, R., & Fearnley, S. (1999). Perceptions of auditor independence: UK evidence. Journal of international accounting, auditing and taxation, 8(1), 67-107. DeFond, M., Raghunandan, K. & Subramanyam, K. (2002), “Do non-audit service fees impair auditor independence? Evidence from going concern audit opinions”, Journal of Accounting Research, 40 (4), 1247-74. 82

Gettler, G., Gordon, J. & Ravlic, T. (2002). Corporate shake up hits accountants, The Australian Financial Review, pp. 1-8. Gill, G. S., Cosserat, G., Leung, P. & Coram, P. (2001). Modern Auditing and Assurance Services, 6th edition, Queensland: Wiley. Gul, F. A. (1989). Bankers’ perceptions of factors affecting auditor independence. Accounting, Auditing & Accountability Journal, 2(3), 0-0. Jaafar Sidek, A.W. (2008). Changing external auditors. The Star Online. Retrieved 3, May 2008 form http://thestar.com.my/news/story.asp?file=/2008/5/3/ bizweek/21046858&sec=bizweek Kleinman, G. and Palmon, D. (2001). Understanding Auditor Client Relationship: A Multifaceted Analysis, Princeton: Markus Wiener Publishers. Muhamad Sori, Z., Mohamad, S., & Karbhari, Y. (2006), “Perceived auditor Independence and Size of audit firm”, Staff Paper 5/2006, University Putra Malaysia, Selangor. Muhamad Sori, Z., Mohamad, S., Ramadili, & Karbhari, Y. (2009), “Audit Committee and auditor independence: The Bankers’ perception”, International Journal of Economics and Management, 3 (2), 203 – 227.

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Pierce, A. (2006). Ethics and the professional accounting firm: A literature review, Institute of Chartered Accountants in England and Wales. Public Oversight Board (2000). The panel on audit effectiveness: Report and recommendations, New York. Sikka, P. (2009), “Financial Crisis and the Silence of the Auditors” Accounting, Organizations and Society, 34, 868-873. Teoh, H.Y. and Lim, C.C. (1996), “An empirical study of the effects of audit committees, disclosure of non-audit fees and other issues on audit independence: Malaysian evidence”, Journal of International Accounting, Auditing and Taxation, 5 (2), 231-48. Zhang, G.J., and Zhang, L. (2009), “An analysis on dealing with audit failure”, Journal of Modern Accounting and Auditing, 5, 62 – 65.

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Chapter 6 Perceptions of Auditor Independence: The Case of Provision of Non-Audit Services Zulkarnain Muhamad Sori, Yusuf Karbhari and Siti Zaidah Turmin

INTRODUCTION The objective of this chapter is to examine the effects of the joint provision of audit and non-audit services on perceived auditor independence from the perspective of senior managers of audit firms, loan officers and public listed companies in Malaysia. The effect of joint provision of audit and non-audit services might be different when auditor perform the services based on their available resources. Thus, the question is what would be the effects of the following mode of provision of non-audit services on perceived auditor independence; (i) provision of non-audit services by audit engagement staff, (ii) provision of non-audit services by staff from separate department, (iii) provision of non-audit services by staff from different entities; (iv) audit firms are prohibited providing non-audit services to audit client; (v) audit firms are completely banned from providing non-audit services; and (vi) audit firms providing non-audit services with disclosure of such provision in client financial statements. The evidence of audit failures documented worldwide have led to major criticism of the auditing professions’ independence and exposed its implication on shareholders’ and stakeholders’ interests (Brody et al., 2014; Koh et al., 2013; Michael, 2014; Fearnley and Beattie, 2004). External auditors are expected not only be independent but more importantly must be seen to be independent when examining and attesting clients’ financial statements (Knechel et al., 2012; Krauss and Zulch, 2013; Lim et al., 2013; Zaman et


Perceptions of Auditor Independence: The Case of Provision of Non-Audit Services

al., 2011). Indeed, auditors are expected to decide on reporting strategies without any influence from their clients’ management. The main question that arises when auditors provide both audit and NAS is whether the auditors are able to conduct their audits impartially, without being concerned about losing or failing to gain additional services, and the subsequent economic implications for the audit firm. In fact, the provision of NAS has the potential to create economic bonding from the significant amount of fees received from clients. The economic bonding between audit firms and their clients would influence auditor independence. It may be that the level of client pressure would increase and auditor becomes less concerned with the quality of audit examination. Indeed, the issue needs serious and immediate attention to ensure shareholders and stakeholders interests are protected and informed economic decisions could be done based on high quality information testified by external auditors. The paper is organised into five sections. The following section reviews the literature on joint provision of audit and non-audit services. Section three discusses the information collection and analysis procedures and the fourth section presents the findings. The conclusions and implications of the findings are summarized in the final section.

study of financial disclosure of NAS, Glezen and Millar (1985) discovered that stockholders were unconcerned about the joint provision of audit and NAS adversely influencing auditor independence. Also, it was claimed that the auditor’s knowledge of the client company would be improved by the provision of NAS, resulting in increased objectivity (knowledge spillover) and independence (Goldman and Barlev, 1974; Wallman 1996). The joint provision of audit and NAS would create ‘economies of scope’; Arrunada (1999, p. 165) pointed out that joint provision of audit and NAS would reduce overall costs, raises the technical quality of auditing, enhance competition, and need not prejudice auditor independence or the quality of non-audit services, which would ultimately increase auditor independence. Based on the standard organisation analysis, Arrunada (1999, p. 169) showed that cost savings gained from the joint provision of audit and NAS will be transferred to customers as a decrease in price in both markets, and also that the provision of NAS would ‘result in an increase in client- and firm-specific assets’ (p. 168), where firm-specific assets would ‘always have a positive effect on independence’ (p. 168). This argument is supported by Grout et al. (1994), who argued that permitting auditors to perform joint services would reduce auditors’ dependence on a single client and encourage them to diversify as a consequence. Opponents to the joint provision of audit and NAS claimed that auditors would not perform their audit services objectively and that joint provision would impair perceived independence (see, for example, Brandon et al., 2004; Frankel et al., 2002; Glezen and Miller, 1985) because ultimately they would be auditing their own work or acting as management and management’s power over the auditor could be increased due to auditors’ reliance on fees received. Thus, it may influence “their mental attitude, impartiality and objectivity, and independence of thought and action” (Flint, 1988, p. 82).

Review of Literature Research on the choice of NAS tends to focus on the selection of service providers, such as from the company’s auditor or elsewhere, and if audit and NAS are jointly provided by the company’s auditor, whether proper segregation of duties exists. Research findings on the association of joint provision of audit and NAS and auditor independence are inconclusive (Alexeyeya and Syanstrom, 2015; Michael, 2014; Ashbaugh, 2004; DeFond et al., 2002; Kleinman et al., 1998). The proponents of joint provision of audit and NAS contend that auditor independence would not be affected but would improve audit quality (Antle et al., 1997). Hartley and Ross (1972) found that only 6% of their respondents believed that the provision of NAS posed a significant threat to independence. Firth (1980) showed that the provision of NAS was considered to be only a minor threat to auditor independence. In a

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Provision of Non-Audit Services The previous section documented inconclusive findings on the issue of impact of joint provision of audit and NAS on auditor independence. It is expected that public accounting firms should have the maximum discretion

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to develop and provide audit and NAS to their clients (Alexander and Hay, 2013; Chen 2012; Ebaid, 2011; Hamuda and Sawan, 2014, Ianiello, 2015). However, Mitchell et al. (1993) rejected this idea and believed that the joint provision of audit and NAS to audit clients would cause unfair competition due to the use of audit services to sell NAS, and suggested that auditors should be banned from offering both services to the same client. Similarly, Flint (1988) believed that auditors would have some form of predisposition towards a favourable assessment because the firm as a whole was involved in the creation, development or consultation of the NAS. As an alternative to a total ban on provision of NAS to audit clients, Arrunada (1999) recommended the use of different divisions that are responsible for each series of services as a safeguard to maintain independence. These divisions are organized as profit centres within audit firms that have their own management and exert little if any influence over the audit partners’ evaluation or compensation process. In fact, the idea is justifiable in the UK environment, where Lennox (1999) found a weakly positives significant association between audit qualifications and disclosed NAS and construed that the ‘current UK policy may be justified in not banning NAS. This conclusion is strengthened if policy-makers take account of the economies of scope that may accrue from allowing the joint provision of audit and NAS’ (p.250). Consistently, Hillison and Kennelley (1988) believed that the approach would enhance auditor independence, especially when appropriate safeguards are in place, such as ‘Chinese walls’ (Mikol and Standish, 1998, p. 546)1.

The potential threat to auditor independence is lessened when there is a separation of personnel performing NAS and audit services (Pany and Reckers, 1984). Similarly, Swanger and Chewning (2001) discovered significant positive associations between auditor independence and joint provision of NAS by staff separation (segregation of duties). Also, Canning and Gwilliam (1999) found that only a small percentage of their respondents expressed concern about the threat to independence when separate departments provide joint services. However, the option of separate workforces to perform audit and non-audit services is only possible if the audit firm has enough resources, and smaller firms may not have such an opportunity for specialisation. However, Quick and Warming-Rasmussen (2005) found that joint provision of audit and NAS by staff from separate departments did not improve perceived independence. Realising the obstacles faced by small firms, Mautz and Sharaf (1961, p. 230) suggested three alternatives: (i) forbid/prohibit small firms from performing auditing services on the conjecture that they cannot appropriately perform both on impartial basis and that auditing is much less likely to be a major source of revenue to small firms; (ii) require each small firm to select which of the two fields of specialisation it will take on; or (iii) permit small firms to take on work as they do at present, performing a variety of services for their clients. Due to lack of incentive for a stringent approach at that time, Mautz and Sharaf (1961) favoured the third course of action, because small firms rarely undertake audit duties for companies that have public interest and usually perform audits for small businesses at the request of bankers or creditors that have good knowledge about the credibility and reliability of local accounting practitioners. They further asserted that the drawback of segregation of duties for small firms is that it will ‘make it more difficult to service their clients and others with no substantial offsetting benefits resulting from such restriction’ (p. 230). In Malaysia, Arens et al. (1999) revealed that Big Four firms audited more than 60% of listed companies and that a large majority of medium and small firms serve unlisted companies with a lack of public interest. However in developed markets, Mautz and Sharaf (1961, p. 230) suggested that ‘as soon as a given client becomes of sufficient size that there is a substantial public interest in its audited financial statements, . . .

1 Section 48 (2) (h) of the UK’s Financial Services Act 1986 illustrates Chinese Walls as “procedures for restricting flows of information within a firm to ensure that information which is confidential to one department is not improperly communicated to any other department within the firm. They are widely used in the financial services sector to manage or avoid conflicts between the duties owed to different customers, or conflicts between the firm’s interests and the duties owed to customers, which arise out of the different activities of the component parts of the firm on different sides of the wall”. On the other hand, the Consultation Paper on Fiduciary Duties and Regulatory Rules the Law Commission (1992) (Law Com. No. 124) describes Chinese Walls as normally involving some combination of the following organisational arrangements: (i) the physical separation of the various departments in order to insulate them from each other; (ii) an educational programme, normally recurring, to emphasis the importance of not improperly or inadvertently divulging confidential information; (iii) strict and carefully defined procedures for dealing with a situation where it is felt that the wall should be crossed and the maintaining of proper records where this occurs; (iv) monitoring by compliance officers of the effectiveness of the wall; (v) disciplinary sanctions where there has been a breach of the wall (House of Lords, 1998).

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a strict separation of auditing and other services should be effected, if not by a division within the accounting firm, then by employment of separate accountants for the two types of services’ (p. 230). Hillison and Kennelley (1988) had recommended three additional alternatives to a total prohibition of NAS provision to audit clients: (i) offer NAS to non-audit clients only; (ii) prohibit certain types of NAS; or (iii) permit all types of NAS with full disclosure requirements. They alleged that although prohibiting all NAS would produce the greatest positive impact on perceptions of auditor independence, it would be the most drastic action. They favoured permitting all types of NAS with full disclosure because it would create the least resistance from practitioners, avoid companies’ rejection on disclosure, and it would possibly be effective in monitoring audit clients’ acquisition of NAS. Although a conflict of interest might arise from the joint provision of audit and non-audit services to audit clients, it might be inappropriate to prohibit accounting firms from offering non-audit services if this issue is observed from the ‘business efficiency’ perspective (Chandler and Edwards, 1996, p.26). Fearnley and Beattie (2004) reviewed prior studies and concluded that there is no need for total prohibition of joint provision of audit and NAS, as the dilemma could be overcome by the following suggestion: “more transparency about how firms manage the conflicts of interest that NAS provision creates; whether audit partners are rewarded for earning NAS; and the nature of the NAS being provided” (p. 124). Additionally, audit committees should play their role in approving the provision of NAS. Indeed, the Securities and Exchange Commission (SEC) in the US and Bursa Malaysian Berhad (BMB) in Malaysia have required public companies to disclose the joint provision of audit and NAS in their financial statements, where the disclosure would “shed light on the independence of public companies’ auditors” (SEC, 2000). In a study of bank loan decisions, Firth (1981) discovered that smaller loans were granted for companies that showed joint provision of audit and NAS in their financial statements than companies that did not have such information. Jenkins and Krawczyk (2001) found that joint provision of audit and NAS had a positive impact on the perceptions of auditor independence, and also discovered that the disclosure of the

amount of NAS and audit fees was preferred by investors. Similarly Raghunadan (2003) lent support to the SEC’s argument that disclosure of NAS fees could influence shareholders’ voting decisions, observing that shareholders did not consider that the provision of NAS would threaten auditor independence even if the companies purchased very large nonaudit services from their auditors. Schleifer and Shockley (1990) evidenced that the other two options to a total ban on NAS, as identified by Hillison and Kennelley (1988), would improve the perceived independence of auditors. Similarly, Gul and Yap (1984) found that the majority of Malaysian auditors, managers, bankers and shareholders agreed that disclosure of NAS fees would enhance perceived auditor independence. Also, Scheiner (1984) provided evidence that disclosure of NAS reduced the purchase of personnel services from the incumbent auditor. Consistently, Schleifer and Shockley (1990) found that over half of the Big Eight auditors and financial analysts and around a third of non-Big Eight CPAs and loan officers opposed the policy to ban auditors from providing joint audit and NAS. The majority of the Big Eight auditors and financial analysts believed that disclosure of NAS would not enhance auditor independence, while the majority of financial analysts, non-Big Eight CPAs and loan officers have conflicting views. Lee (1993, p. 109) stressed that perceived auditor independence would only improve if the joint provision of audit and NAS was either completely prohibited or publicly disclosed. However, Canning and Gwilliam (1999) found that the threat to auditor independence would be minimal when the provision of NAS was to non-audit clients only i.e. ban NAS to audit clients. However, Flint (1988) disagreed with the suggestion that an alternative “organisational and constitutional structure” (p. 82) should be created for audit firms to provide joint audit and NAS, and argued that the potential conflict of interests would still exist. Sherer and Kent (1983, p. 27) maintained that ultimately, auditors would be examining their own work and asking for explanations from a member of the client’s staff in whose appointment process they had been involved (i.e. rendering human resource services), and argued that the joint provision of audit and NAS must be prohibited. Also, Flint (1988) argued that auditors might find themselves at a point where they had to decide whether to criticise or to

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take exception to a situation where the firm had a direct interest in the outcome of the audit that conflicted with their role as consultants. Indeed, there would be an “economic bond or a legal bond – particularly a bond of joint responsibility and liability” (Flint, 1988, p. 83). He argued that the firm as a whole would receive ‘net benefit’ from the NAS work brought in by the audit division, and as a result the audit function would be unduly affected by “a general directorial or managerial point of view” (Flint, 1988, p. 83).

Table 6.1 Analysis of Responses

Research Methodology This study was conducted in two stages. The first stage involved the use of a postal questionnaire to seek information from auditors, loan officers and senior managers of public listed companies on the impact of joint provision of audit and non-audit services on auditor independence. The questionnaire was pilot-tested to increase the relevance and validity of the information sourced. The second stage entailed a series of interviews with senior managers of audit firms, banks and publicly listed companies to solicit more detailed information on the issue of interest. Auditors were selected because they are the main subjects of the issue of interest that provide certification and/or information credibility assessment to the stakeholders (Humphrey, 1997). Furthermore, Flint (1988, p. 76) pointed that the person to whom the audit reports is addressed and the person that are subjected to audit have a direct interest in the audit outcome. Gul (1991, p. 165) argued that bank officers are relatively sophisticated financial statement users who could be expected to understand the importance of auditor independence. Finally, the manager is the agent of the principal, who conducts business on behalf of the principal and, hence, requires a monitoring mechanism (i.e. an auditor) to report on their performance (see Jensen and Meckling, 1976), and on this basis, senior managers’ perceptions of auditor independence are valuable to this study. The total questionnaires distributed and responded are reported in Table 6.1, where 31%, 44% and 36% of the questionnaires were returned from auditors, loan officers and senior managers of public listed companies respectively.

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Category Audit Firms Financial Institutions Public Listed Companies Total

Questionnaires Issued Frequency 300 200 300 800

Usable Response Frequency 93 87 107 287

Response Rate % 31 44 36 36

An analysis was carried out of the designation of the respondents and details of the findings are tabulated in Table 6.2. The majority of the respondents held relatively senior positions in their respective organisations: 46% of the responding auditors were line managers, while 47% and 43% of the loan officer and corporate management groups were senior managers, the remainder being the first line of management and the chief executives of the respective organisations. The respondents were responsible for the auditing, accounting and finance function and their seniority indicates the validity of the information provided. Table 6.2 Profile Analysis Status

Auditors Loan Officers Freq % Status Freq

Audit Senior Line Manager Senior Manager Total

38 43 12 93

41 Officer 46 Senior Manager 13 Chief Executive 100

34 41 12 87

% Status

Senior Managers Freq %

39 Financial Accountant 47 Senior Manager 14 Chief Executive 100

36 46 25 107

34 43 23 100

Findings Mode of NAS Provision This section reports research findings of the study. Respondents were asked to provide their perceptions on six literature based (Arrunada (1999), Canning and Gwilliam (1999)) mode of provision of non-audit services; (i) provision of non-audit services by audit engagement staff, (ii) provision of non-audit services by staff from separate department, (iii) provision of non-audit services by staff from different entities; (iv) audit firms are prohibited providing non-audit services to audit client; (v) audit 93



firms are completely banned from providing non-audit services; and (vi) audit firms providing non-audit services with disclosure of such provision in client financial statements. Besides the above issues, respondents were asked for the reasons underlying for the support of or objection to the joint provision of audit and non-audit services to audit client.

there is a need for different people to independently scrutinise the audit and non-audit work. Interestingly, the majority of the loan officers (80%) pointed out that they did not take into account the provision of non-audit services to audit client in their loan making decisions. A manager of the corporate loan division of a top bank noted:

Provision of NAS by Audit Personnel It was found that 76% of the auditors, all of the loan officers and 91% of the senior managers of public listed companies agreed with the statement that the provision of NAS to audit clients by audit engagement staff threatens auditor independence (refer to Table 6.3). Although there is strong agreement from the auditors, this is less than that expressed by the loan officers and senior managers of public listed companies, and this reflects on the unwillingness of a minority of the auditor respondents to acknowledge any problems that the joint provision of audit and non-audit services by staff from the same department. The result is consistent with a study of Irish users of financial statements by Canning and Gwilliam (1999). The interview survey revealed that the majority of the auditors (77%), loan officers (88%) and senior managers of public listed companies (82%) agreed that auditor independence would be threatened if the same personnel provides joint provision of audit and non-audit services. The interviewees were concerned with the ability of the auditors to behave independently and professionally and to resist management pressure due to their dependence on income from both services. The interviewees disclosed that auditors’ financial dependence on the client would create a tendency to threaten auditor independence and would lead the auditors to think in the client’s way. The interviews also disclosed that auditors tend to succumb to client pressure when there is a lack of monitoring activities. In fact, some of the interviewees noted that auditor independence would be threatened if they were to gain more knowledge of various aspects of the client’s business from their regular review of the business in audit and non-audit services. Thus, they would be familiar with the system’s weaknesses and as a consequence expose to manipulation. The interviewees disclosed that 94

In analysing the financial statement for loan processing, we actually do not look at this criterion. Perhaps it is good to know the way they operate. But, our knowledge is limited to the information disclosed by the company.

Only a small number of interviewees (i.e. 23% of the auditors; 12% of the loan officers; 18% of the senior managers of public listed companies) disagreed with the statement that joint provision of audit and non-audit services would threaten auditor independence and argued that auditors are professional enough to perform their duties independently without any bias. It may be the case that auditors are bound by their professional ethics and will not compromise their ethical standards for the sake of their business. The occurrence of misbehaviour among auditor was said to originate from a small and insignificant number of ‘bogus’ accountants. Indeed, the large majority of the auditors were said to adhere to the spirit of the rules and regulations on auditor independence. Provision of NAS by Staff from Separate Department As an alternative to joint provision of audit and NAS by audit personnel, it was suggested that the provision of these services should be performed by staff from separate departments. The majority of the auditors (51%), loan officers (42%) and senior managers of public listed companies (58%) disagreed with the statement that auditor independence would be threatened if the provision of NAS to audit clients were to be undertaken by staff from different departments within the same firm (Table 6.3), and this reflect the respondents’ confidence in the safeguards of auditor independence by splitting the provision of audit and NAS into separate departments, which is consistent with Canning and Gwilliam (1999) and Pany and Reckers (1984). Indeed, the separation of personnel is one of the 95



alternatives to a total ban on the joint provision of audit and NAS (Hillison and Kennelly, 1988). In the interview survey, the vast majority of the auditors (85%), loan officers (71%) and senior managers of public listed companies (59%) indicated that auditor independence would not be threatened if the provision of audit and non-audit services to audit client was performed by staff from different departments, which is consistent with the result of questionnaire survey. The interviews disclosed that this mode of NAS provision would allow segregation of duties in monitoring activities, widely known as the ‘Chinese Wall’ (Mikol and Standish, 1998). It was believed that different partners would handle the different departments, which would result in greater monitoring activities and mean that the audit division might not lose sight of the material issues. As a manager of a Big Four audit firm pointed out:

auditor independence. They were skeptical about the ability of audit firms to ensure total segregation of duties, and suggested that most audit firms would try to achieve economies of scale by allocating idle staff to any department within the same firm that required their services. Also, some of the interviewees expressed concern about the ability of auditors to act professionally and differentiate between friendship and responsibility to the general public. They indicated that partners in the same audit firm that perform audit and non-audit services are closely connected.

You may not detect the errors that you made yourself. By having different departments, at least someone else is looking into your work, rather than you performing both of the services.

In fact, some of the interviewees argued that auditors are still good candidates for provision of NAS to their audit clients, due to their understanding and knowledge of clients’ business operations, which would speed up the process and allow them to deliver better quality services. A chief executive of a merchant bank remarked: I think it is good to have separate departments that perform the services rather than one person wearing two hats, but ultimately it goes back to the people, their professionalism and their characters. Also, some of the interviewees indicated that this kind of arrangement would ease information exchange, which may not be achieved if NAS are provided by other firms. Perhaps, audit firms could effectively utilise their personnel who have a good understanding of the client’s business to speed up the process and subsequently produce a high quality financial statement. However, a small minority of the interviewees disclosed that the provision of non-audit services by a separate department would threaten

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Provision of NAS by Staff from Separate Entity As shown in Table 6.3, 74 percent of the auditors, 85 percent of the loan officers and 58 percent of the senior managers of public listed companies indicated that auditor independence would not be threatened when the provision of NAS to audit client is done by a separate entity where the auditors have an interest. Perhaps, the attitude demonstrated by the respondents in this issue indicates their support in the “Chinese Wall” concept that received much attention among Malaysian professionals recently. The increase in respondents support in this issue indicate the objective to segregate job functions between audit and NAS would be more attainable when exist separate entities to handle different responsibilities as compared to separation of department. The interview survey indicated that as many as 92% of the auditors, 94% of the loan officers and 82% of the senior managers of public listed companies interviewed agreed that the provision of audit and non-audit services by separate entities would safeguard auditor independence. The interviews disclosed that this mode of provision of NAS would safeguard auditor independence due to the structure of audit and non-audit firms, which would ensure greater transparency of financial reporting (i.e. Chinese Wall). When different staff from different entities is handling the assignments, most of the interviewees indicated that each entity would act independently and perform ‘checks and balances’ on each other’s work. Therefore, the majority of the interviewees disclosed that it would act as a deterrent to auditors against compromising their independence.

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The responses were reported on a 5-point scale ranging from 1 (strongly disagree), through 2 (disagree), 3 (no view), 4 (agree) to 5 (strongly agree). For presentational purposes these 5 points have been collapsed into disagree (scored 1), no view (scored 2) and agree (scored 3) and the reported means are calculated on this collapsed scale. However, the significance tests are based on the full 5-point distribution of responses.

Note: ***, **, * indicates that the distribution of responses is significantly different at 1%, 5% and 10% level (using the Kruskal Wallis test).

* 1.76 18 42 16 1.60 40 Provided by the auditor to all clients but full disclosure is made in the client financial statements

60

-

30

54

1.86

40

** 1.44 6 62 1.39 61 Not provided at all

39

-

71

29

1.29

32

*** 1.12 88 1.44 66 Provided to non-audit clients only

24

10

99

1

1.01

12

*** 1.66 24 18 58 1.29 14 1.38 74 Provided to audit clients by a separate entity where the auditors have an interest

14

12

85

1

58 38 1.83 51 Provided to audit clients by a separate department within the audit firm

15

34

42

20

1.95

11

31

1.73

*** 2.84 91 3 6 3.00 100 2.56 76 3 21 Provided to audit clients by personnel involved in audit

Agree Mean % No View %

Senior Managers (N=107)

Agree Mean Disagree % % No View %

Loan Officers (N=87)

Agree Mean Disagree % %

Auditors (N=93)

No View % The independence of the auditor, Disagree for the purpose of audit, is % reduced if NAS are

Table 6.3 Analysis Showing Perceptions of the Method of NAS Provision

Significance


Although the majority of the loan officers supported the notion that auditor independence would not be threatened if separate entities existed to perform these different services, it was discovered that most of the Malaysian bankers did not take into account the methods of provision of NAS to audit clients in their daily duties of loan processing as indicated in the above sub-section. The interviews indicated that Malaysian auditors were currently performing a good job and producing reliable financial statements. These loan officers may have come to hold this view due to a lack of disclosure of non-audit services in financial statements. Regarding the loan officer’s belief, a manager of a corporate loan department of a local bank revealed his experience in analysing corporate loan applications: … as bankers, we don’t take into account whether there is a segregation of duties between audit and other services. We accept the accounts as good, as long they are audited and there is a stamped, signed declaration by the auditor, that’s good enough for us. It doesn’t matter whether they provide non-audit services to the company.

In addition, the interviews disclosed that the separation of entities is an effective way to minimise the auditor independence dilemma because audit partners in the different entities do not have any direct interests, either financial or personal, that would cause them to compromise their objectivity. A manager of a Big Four firm noted: They do not directly share the same pool of revenue and profit. Thus, each of them will protect their interest and professionalism and will conduct their business objectively.

A small minority of the interviewees who were opposed to the suggestion to separate the entities contended that staff from different entities that undertake audit and non-audit services still belong to the same organisation and will ultimately report to the same group of partners. Their concern was focused on the willingness of partners within the same firm to expose the weaknesses, mistakes and wrongdoings of their colleague to the regulators or the public, hence, damaging the firm’s reputation. A chief internal auditor of a public listed company pointed out:

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All of them will report to the same partner, unless they have formalised some internal controls that are transparent to outsiders, which most of them claim that they have done; sure, they can say they have separate systems, they have separate reporting lines. However, who checks all these claims? Nobody checks the auditors. I don’t know who audits their accounts, or what the accounts look like. Right now the disclosure of work is only on the clients’ annual reports, not on their part. So when it comes to monitoring their independence, how do you do that?

disagreed with the statement that auditor independence would be reduced if auditors were prohibited from providing non-audit services. Although there is strong disagreement from the auditors (61%) and senior managers of public listed companies (62%), this is less than that expressed by the loan officers (71%), as shown in Table 6.3, and this might reflect the loan officers’ concern with the potential drawbacks associated with the joint provision of audit and NAS to audit clients. When the interviewees were asked about the issue of limiting the provision of NAS to non-audit clients or completely prohibiting auditors from providing NAS, all of them agreed that both approaches would safeguard auditor independence, which is consistent with the questionnaire survey findings. Discussing the potential improvement to auditor independence, a director of a merchant bank remarked:

Furthermore, the interviews revealed that users of financial statements might be misled by the different names under which both services were performed, when in actual fact the same person was running the firms. Provision of NAS to Non-Audit Client and Total Prohibition The majority of the respondents disagreed with the statement that auditor independence would be reduced if auditors were only allowed to provide non-audit services to non-audit clients. Although there is strong disagreement with the statement from the auditors (66%) and senior managers of public listed companies (88%), this is less than that expressed by the loan officers (99%), as shown in Table 6.3, and this might reflect the confidence of the loan officers in the safeguard to auditor independence created from the prohibition of provision of NAS to audit clients. This result is consistent with Canning and Gwilliam (1999). Teoh and Lim (1996) in Malaysia suggested that there is a need to restrict the provision of consulting services to non-audit clients. The result might be a sign of the need for auditors to concentrate on their main function, to provide assurance as to the truth and fairness of clients’ accounts, and not involve themselves in providing non-audit services to audit clients. In addition, the responses shown by the majority of the respondents might reflect their belief that auditors should concentrate on providing one kind of service to their clients, either audit or non-audit services, as this would reduce the risk of conflict of interest (Canning and Gwilliam, 1999). Opponents to the joint provision of audit and NAS have pointed out that auditors should be banned from providing NAS (e.g. Flint, 1988; Sherer and Kent, 1983). It was observed that the majority of the respondents 100

I think the scope would be less, if you ask me about impairment. I don’t see total elimination, I see less, the reason being because I think the business world today is based on networking and contacts, so it is more likely that the audit firm might actually introduce whatever tax consultant, financial consultant, at the end of the day I mean we hate to say this, but there might be a certain kick back, there might be certain other benefits derived somehow, somewhere.

However, the interviews disclosed that the prohibition would be too stringent for local accounting profession, where there are other possible alternatives to overcome auditor independence issues. They indicated that the Malaysian accounting profession would severely resist this suggestion, due to the fact that fees from NAS could compliment their low incomes from audit fees, and pointed out that there is lack of financial services experts in Malaysian capital market to replace those audit firms. A chief of an internal audit department of a public listed company remarked: If you look at the accounting firms, there are not many of them out there. We hate to lose some of the good work done by the KPMG or PriceWaterHouse or Ernst and Young and others. They are good consultants and also good at auditing statutory accounts. If you prohibit the business altogether, you’ll lose that expertise and talent. Why would we go and shoot ourselves in the foot? 101



Therefore, the majority of the interviewees felt that these suggestions were not the best solutions to the problem faced by the profession.

argued that a majority of small investors would not pay much attention to this type of disclosure. A financial controller of a second board company described her experience as follows:

Joint Provision of Audit and NAS with Full Disclosure in Client’s Financial Statement As shown in Table 6.3, a sizeable percentage of the auditors (40%), loan officers (30%) and senior managers (42%) disagreed with the statement that auditor independence would be reduced if full disclosure on NAS were to be made in the clients’ financial statements, and this might reflect the confidence of the respondents in the potential benefits that disclosure on NAS might bring. When interviewees were asked about what impact full disclosure in the client’s financial statement of the provision of NAS by auditors to audit clients would have on auditor independence, about half of the auditors (54%), loan officers (53%) senior managers of public listed companies (53%) and senior managers of regulatory bodies (59%) agreed that this approach would safeguard auditor independence, which is consistent with the questionnaire survey findings. The interviews disclosed that such disclosure could inform shareholders and regulators about auditors’ involvement in clients’ companies, and would trigger them to ask questions about the auditors’ relationship with management. The interviews indicated that such disclosure would allow shareholders and the general public to assess the amount of money paid to the auditor and ask questions if they were not comfortable with the figures. A partner of a medium size audit firm noted:

I have attended so many AGMs, and none of the shareholders ask questions. They are not really interested in what the company does, and as long as the company pays dividend, they’ll keep quiet. They don’t really try to understand the business of the company. We don’t have people that stand up and ask questions like ‘why we are paying so much for consultancy?’

This argument was further supported by a vice president of a listed company, who added: I supposed it also depends on the type of shareholders that we have. In general, Malaysian shareholders are still not aware of their rights, and do not question this issue during the AGM. If the majority of shares are controlled either by a single entity or a family, the minority shareholders may not ask the company or director questions.

The interviews disclosed that Malaysian regulators should require the disclosure to include further details that outline the type of non-audit services provided, together with the amount of fees paid for the services and not only the total amount, as practiced currently.

Conclusion

Some of the interviewees disclosed that many Malaysian investors did not care about accounting disclosure in financial statements, and were more concerned about the company’s profits and payment of dividends. It was

This study investigates the perceptions of Malaysian auditors, loan officers and senior managers of public listed companies on the effect of joint provision of audit and non-audit services on auditor independence. The majority of the respondents agreed that the provision of NAS to audit clients by the audit engagement team would threaten independence. Perhaps, this might indicate the respondents’ concern about the ability of auditors to independently act as a watchdog to assure the truth and fairness of clients’ accounts, and at the same time to perform their NAS duties to advise and consult with the client. The main concern indicated by the interviewees was with the ability of the auditors to behave independently due to their dependence on income from both services. Also, there would

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It will create awareness among the public, shareholders and stakeholders. It also triggers them to ask question in the AGM, like ‘Who is the auditor and consultant, and how will the management ensure there is a split of independency between the two?’ If we don’t have such disclosure, it is not fair to the public, who have a lack of knowledge on the operation side.



be a lack of ‘checks and balances’ if both duties were to be performed by the same person. The Friedman two-way ANOVA and Wilcoxon matched pairs signed ranks tests indicate that the joint provision of audit and NAS to audit clients by audit staff as the most threat to auditor independence. On the other hand, the majority of the respondents agreed that auditor independence would not be threatened if the provision of audit and NAS were to be provided by staff from a separate department and entity. The result indicates that the respondents had faith in the segregation of duties or ‘Chinese Wall’ offered by these approaches. Though the departments and entities are under the same ultimate control or belong to the same firm, the level of communication between both parties is minimal, because each of them is responsible for the operation of their own department/ entity. Consistently, the interviews indicated that auditor independence would not be threatened if staff from separate departments or entities were to provide audit and NAS. It was mentioned that these modes of provision of NAS would allow segregation of duties, which would result in greater monitoring activities. Despite the consistent view among the respondents, it was pointed out that the loan officers did not consider the method of provision of NAS as an important issue in their daily duties of loan processing because they believed that the auditors were currently doing a good job and producing reliable financial statements. In addition, the majority of the respondents indicated their agreement that the threat to auditor independence would be less if the provision of audit and NAS were limited to non-audit clients or if it was completely prohibited for auditors to provide joint services, consistent with the interview survey findings. However, these approaches are indicated to be too stringent and would be severely resisted by the profession because income from NAS complements the low income derived from audit services for some audit firms. The results suggest that auditors should concentrate on one type of service: either auditing or NAS. Through concentrating on audit or non-audit services, the risk of conflict of interest could be reduced or eliminated. Finally, the majority of the respondents agreed that auditor independence would be safeguarded if auditors were to provide full disclosure in client accounts following the provision of NAS. In interview survey, it was revealed that such disclosure could inform shareholders and

regulators about the auditor’s relationship with the company, while some of the interviewees contended that the Malaysian investors did not care about accounting disclosure because they were more concerned about the company’s profits and payment of dividends. The result might suggest that the users become aware of the level of relationship between auditors and clients’ management, and could question both parties on any issues about which they need further clarification during the annual general meeting. Based on the findings in this study, it is recommended that the best alternative to prohibiting audit firms from providing NAS is a proper segregation of duties between staff that perform audit services and NAS. This segregation of duties should be in the form of separate departments or entities, where different partners and team provide the two services. Audit partners should not be involved, directly or indirectly, in the provision of NAS or even in the marketing of these services. In order to monitor this practice, each audit firm and its NAS arm should lodge its organisation profile, which should clearly state the identities of the audit team and the NAS team, with the MIA.

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Shariah Committee, Shariah Governance in Islamic Financial Institutions

Chapter 7 Shariah Committee, Shariah Governance in Islamic Financial Institutions Sabarina Mohammed Shah and Mohammat Sabri Hassan

INTRODUCTION Effective governance is an essential element of Islam as a way of life and also terms as al siyasah al shari’yyah which had been manifested under the reign of Umar Ibnu al Khattab Rdhu as reiterated by Sharifah Hayaati and Asmak (2011). According to Mohd Zaidi and Mohd Sani (2011), governance in Arabic is tadbir of which the adab (ethics) oriented tadbir in Islam emphasis on the substances of the decision making and the processes involved in achieving a desired outcome. It is also term as wilaya or hawkamah (Zulkifli 2011). Hence, the concept of governance is not an alienated concept within Islam. The Islamic Financial Services Board (IFSB) under the Guiding Principles on Shariah Governance System (IFSB 10: 2) has defined Shariah governance as “a set of institutional and organization arrangements through which an institution offering Islamic Financial Services (IIFS) ensures that there is effective independent oversight of Shariah compliance.” Comparatively, there is similarity between Shariah and corporate governance as Rashidah (2006) summarised that the latter is a set of interrelated mechanisms be it internal and external. The former mechanism includes the Board of Directors (BOD), the executive compensation as well as the managerial ownership. Meanwhile, the latter mechanism comprises of the market pressure which include the institutional ownership, the threat of takeovers, the competitions of products and the legal system. Subsequently, this

forms the structure that facilitates the processes involving a number of participants in achieving the stated objectives. Nevertheless, the definition of corporate governance has been well established in all parts of the world as compared to the Shariah governance. It has been observed that the crises affecting the financial industry have been a recurring phenomenon. According to Mohd Nazari (2010), the down fall of these institutions was due to the speculation nature of its financial transactions. Meanwhile, Gup (2007) viewed that it was attributable to poor corporate governance. Ironically, the phenomenon recurs which is attributable to the fact that people forgets when the economic is booming (Crowther 2012). This is evident through the downfall of Conventional Financial Institution (CFI) throughout the centuries. Some of the examples over the past two decades are the Bank of Credit and Commerce in 1991, Barrings Bank in 1995, Societe Generale in 2008, Madoff Hedge Fund in 2008 and Stanford Financial Group in 2009. Now, the issue of financial crisis is affecting countries at a larger scale around the globe including Japan, the United States and the European countries. Essentially, the IFI is seen as a viable alternative to CFI as it is found to be more stable (Asiamoney 2008; Hamzani 2008) due to its unique value system (Deehani et al. 1999; Olson & Zoubi 2008; Saiful Azhar 2005). Al-Zuhayli (2003) expressed his opinion that the objective of the IFI establishment is to adhere to the Shariah. Furthermore, Mustafa Omar and Fauziah (2011) purported that the IFI ultimately aims to achieve the maqasid al Shariah. The maqasid al Shariah is defined as the intent of the higher objective of Islamic law which includes the wisdom behind the Islamic law or ruling (Auda, 2010). This is consistent with the current thinking of translating the legal spheres of the maqasid al Shariah and relating it to the society and its activities (Auda 2014). These are objectives which departs the IFI from the CFI. Nevertheless, the IFI is still susceptible to failure in the event of poor corporate governance (Asiamoney 2008; Chapra & Ahmed 2002). Meanwhile, IFSB 10: 2 definiton of Shariah governance extends beyond the focus of the underlying contracts as it includes “a set of institution and organizational arrangements” which is similar with the definition provided under SGF (2011). Therefore, it does not imply that the failure to address Shariah governance is to be borne 111



solely by the Shariah Committee members as there are other governance organs, interrelated systems and processes involved. Table 7.1 indicates the governance issue affecting IFI which reflects the failure of interrelated internal and external systems and the contravening of the underlying contracts. This clearly demonstrates a need for continuous sound governance in the financial industry be it the CFI or IFI. This is to achieve the financial stability and economic sustainability in a country (Adams & Mehran 2003; Ciancanelli 2000; Polo 2007). In the case of the latter, it means to achieve Allah SWT barakah (blessing) (Rusnah 2011; Tapanjeh 2009), therefore an effective board is crucial in ascertaining sound corporate governance (Fama & Jensen 1983; Greuning & Bratanovic 2009) which eventually creates value (Cadbury Code 1992; Huse et al. 2005). In the case of the IFI, the Shariah Advisory Board (SAB) is the gatekeeper (Siti Faridah 2010) which presents the IFI distinguish extended feature board structure as compared to the conventional financial institution (El-Muhammady 2009; Nathan & Ribiere 2007).

According to Zulkifli (2011), the term Shariah governance had found its’ placed due to the needs and development of the organizational structure within the context of the Islamic Financial Institution. Essentially, the main difference of Shariah and corporate governance is that the former “governs a wider scope and has extended obligation” as compared to the latter (Tapanjeh 2009: 566). The extended obligation denotes the welfare of the community at large; spiritual and material that one needs to be accountable before Allah in the hereafter. Furthermore, Rusnah (2011: 29-30) through her study found that the impact of Shariah noncompliant simply means “against the commands of Allah SWT, impediment of Allah SWT blessing or barakah, invalidation of contract (aqd). Therefore, the profit gain would be considered non Halal Income, which will subsequently have an impact on Capital Adequacy Ratio and the contravention of the IBA 1983”. As at 2013, IBA 1983 had been incorporated under the new IFSA 2013. It has been observed that different terminologies have been used namely the Islamic corporate governance (Maria & M. Ishaq 2012), corporate governance from Islamic perspective (Sulaiman Abdullah & Joriah 2012) and Shariah governance (Zulkifli 2011, Surianom & Muhammad Amrullah 2013). However, the term Shariah governance is widely used in the current literature to highlight the governance of an Islamic institution and to differentiate it apart from the corporate governance of which is practiced in the conventional institution. The immediate section discusses the existing Shariah committee structure practice worldwide.

Table 7.1 Governance issues affecting the Islamic Financial Institution IFI

Country

Reasons

Internal and External Systems and Processes Ihlas Finance House Turkey Lack of internal (IFH) (2000-2001) control and other external factors Bank Islam Malaysia Malaysia Lack of internal Berhad (BIMB) (2006) control on nonperforming loans Dubai Islamic Bank United Arab Lack of internal (2004-2007) Emirates control: Fraud

Effects Closure of IFH RM2.2 billion USD501million

Underlying Contracts Kuwait’s Investment Dar Kuwait (2009-2010) Tabung Haji Malaysia (2001, 2003) BIMB (2009-2011) Malaysia

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Dispute on wakala

USD10.7million

Forex losses (a form of gharar Dispute on bai al inah

RM 200 million RM67.4 million

THE STRUCTURE OF SHARIAH COMMITTEE The IFI, although founded on a religious ground, must demonstrate that it has a proper framework for optimal Shariah governance and implements it in an effective and efficient manner. This will assure clients, its stakeholders and the public at large that the IFI is upholding the principles of Islam in its financial dealings (Alchaar 2009). A proper framework includes among others are the elements of shura, supporting infrastructure or facilities such as hisba and most important is the selection of the right personnel to be accounted for (Chapra & Ahmed 2002; Abdul Rahim 1998). This proper 113



framework has been advocated and evidenced in the period of the Prophet Muhammad SAW and his companions, the Khulafa al-Rasyidin namely Abu Bakar Rdhu, Umar Rdhu, Usman Rdhu and Ali Rdhu (Sin 1997). The concept of shura is that the decision making should be on mutual consultation in the hands of a group of people. This is in accordance with the Ash Shura (42: 38) which states:

one tier and two tier board. The one tier model is commonly perceived as being shareholder and market oriented, aims to maximize shareholders wealth and relies on external disciplinary mechanisms. This structure is being practiced in countries that uphold the common law examples are United Kingdom, United States and in majority of the European Union member states. On the contrary, the two tier board originated in a society where external governance mechanisms were historically less developed. Thus, a strong internal control devices are pertinent such as the establishment of the Supervisory Board (Shleifer & Vishny 1997). This Supervisory Board comprise of members that are representative of the employees, bankers or other related parties which have vested interest in the organizations. The two tier board structure is predominant in the countries that uphold the civil law (Xiao et al. 2004) such as Germany, China and Japan. As for Malaysia, being part of the commonwealth country, the corporate organization followed the practice of having the unitary or one tier board structure (Rashidah 2006). There are debates concerning which type of board structure is more effective; the unitary or the two tiers. It is found that neither board structure is fault free (Xiao et al. 2004). This is because scandals such as Enron and Worldcom and earlier ones like Maxwell and Barings Bank had cast doubt on the effectiveness of the unitary board. However, failures such as Metallgesellschaft’s massive loss on oil price speculation had discredited the two tier board model (Xiao et al. 2004). Meanwhile, the Shariah Committee board structure worldwide displays three types of model namely the Central Shariah Board or also term as two tier infrastructures, Financial Centres Shariah Board and self-regulated IB (Akhtarzaite 2010). Table 7.2 presents the types of Shariah Committee structure which are being exercised worldwide where Malaysia, Pakistan and Sudan use the first type of Shariah Committee structure that is the Central Shariah Board.

And those who answer the call of their Lord (i.e to believe that He is the only One Lord (Allah), and to worship none but Him Alone), and perform As Solah (the prayers) and who (conduct) their affairs by mutual consultation, and who spend of what We have bestowed on them.

Through this concept, the Muslim is able to have a strong bond between themselves as stated in Al Imran (3: 103) as follows: And hold fast, all of you together, to the Rope of Allah (i.e. this Al Quran), and be not divided among yourselves.

It is essential to set up shura as one of the institutions for effective checks and balances. Chapra (2008: 26) discussed the governance at the state level, equates shura with the institution of parliament. In terms of an organization, there exist a consensus among the contemporary Islamic scholars on the importance of having shura in place to ensure good corporate governance (Choudhury & Hoque 2006; Tapanjeh 2009). However, it is unclear of how shura should be implemented in an Islamic organization (Zulkifli 2011). Similarly, in the conventional organization as denoted by Forbes and Miliken (1999: 490) which is as follows: The very existence of the board as an institution is rooted in the wise belief that the effective oversight of an organisation exceeds the capabilities of any individual and that collective knowledge and deliberation are better suited to this task.

Basically, there are two types of board structure in the corporate organizational settings, being practiced worldwide namely the unitary or 114

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Table 7.2 The types of Shariah Committee structure worldwide

the differences in the legal perspectives of the countries namely Malaysia, Gulf Cooperation Countries and the United Kingdom. The development of the IFI governance has been divided into two main phases namely pre and post 20th century, with the latter period is further divided into first stage (pre-1970s) and second stage (post-1970s). It is observed that there is no corporate governance structure is being exercised during the period of pre-20th century. This is attributed to the “none existence of corporation in the form of the 20th centuries corporations as the banking activities were carried out by sarrafs and djahbadh. The corporate governance in the IFI only emerged during the second stage (post1970s) in the post 20th century. The first stage that is the pre-1970s, there was less concern due to the nature of the entity which is of cooperatives in nature and the operational was quite small. However, during the post 1970s, the entity was a proper corporation or institution which operates at a larger scale. This is coupled with governance issues that had happened to some of the IFI. These events had resulted in several institutional at the international level to be set up1. The institutions which specifically address the governance issues by formulating governance standards are The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) based in Bahrain and the International Financial Services Board (IFSB) based in Kuala Lumpur. AAOIFI was established in accordance with the agreement of Association which was signed by IFI on 1 Safar, 1410 Hijrah corresponding to 26 February 1990 in Algiers. It was then registered on 11 Ramadhan 1411 Hijrah corresponding to 27 March, 1991 in the state of Bahrain as an international autonomous nonprofit making corporate body. Meanwhile IFSB was officially inaugurated on 3 November 2002 and started operations on 10 March 2003. As at 2010, AAOIFI had issued 7 governance standards in total, two specific standards are on Shariah Supervisory Board (SSB) namely SSB: Appointment, Composition and Report (GSIFI 1) and Independence of SSB (GSIFI 5). Meanwhile, IFSB had issued 4 governance standards in total, three specific standards to the

Types Central Shariah Board

Features Central SAC and different SC at the individual institutional level

Countries Malaysia, Pakistan and Sudan

Financial Centres Shariah Board

Shariah Advisory Boards at the Qatar, Dubai and individual institutional level GCC Countries

Self Regulated IFI

Outsourcing of Shariah Advisory services, Central Shariah Board for the whole group (Dallah al Barakah), individuals undertaking the Shariah Advisory roles.

United Kingdom, Singapore and Kuwait.

Source Akhtarzaite (2010)

Meanwhile, Qatar, Dubai and the GCC Countries use the second type of Shariah Committee structure namely the Financial Centres Shariah Board. Finally, the United Kingdom, Singapore and Kuwait use the third type of Shariah Committee structure that is based on self-regulated IFI. The first type is in the form of “two tier structure” which is a different concept as the ones implemented in the corporate organization in the conventional settings. It refers to the establishment of the Shariah Advisory Council (SAC) at the Government Central Bank of a country. As for the Shariah Committee, it is established at the individual financial institutional itself or term as an internal organ of the particular IFI. The Shariah Committee board structure setting in the IFI appears to adopt the one tier or unitary model of board structure with the exceptional of the setting up of the Shariah Committee structure. This may be due to the influence of the law adopted from the long occupation of the colonization, an example is the common law applied in the Commonwealth Countries through the British occupation. Second is where the countries in the GCC Countries set up their own model of financial centres of Shariah board. Finally, the third type of model is the self-regulated IFI which is evident in the countries where the Muslim population is a minority. Zulkifli (2011) indicated that the differences of the types of the Shariah Committee structure is attributed to 116

1 See Zulkifli (2011) for a detailed discussion on the development of the notion of corporate governance in the IFI.

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governance of IFI namely the IFSB 3, 8 and 10. These standards are highly recommended however, they are not compulsory to be implemented by their members. In addition, the IFSB had proposed the standing structure of the Shariah governance which is found to be similar to the board standing structure of corporate governance in a conventional setting. The standard proposed to set up an Islamic Shariah Compliance Unit (ISCU) and Islamic Shariah Review Unit (ISRU). Ideally, this is then followed by an annual Shariah external audit. However, these Shariah standing structures may not be in placed due to the constraint of having enough trained Shariah personnel. Thus, the Shariah governance structures are still very largely dependent on the conventional settings. The Shariah governance process among others includes as well the issuance of the standards or pronouncements, dissemination of information to operative personnel by the regulators and international standard setters namely AAOIFI and IFSB. It is imperative to acknowledge that there is no one specific structure, standards or regulation that can be claimed as the best method, there is no size that fits for all. Nevertheless, it is indispensable that whatever form of the Shariah Committee board structure, it must be able to facilitate the Shariah Committee to discharge their roles effectively. The following section presents issues affecting Shariah Committee worldwide.

Accounting and Auditing Organisation for Islamic Financial Institution (AAOIFI). Eventually, these would lead to the conflict of interest and impose threats on the succession planning (Maha Khan 2012). In addition, concern has also been raised in terms of the diversity in the ruling of what is permissible (halal) and what is not permissible (haram). Thus, this creates inconsistency at the international level. Although differences of opinions itself is a blessing nevertheless, “without consistency and predictability of fatwa and Shariah resolutions, the industry will have no hope of meeting international standards and growing beyond its “niche” status (Elgari 2010). Examples are the permissibility of bai al inah in Malaysia which is not permissible in other parts of the regions and the pronouncement of the non-permissibility of financial instrument which had been in the market for quite sometimes as in the case of sukuk by Maulana Justice M. Taqi Usmani2 in 2008 had adversed impact on the market. This may be attributable to the fact that the IFI financial technologies have yet to reach a maturity level as it “evolves and requires more decades of trial and error” (Sairally 2005:425). Notwithstanding this, there is also the threat of the black box symptom as raised by Shaykh Yusuf Talal Delorenzo (2007) as new innovation and better financial products and processes appears to ignore the spirit of the law. Furthermore, the concern is on the absence of an Audit Committee raised by Safiedine (2009) which indicates an ineffective board standing structure is present in the IFI. Thus, has led to the risk of information asymmetry within the institution itself. An example is the transparency of the information provided which had dented the relationship between the Bank’s Board and Shariah Advisers as in the case of Kuwait’s Investment Dar and Lebanon’s Bloom Bank (Pasha 2010; Sing 2010). Here, there was a weakness in the relationship betwen the Shariah Committee and the Top Management Team (TMT) which had resulted in the issuance of non-compliance financial products with the Shariah. This is due to greater group diversity within the IFI which may dampen the board process as Shariah Committee has to interact with Chief Executive Officer (CEO), BOD and TMT in discharging their roles.

ISSUES AFFECTING SHARIAH COMMITTEE WORLDWIDE The Islamic Financial Institution has been established form more than three decades: however, it is still indistinguishable from the Conventional Financial Institution (Khan 2010; Mansour 2015). Thus, this has placed the Shariah Advisory Board into the limelight as they are considered the apex of the Shariah discourse in these institutions (Siti Faridah 2010; Laldin 2012). Currently, there exists scarcity of well qualified Shariah Scholar worldwide (Unal 2011) even in Saudi Arabia (Sharia Finance Watch 2013). As a result there is a high concentration level of the Shariah Scholars. This is further exaggerated by the fact that there is no clear demarcation between the governed and the governing as these scholars also sit on the boards of the standard setting bodies, an example is the

2 He is currently the Head of the AAOIFI Shariah Advisory Board, formerly he was the

Pakistan Supreme Court’s Shariah Appelate.

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Essentially, in practice the Shariah Committee members play a different role than the Board of Directors. However, these two do exhibit similarity in terms of the nature of their role that is the concept of shura or mutual consultation (Choudhury & Hoque 2006; Tapanjeh 2009) of which regular meetings were carried out. Hence, the Shariah Committee role must be carried out in an effective manner under a proper structure taking into account the context of a particular country. Thus, the immediate section concludes this chapter.

Islamic Finance:Why Islamic Banks must offer a cushion against collapse. Asiamoney. (2008). Retrieved from http://web.ebscohost.com.www.ezplib. ukm.my/ehost/detail? (5/11/2009).

CONCLUSION Shariah Committee members play an indispensable role in the Shariah governance of an Islamic Financial Institution. Regardless of the challenges faced by IFI under its existing environment, the Shariah Committee members are bounded by their accountability to first and foremost, Allah SWT and the ummah. Inevitably, the Shariah Committee effectiveness in discharging their roles is crucial to the survival of the IFI (Choudhury & Hoque 2006; Roszaini & Hudaib 2007). In anticipation of the importance of an effective Shariah Committee thus, there is a need to bridge the wide expectation gap from stakeholders.

Auda. J. (2010). Maqasid Al Shariah as Philosophy of Islamic Law: A System Approach. Herndon, USA: The International Institute of Islamic Thought. Auda, Jasser in a workshop entitled “Youth and Civil Society Issues and Challenges” which was jointly organized by International Institute of Advanced Islamic Studies (IAIS) Malaysia, Ministry of Youth and Sports Malaysia, Muslim Youth Movement of Malaysia (ABIM) and National Union of Malaysian Muslim Students (PKPIM) on 31 May 2014. Cadbury Code. (1992). Report of the Committee on the Financial Aspects of Corporate Governance: The Code of Best Practice. Chapra, M. U. (2008). The Islamic Vision of Development in the Light of Maqasid Al Shariah. Occasional Paper Series London Office: The International Institute of Islamic Thought. Chapra, M. U. & Ahmed, H. (2002). Corporate Governance in Islamic Financial Institutions. Islamic Development Bank; Islamic Research and Training Institute 6,1-157. Choudhury, M. A. & Hoque, M. Z. (2006). Corporate Governance in Islamic Perspective. Corporate Governance 6(2), 116-128.

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Forbes, D. P. & Miliken, F. J. (1999). Cognition and Corporate Governance: Understanding Boards of Directors as Strategic Decision Making Groups. Academy of Management Review 24(3), 489-505. Gup, B. E. (2007). Corporate Governance in Banking: A Global Perspective. Corporate Governance in Banks: Does the Board Structure Matter? United Kingdom: Edward Elgar Publishing Limited. Greuning, H. V. & Bratanovic, S. B. (2009). Analyzing Banking Risk: A Framework for Assessing Corporate Governance and Risk Management. 3. Washington D.C: The World Bank. Hamzani, M. A. (2008). Islamic Banks Unaffected by Global Financial Crisis. http://www.asharq-e.com/news (17 March 2010). Huse, M., Minichilli, A. & Schoning, M. (2005). Corporate Boards as Assets for Operating in the New Europe: The Value of Process-Oriented Boardroom Dynamics. Organizational Dynamics 34(3), 285-297. Khan, F. (2010). How ‘Islamic’ is Islamic Banking? Journal of Economic Behaviour and Organisation 76, 805-820. Laldin, M. A. 2012. Duties and Responsibilites of Shariah Boards from a Legal and Regulatory Perspective. Retrieved April 1, 2015 from http://www.amanieiconnect.com/component/k2/item/31-duties-and-responsibilities-of-shari . Maha Khan, P. (2012). Islamic Finance Debate: Shariah Scholars Under Fire Part 2. Retrieved March 6, 2015 from http://www.intelligenthq.com/banking/ islamic-finance-banking/Shariah-scholars-under fire. Mansour, W., Jedidia, K. B & Majdoub, J. (2015). How ethical is Islamic Banking in the light of the objectives of Islamic law? Journal of Religious Ethics 43(1), 51-77.

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Sairally, S. (2005). Evaluating the ‘Social Responsibility’ of Islamic Finance: Learning from the Experiences of Socially Responsible Investment Funds. 6 International Conference on Islamic Economies and Finance, Islamic Economies and Banking in the 21 st century. Jakarta, Indonesia. Shariah Finance Watch 2013. Conflict of Interest: Same Shariah Advisory “Bureau” Advises 22% of Insurance Companies in Saudi Arabia. Retrieved April 1, 2015 from http://www.shariahfinancewatch.org/blog/2013/07/30/ conflict-of-interest-same shariah-advi. Shariah Governance Framework 2011.

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Shariah Committee and Shariah Governance Framework: Some Evidence

Chapter 8 Shariah Committee and Shariah Governance Framework: Some Evidence Zulkarnain Muhamad Sori, Shamsher Mohamad and Mohamad Eskandar Shah Mohd Rashid

INTRODUCTION Over the last few decades, the Islamic financial system has shown a strong and improved performance, where the global total assets of the industry as of end 2014 has exceeding USD2.0 trillion or a compounded annual growth rate (CAGR) of 17.4% between 2009 and 2014. The Malaysia International Islamic Financial Centre (MIFC) reported monumental issuances in sovereign Sukuks by the governments of the UK, Senegal, Hong Kong, South Africa and Luxembourg amounting to USD 115 billion. As the “big four” global centres in Islamic finance, Malaysia has recorded a remarkable achievement in Islamic finance industry where it is the major market place for Islamic capital market for sukuk and equity, Islamic unit trust (mutual fund) and takaful market, Islamic finance education provider and Islamic banking market (PwC, 2010). A well-functioning and vibrant Islamic financial system can only be guaranteed and sustained over years with a good corporate governance that comply with the Shariah guidance. Grassa and Matoussi (2014) pointed out that the governance system of Islamic banks (i.e. Islamic Financial Institutions) should be different that their counterpart in conventional institutions due to various stakeholders involved in the Islamic governance system such as investors, depositors, shareholders, regulators and Islamic community. These key parties rely on IFIs’ governance system to protect their interests towards achieving the full compliance of Shariah principles which is the ultimate objective of IFIs as stipulated in the Islamic Financial Services Act 2013.

Various efforts have been continuously taken by the regulators to ensure that the Islamic finance industry is on track to achieve its set objectives and sustain Malaysia as the world Islamic finance hub. The Shariah governance framework guidelines issued by the Central Bank in 2010 that become effective in January 2011 have clearly identified the key mechanisms of Shariah governance. One of the main drivers of good Shariah governance is establishment of Shariah committee that provides a clear guide for IFIs to comply with Shariah principles in its business. The governance framework requires the Shariah committee to be independent and comprised of qualified members both in Shariah and conventional finance to effectively perform its responsibilities. The concept of ‘independence’ is crucial and should become an important agenda of the regulator of Islamic financial institutions (IFIs). The absence of independent Shariah committee would result in weak Shariah governance, which in turn leads to market failure and Islamic capital market dry up, and finally, lead to the demise of the whole Islamic financial system. The objective of this paper is to examine the importance of Shariah committee independence in delivering their duties. Shariah committee chairman and members were interviewed to collect the required information.

Shariah Governance Framework by the Malaysian Central Bank The Central Bank (Bank Negara Malaysia) has introduced the ‘Shariah Governance Framework for Islamic Financial Institutions’ (SGF) (Ref No: BNM/RH/GL_012_3) that took effect from 1 January 2011. The guidelines provide roadmap for IFIs to develop a sound Shariah governance and to reinforce the regulators expectation on effective and efficient IFIs governance system. The SGF is applicable to all Islamic Financial Institutions (IFIs) that fall under the following definitions: (i) an Islamic Bank under the Islamic Banking Act 1983 (IBA); (ii) a takaful and retakaful operator registered under the Takaful Act 1984 (TA); (iii) a financial institution licensed under the Banking and Financial Institutions Act 1989 (BAFIA) that participates in the Islamic Banking Scheme; (iv)

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a development financial institution prescribed under the Development Financial Institutions Act 2002 (DAFIA) that participates in the Islamic Banking Scheme. Among other aspects, the emphasis is on independence of the Shari’ah Committee in ensuring sound Shariah decision-making and emphasis on the role of the board of directors in recognizing the independence of the Shariah Committee. The ultimate goal of this framework is to ensure continuous public confidence on the strength and credibility of Islamic finance industry. Two-tier Shariah governance infrastructure comprising of two (2) vital components namely the centralised Shariah Advisory Council (SAC) at the Central Bank and an internal Shariah Committee established in each of the IFIs. The SAC was given the ultimate authority in the determination of Islamic law on any financial matter relating to Islamic business operations, activities or transactions. On the other hand, the Shariah Committee is given a mandate to provide guidance to the respective IFIs on Shariah matters. The key players of Shariah Governance are Board of Directors, Board Risk Management Committee, Board Audit Committee, Management and Shariah Committee in ensuring that Shariah as overarching principle in Islamic finance as shown in Figure 8.1. They are supported by 4 main functions namely Shariah Risk Management Control Function, Shariah Review Function, Shariah Research Function and Shariah Audit Function. In this perspective, Shariah Committee plays a significant role in assisting the Board of Director in making decision on policies, operations and others relating to Shariah compliance. All functions are expected to provide information/input to Shariah Committee and the other key players are expected to refer to Shariah Committee in making decision on Shariah compliance.

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Figure 8.1 Shariah Governance Framework Model for Islamic Financial Institutions Source : Bank Negara Malaysia (2010)

The SGF specifically outlines the requirements on Shariah committee independence in Principle 3 of the framework. Observing independence in exercising their duties is expected would result in the Shariah committee to come out with objective and informed decisions without any ‘fear’ or ‘favour’ and influence from the management or other interested parties. The Shariah committee is entrusted by the Central Bank to inform the board of directors any non-compliance activities by the IFIs and to recommend appropriate rectification measures and the Shariah committee has the responsibility to inform the Central Bank on non-compliance issues and if the IFIs did not take enough or appropriate measures to rectify the noncompliance issues. On the other hand, the board of directors is required to ensure that the Shariah committee decisions and deliberations are duly implemented without any modification and with the consent of the Shariah committee. Finally, the issuance of the SGF is consistent with the provisions in section 59 of the Central Bank of Malaysia Act 2009, section 129



53A of the IBA, section 69 of the TA, section 126 of the BAFIA and section 126 of the DAFIA that makes all institutions under the purview of these acts are obligated to observe the guidelines.

Methodology The objective of this paper is to ascertain the Shariah committee independence in their fiduciary responsibilities. Semi-structured interviews were conducted with 16 Shariah Committee members from Islamic banks, Takaful/Retakaful, development banks and regulatory bodies as shown in Table 8.1 below. Table 8.1 Background information of the interviews Years of Experience of Sampled Shariah Committee Member Longest serving Shariah Committee Member Shortest Serving Shariah Committee Member Average Years of Experience as Shariah Committee Member

Years 13 2 6.13 Number 16

Total Sample Distribution of Sample Islamic Bank DAFIA Takaful/Retakaful Regulatory Body

10 2 2 2

The average years of experience as Shariah committee members of the sample is 6.13 years with the longest serving at 13 years and the shortest serving member at 2 years. The average 6.13 years’ experience is considered important for Shariah Committee members to fully learn and experience the matters relating to the industry and justify the validity and reliability of the information provided. The aggregate results based on phenomenological technique are provided in the following section.

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Findings This section reports the findings. Consistent with the role of Shariah committee to issue IFIs resolutions, independence in fact (i.e. the state of mind) and independence in appearance (i.e. be seen as independent) of members of the Shariah committee are important. The SGF outlined the importance of members of the Shariah committee to maintain their independence from management influence in making decisions. It is understandable that the IFIs spent a lot of money and efforts in developing products and services and the CEO is usually obsessed with keeping KPIs on track to ensure their targeted remuneration. Since the Shariah committee members are provided with financial incentives for their efforts, it is only easy to err in line with management biasness. The interviews revealed that Shariah committee independence should not be tolerated and the value of their work depends on this criterion: “Shariah committee members should be independent because sometime the IFIs management will only look at issues from profit and business perspective. There is situation when Shariah committee has to make a tough decision. If Shariah committee is not independent, they will tend to be influenced by the management. In fact, the management will come few times if our decision is not in line with business direction of the bank. I mean that is normal. So, to have and to emphasise on the need to be independent is very important.”

In support with the above argument, another interviewee added, “It is very important because if you are not acting professionally, Shariah committee members independence may be compromised… Keep in mind that there is fees, there is allowances given to the Shariah Committee. So, may be if you don’t have that kind of independence, you may favour the management, you may satisfy the management in order to keep your position, to keep those allowances, so on so forth… so, you will be having that kind of conflict of interest.”

All of the interviewees are consistent on this matter, where an interviewee is critical on this issue and relate it to his personal experience as follow:, 131



“…even though the management may not want to say it out rightly, but then the Shariah committee may feel dutifully to confirm, meaning that if there is any proposal by the management that reflected the commercial objective of the bank rather than Shariah objective… that Shariah committee member, because of you be in the committee, you have your allowances, you have the monetary interests, meaning that there is an income, you are obliged, to stay put and of course sacrificing your principle.”

“If we can define what is meant by independence…I think that will add more to Islamic finance. That will give full understanding… what and how you define as independence in regards to Shariah committee function. I think that will help the industry.”

The interviews revealed that the issue of compromising independence in fact is much more crucial to Shariah committee members as it happened unnoticed due to personal interests to keep the position and to continuously receive the remuneration packages. In this context, the state of mind of Shariah committee members is at stake, which is difficult for them to control and observe. An interviewee pointed out that, “…some banks may just give you one term. …For example, I’m very hard on the bank that I served especially on issues like al-Inah. During Shariah committee meetings, I’m quite rough. So, my tenure is very short and they appoint a new guy to replace me… If you want to allow the bank to bully, because of monetary interests, that’s too bad. If there is an implicit signal from the management that you will not stay long because you are too outspoken, that’s very unhealthy.”

The emphasis on the importance of independence in carrying out Shariah committee duties is crucial. In fact the interviews revealed that the industry should learn from auditing profession where independence has been clearly defined and a set of rules and procedures being developed to ensure the relevant parties are aware on the matters. There should be a clear guideline, code and/or by-law of professional body on Shariah committee independence issued by body like ASAS (Association of Shariah Advisors) or the regulators like the SC (Securities Commission) or the Central bank that explain the meaning of independence for Shariah committee. The guideline or code should spell out threats and safeguards to independence of Shariah committee. An interviewee stressed out that,

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On the other hand, the requirement for the Central Bank to provide endorsement on every appointment and dismissal of Shariah committee members would give strong safeguards for the committee to act independently. They could raise any issues or matters concerning IFIs policies and operations without ‘fear’ or ‘favour’ of threat of dismissal by the bank management. The bank cannot simply dismiss any members of the Shariah committee due to their professional comments or remarks or decision made without a concrete decision to remove the person. An interviewee, conclude the issue by saying, “The appointment and dismissal of Shariah committee is subject to final approval by the Central Bank. They cannot simply dismiss Shariah committee members. So, this will give a degree of independency. To give a fair and sound judgement, looking at very objective of the issue, without keeping in mind that my decision may upset the management that they may terminate me.”

The interviews revealed that Shariah committee members understand that they should be objective in deliberation of issues, act independently and honestly in the interest of shareholders, depositors, investment account holders and the other stakeholders. Indeed, there should be a system for ‘check and balance’ and performing ‘hisbah’ in the effort for Shariah committee to satisfy the expectation of all parties. The independence values would help all parties in the sense that the committee looking for discrepancies on Shariah non-compliance risk and take appropriate action to rectify it. The committee members should have a strong personality in a way that they might have different opinion with the CEO, but, they cannot simply be influenced by the management. Indeed, an interviewee pointed out that any deliberation and resolutions issued by the committee should be based on proof and supporting evidence, where they have to provide justification on every decision. He stressed out that,

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“If there is a new product, we have to deliberate based on our understanding whether it is in compliance with Shariah. If it is comply, what is the basis? If it is not in compliance, what is the basis? Why? The management did not involve in the decision making. From business perspective, they can say the advantages and disadvantages. But, the Shariah committee can still be independent. We are not trying to please the management of whatsoever, because this is about halal or haram. If it is not comply, we just say no.”

by IFIs are truly Shariah compliant. Shariah committee independence can be defined as the ability to make objective decisions on compliance status of products and services without any management influence. Interviews with Shariah committee members in the IFIs suggests that some committees don’t view the committee as ‘independent’ as every decision is in the purview of the Shariah Advisory Council (SAC) of the central bank, while other committees do not give due focus to ‘independence’ in their decision process. To improve the Shariah committee independence, there is a need for a proper guideline to define ‘independence’ and a mechanism to ensure that these guidelines are strictly adhered to instill international confidence in our Islamic finance industry. Indeed, the Association for Shariah Advisors in Islamic Finance (ASAS) should issue a by-law on independence for their members to adhere to, and at the same time the Central Bank should make it mandatory for all Islamic financial institutions’ Shariah committee members to become a member of ASAS. Thus, their actions will be bound by rules and regulations enforced by ASAS.

Also, Shariah committee members should be able to split their personal and professional relationship with the management. The interviews indicated that fees and allowances paid to Shariah committee members will not influence their state of mind and behaviour towards accommodating the management interests. To conclude the interview, an interviewee pointed out that, “…Independence is very important as a principle, but, how many people are willing to behave like that? At the end of the day, everybody just say ‘YES, YES’. If you want to introduce some change, then you have to make sacrifices. If that bank, that entities not conducive enough to let you have that chance to show them the ways, then you have to get out.”

But how many will opt to get out. So far, no committee member has taken the decision to leave the committee because of inconsistencies imposed by management. At the end of the day, Shariah committee members are humans and decisions cannot be expected to be fully objective, after all there is a ‘catch-all’ justification of “umum-balwa” to justify their decisions.

CONCLUSION With the remarkable achievement of global Islamic financial system in a very short period of time of over four decades, there has been a concerted and continuous effort to ensure effective Shariah governance. This will ensure public confidence and trust in the Islamic financial system and help the growth of the industry. This paper address the issue of Shariah committee independence in ensuring all products and services introduced

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REFERENCES Bank Negara Malaysia (2010). Shariah Governance Framework for Islamic Financial Institutions. Retrieved from http://www.bnm.gov.my/. Finance Committee on Corporate Governance (FCCG) (1999). Report on Corporate Governance, Malaysia: Ministry of Finance. Grassa, R. and Matoussi, H. (2014). Corporate Governance of Islamic Banks. International Journal of Islamic and Middle Eastern Finance and Management, 7(3), 346-362. ICAEW (1985), Guide to Professional Ethics, London: Institute of Chartered Accountants in England and Wales. PwC (2010). Gateway to Asia: Malaysia as Islamic Finance Hub. Kuala Lumpur: PricewaterhouseCoopers. Retrieved from https://www.pwc.com/en_MY/my/ assets/ publications/Gateway-to-Asia.pdf

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The ‘Gatekeeper of Financial Truth’ in Malaysian IFIs: Some Evidence

Chapter 9 The ‘Gatekeeper of Financial Truth’ in Malaysian IFIs: Some Evidence Shamsher Mohamad, Zulkarnain Muhamad Sori and Eskandar Shah

INTRODUCTION The concept of Shariah governance has its foundation in the Qur’an and the Sunnah1. Shariah (which literally means “the way”) is the divinely ordained guidelines of conduct for Muslims in all aspects of their life, which includes financial matters. Any form of transaction, irrespective of financial or otherwise, must be free of any element of injustice to the transacting parties. For financial transactions, any element or form of activity that could be construed as ‘riba’ or injustice to any of the participants in the transaction is absolutely forbidden. The objective is to ensure that the operations of Islamic Financial Institutions (IFIs) are Shariah compliant, failing which will result is loss of confidence and credibility that will impede the future growth of Islamic finance Industry. The Anglo-Saxon concept of corporate governance is a guideline to help manage a corporation effectively to achieve its set objectives, which incorporates the elements of transparency, fairness and accountability in the interest of capital providers. The Shariah based governance guidelines upholds similar attributes except that it focuses on the interest of all stakeholders in the sense that there is no injustice to any stakeholder (which 1 Al-Sunnah refers to way, custom and habit of life, be it good or bad. The meaning of the word in that manner can also be seen in a hadith of the prophet. In Juristic usages, al-Sunnah can be understood from various perspectives. From perspectives of sources of Shariah, Sunnah can be defined as anything that originates from Prophet Muhammad (pbuh) which includes his conducts, sayings and all of his tacit and explicit approvals (Hassan, 2011).

relates to accountability to God) that implicitly ensures that everyone in the whole chain of process are responsible to perform as best possible and accountable for their assigned responsibilities. The basis for Shariah governance framework is from the following verse in the Qur’an: Those who remember Allah standing, sitting, and lying down on their sides, and think deeply about the creation of the heavens and the earth, (saying): “Our Lord! You have not created this without purpose, glory to You! Give us salvation from the torment of the Fire. (Al-Qur’an, 3:191)

Another verse of the Qur’an (51:56), further points out the Tawhid dimension in Islam as AIlah (S.W.T.) says, “And I created not the Jinn and mankind except that they should worship Me”. Both these verses provide fundamental principle of governance where everything created by Allah (S.W.T.) has a purpose and human beings are created to be the vicegerent of God. An effective practice of good governance requires all those involved to carry out their responsibilities in the best manner possible with the infrastructure support in the form of procedures, processes and oversight mechanisms. For an IFI, the oversight mechanism is usually their Shariah department and in Malaysia this is further strengthened by the Central Bank’s requirement that all IFIs are required to set up a Shariah Committee (with members from 5 to 7 and with specified qualifications) to ensure IFIs products and services and the processes through which these products and services are generated comply the shariah requirements and in summary, keep the gates of Shariah governance.

The Shariah Committee The IFSB-10 defines the Shariah governance system as “a set of institutional and organizational arrangements through which IFIs ensure that there is an effective independent oversight of Shariah compliance over the issuance of relevant Shariah pronouncements, dissemination of information and an internal Shariah compliance review” (IFSB, 2009, p. 2). This requires an institutional arrangement such as the Shariah committee to provide an independent oversight and ensures that all transactions are Shariah compliance, supervise and certify the development of Shariah compliant 137



products and processes, advise on Shariah training programs and prepare periodical reports on their activities. In essence, the Shariah Committee is expected not only to focus on developed products and services but to focus on the whole chain of activities that leads to development of new products and services. However, the Shariah committees are only responsible for forming and expressing opinions on the extent of Shariah compliance on products, professional competence and behavior towards the observance of Shariah norms (Ayub, 2007). Institutions offering Islamic financial services and products need to reassure stakeholders that their activities comply with Shariah principles. IFIs are required to establish a Shariah Committee2 that has the authority, independence and responsibility to provide assurance on Shariah compliance issues. The Shariah Committee is expected to perform an oversight role on shariah matters related to institution’s business operations and activities through Shariah review and Shariah audit functions. The credibility of the Shariah committee in helping IFIs in practical applications of the Shariah principles requires its members to have good knowledge not only of revealed law in the Quran and the Sunnah but also on the real world financial products and transactions. In Malaysia, one of the pre-requisite for the appointment as a Shariah Committee member is that the candidate needs to have knowledge of fiqh and usul fiqh as well as the modern Islamic banking and finance operations. In practice, it is a big challenge to find members that have both knowledge of Sharia and conventional finance, and therefore the Malaysian Central Bank requires the majority of the committee members to hold bachelor’s degree in Shariah, which includes study on Usul Fiqh (the origin of Islamic law)

and fiqh muamalat (Islamic transaction/commercial law) and at least two of the five (minimum) or seven (maximum) members be conversant with the conventional finance. This paper discusses some challenges of Shariah committees in Islamic Banks in dispensing their responsibilities and in the process mitigating the non-compliance risks. The non-compliance risks or commonly termed as Shariah risks could be due to either non-standard practices of Islamic financial products or the risk that is due to non-compliance with Shariah (IFSB, 2006, p. 26). The real example is the case of Organization of the Islamic Conference (OIC) Fiqh Academy’s declaration on the impermissibility of tawarruq despite its wide use in the Middle-East (or controversial practice of buying goods on deferred payment and then selling the goods to a third party at a lower price for cash) and the Malaysian National Shariah Advisory Council’s (at the Malaysian Central Bank) endorsement on the issue of bay’ bithaman ajil (BBA), the middleeastern scholars have disapproved this practice because it is considered a legal trick (hilal) to circumvent the practice of riba. (It is a transaction whereby financial institutions buy assets from consumers at a cash price which is lower than the price the banks charge the consumer when selling back the asset to the consumer on a deferred payment basis). Also discussed are the proactive measures taken by the Malaysian Central Bank to address these challenges. Ineffective or weak governance has always been the cause of financial failures in financial markets. History of failures such as Ihlas Finance in Turkey, Islamic Bank of South Africa and Islamic Investment Companies of Egypt, the commercial losses of Dubai Islamic Bank and Bank Islam Malaysia Berhad (Refer to Table 1) reminds us that failure will continue to happen, irrespective of conventional or Islamic market, as long as there is weak governance. Ali (2007) and Parker (2005) attributed factors linked to weak enforcement mechanism, poor internal control, irresponsible management, insider trading and lack of competency of those in authority to make decisions for these failures. The essence of the problem was poor management of operational risk.

2 In different jurisdictions, the committee is also referred as Shariah Supervisory Board or Shariah Board. On the other hand, the Malaysian Central Bank has established the highest Shariah authority in Islamic Finance in Malaysia that is called Shariah Advisory Council (SAC). The SAC has been given the authority for the ascertainment of Islamic law for the purposes of Islamic banking business, takaful business, Islamic financial business, Islamic development financial business, or any other business, which is based on Shariah principles and is supervised and regulated by the Malaysia Central Bank. It is important to highlight that the rulings of the SAC shall prevail over any contradictory ruling given by a Shariah body or committee constituted in Malaysia, the court and arbitrator are also required to refer to the rulings of the SAC for any proceedings relating to Islamic financial business, and such rulings shall be binding. The Shariah Committee might not allow certain products or services, though the SAC allows, but cannot be vice-versa.

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Table 9.1 Corporate Governance Issues and Corporate Failures

However, an effectively functioning Shariah Committee will be able to mitigate non-compliance risks and uphold the reputation of this growth industry. Highlights on some practical challenges faced by Shariah Committees in dispensing their responsibilities are discussed next.

Ihlas Finance, Turkey

Ihlas Finance in Turkey was closed on 10 February 2001 due to financial distress and weak corporate governance. Ali (2007) reported that the closure of Ihlas Finance was mainly contributed to the failure of corporate governance and internal checks and balances. It was found that the bank was run without a proper system of internal control, the management did not prepare for any changing circumstances of regulations and unclear scope of regulations.

The IBSA was closed in November 1997 with debts of between R50-R70 million due to lack of supervision from a regulatory authority, bad management, weak Islamic Bank South risk management, and numerous loans to insiders (Okeahalam, 1998, pp. 37-38). It is sad to mention that Africa (IBSA) the IBSA was unable to compensate all of the depositors who were mostly Muslims who specifically had saved their money to perform their pilgrimage in Mecca

Islamic Investment Companies of Egypt (IICE)

The closure of the lICE in 1988 was due to weak corporate governance, irresponsible management, and improper regulatory frameworks as well as engaging in Shariah non-compliance activities (Zuhaida, 1990). Over one million small investors lost their investments when the lICE and other investment companies collapsed. The IICE was an investment company that offered services free from interest.

Dubai Islamic Bank (DIB)

This refers to the fraud case in DIB involving US$501 million. Seven individuals were charged, including Dubai Islamic Bank former executives (Morris, 2009). This was the biggest case in the Dubai Court of First Instance, in terms of the amount. of financial irregularities (Za’za, 2009).

Bank Islam Malaysia Berhad (BIMB)

The BIMB declared; losses, totaling RM457 million in 2005 mainly due to the provisioning of RM7.74 million as a result of bad financing and investments incurred by its Labuan branch (Parker, 2005). The composition of the board was not appropriate as there were no board members who were familiar with the banking sector. as well as no sound and proper credit and debt collection (Parker, 2005). 140

Challenges A well-functioning Shariah committee is expected to be effective, efficient, consistent and transparent in its deliberations and decisions. This directly relates to issues of independence, confidentiality, competence, consistency and disclosure by Shariah committee when auditing for Shariah compliance of IFI activities. It cannot be denied that Islamic law in most countries with predominantly Muslim population has been separated from common law practice in all aspects of life except in personal and private affairs. It is a challenging task for Shariah Committees to apply Islamic commercial law in its entirety in actual commercial transactions as the form and substance of most transactions are conventional. In Malaysia, every IFI is required to set a Shariah Committee to take this responsibility, though most IFIs also have a Shariah department that supports this function but members of the Shariah department in the IFI are not allowed to be on the Shariah Committee. The Shariah Committee is supposed to be represented on the Board of the IFI (though in most cases, the chairman of the Shariah Committee is only invited to make presentation on Shariah Committee resolutions but not is not appointed as member of the board), and is responsible to the Shariah Advisory Council (SAC) at the Malaysian Central Bank. The SAC has a legal authority to take actions against IFIs that do not comply with the requirements as reported by the Shariah Committee. This facilitates the decision making process as IFIs can always refer to the SAC in the Central Bank for any form of ambiguity and disagreement, it also mitigates the school of thought (‘mazhzab’) issues when making decisions. This form of institutional arrangement helps coordinate, manage and take responsibility to ensure uniformity in practice. The first issue is on the ability of the Shariah committee to make objective decisions independently, which is without any fear (in the form

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of influence or coercion from the management) and favor of the IFI. The Shariah committees can only express opinions, or expert testimony but do not have the legal authority to force the management to follow-through with the opinion. In practice, substantial amount of resources are usually spent by the management of IFI in developing the processes and the product, and management are usually very keen to fulfil their short-term ‘key performance index’ to earn their targeted remunerations, and therefore there is a possibility that the product review could be just perfunctory, with Shariah committees relenting to IFI management pressure. This is also because Shariah committee members receive remuneration from the IFIs (though it is a token sum compared to what the board members are paid), there exists a potential conflict of interest in legitimizing unlawful or dubious operations. For example, Warde (2010) explains debates between scholars employed by the IFIs and scholars from the government in Egypt with the accusation that scholars employed by IFIs are paid handsomely to offer tailor-made pronouncements that would legitimate certain dubious practices from the religious perspective. In Malaysia, the appointment, removal and renewal of Shariah committee members are regulated directly by the Central Bank. For appointments, the IFI recommends the candidate to the Central Bank with all the required details and the final decision is made by the central bank after proper due diligence. IFI can only request a change or removal of a member to the Central Bank and the latter will have the final decision after due deliberation. The only reason the Central Banks will remove a member from the committee before his term expires is that due to being absent from the scheduled meetings and for health reasons. However, with regard to the remuneration to the members by the IFI, the Central Bank does not have any guidelines but leave the quantum to the respective IFI’s. A better way to mitigate any potential influence is to establish a separate independent fund with an oversight from the Central Bank that pays a standard remuneration to Shariah Committee. The standard payment will also mitigate the possibility of some IFIs paying huge allowances to align the decisions to their interest.

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Shariah Committee Report In practice, a Shariah Committee is required to prepare and issue report on its activities, information on duties and services, Shariah pronouncements and declaration of Shariah compliance on annual basis. Before an IFI prepare a report on its activities, it is required to undertake Shariah review processes by an independent internal Shariah auditor to ascertain that all transactions are in conformity with Shariah principles. The review process sometimes becomes difficult due to lack of standard mechanism to facilitate collection and coalition of information. Even when the information is available, it might be incomplete to provide sufficient details to ascertain its usefulness in making decisions. The implication is that it makes the role of information irrelevant in promoting the industry and enforcing effective Shariah governance. Grais & Pellegrini (2006) found that four out of every 13 institutions offering Islamic financial services failed to issue Shariah reports. In Malaysia, the Central Bank requires all IFIs to prepare a Shariah report to be submitted with their annual audited financial statements. The Shariah report is prepared based on a standard recommended format, which helps Shariah Committees to highlight the potential risk, non-compliance and the appropriate measures taken to address the non-compliance. The members of the Shariah Committee are expected to be competent in areas of risks, business strategies and banking business, besides being conversant with Shariah rules and principles. This implies on the effectiveness of Shariah committee decisions. This is why Malaysia has taken the initiative to have a majority of shariah committee members to be Shariah scholars (specifically in areas of Fiqh and Usul Fiqh) and the rest being conversant in other banking and finance disciplines. It also allow those IFIs that require specific solutions due to their unique circumstances could then find a solution based on the relevant general standard of the central Shariah Advisory Committee (SAC) or based on their deliberations. However, in practice, there is a standard reporting format and disclosure requirement that all IFIs follow religiously, though individual IFIs can submit in format of their discretion as long as the reports disclose the required information.

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Interlocking The rapid growth of the Islamic finance industry on a global scale has led to the increase in need for more qualified Shariah scholars and has highlighted the issues of possible conflicts of interest and opinions on same issues by different Shariah Committees. Another issue of concern is the multiple appointments of same scholars on multiple Shariah Committees in some countries. In many Middle-Eastern countries, multiple appointments are allowed and many IFIs take proud of appointing very popular scholars known for their knowledge and reputation and also leniency and increasing the risk of fatwa shopping by IFIs. Multiple appointments could have implications on conflicts of interest (for example, Shariah scholar’s relationship with other office bearers could affect the impartiality and objectivity of their decisions), taking similar views on similar issues under different jurisdictions (in the interest of expediency) that may actually require different considerations due to different circumstances. Also, the issue of concern is on the capability of the scholars to manage their time to be on many committees at the same time. It is therefore imperative for a proper policy or regulation on this issue to safeguard the credibility of IFIs. Adopting the Malaysian practice on this issue will certainly help improve independence and mitigate the ‘fatwa shopping’ practice. In Malaysia, Section 16 B (6) of the Central Bank of Malaysia Act 1958 does not allow any Islamic Financial Institution (IFI) to appoint any member of the Shariah Committee of another Islamic Financial Institution in the same industry. However, they can be also a member of Shariah Committee of another Islamic Industry like Takaful, but cannot be members of more than two Shariah Committees at the same time. Multiple appointments is a two-way sword in the sense that it enhance independence but could compromise confidentiality as it entails access to sensitive information about different and competing IFIs.

Fatwa Consistency The inconsistency and conflicting views on similar issues in different jurisdictions further negates the compliance and harmonization issue in the Islamic finance industry. This compromises the consistency of 144


judgments across IFIs. For example, the General Council for Islamic Banks and Financial Institutions (CIBAFI) reported that ten percent of the 6,000 fatwas issued by different IFIs with over 100 Shariah scholars were not consistent across IFIs (Iqbal & Mirakhor, 2007). The IFSB survey (2008) indicates a low percentage of reconciled Shariah issues pertaining to differences of Shariah resolutions. The diversity of the interpretation of Shariah affects the determination of certain rulings on a particular issue, where an IFI would accept a new product as being Shariah-compliant in one jurisdiction while others would decide it to be non-compliant (McMillen, 2006). The case in point is the issuance of Sukuks in Bahrain, Kuwait and UAE compared those issued in Malaysia. The former countries consider Malaysian Sukuks non-compliant due to government guarantee on the capital invested. This inconsistency undermines investors’ confidence and negates the healthy growth of the Islamic finance industry. However, on the positive note, the inconsistencies in the Shariah resolutions are not totally unexpected as there are different schools of thoughts that allow different level of leniency on the same issue. For example, the case of BBA, the Shafi’s school of thought allows it to overcome the problem of liquidity in the market and on the grounds that it is better of the two evil. Whereas the Maliki and Hanbali schools of thought disallows it as it is considered as a legal trick (hilah) to circumvent riba. In Malaysia, though the Shafi’s school is predominant, it is not imposed on Shariah committee members to base their decision on a particular school of thought. However, there are possibilities that scholars approved certain transactions or products on the basis of ‘maslaha’ or ‘greater interest of the industry and society’. However, this could lead to abuse of such reasoning by IFIs as evidence suggests that the exceptions permitted in the earlier years of this industry have now become a norm in the industry. For example, when scholars allowed fund managers to invest in firms that had debt more than a third of their capital structure, it was permitted in the hope that upon taking ownership, initiatives are taken to reduce the debt level from the capital structure to make the investment Shariah compliance. But instead, the one third debt rule has become a norm for fund managers and without any serious efforts to reduce debt after taking ownership (Askari, Iqbal and Mirakhor, 2010) which is inconsistent with the letter and spirit of Shariah principles. 145



Shariah Non Compliance

Other Issues

There is also an issue of conventional benchmarks like LIBOR (London Interbank Offer Rate) for benchmarking performance of Shariah compliant investments. The concern is ‘how do we benchmark the returns on real economic activity of Shariah investments using the LIBOR that merely reflects opportunity costs on debts?’ The usual rationale is either ‘maslaha’, ‘better of the two evils’ or simply ‘until a new compliant benchmark is available’, which seems to create some kind of complacency on initiatives for a more objective benchmark. Similarly, in the case of sukuks, there is yet a specific valuation model in practice and IFIs conveniently use the valuation formula for conventional bonds. Usmani (2007) raised concerns on the prevailing practice of sukuk holders not having a complete ownership of the underlying real assets (rather than just ownership interest) and earning real net returns from these assets rather than predetermined returns. There is also an issue of Shari’ah non-compliance risk that comprises of either fatwa rejection or differences, non-standard practices of Islamic financial products, and non-compliance with Shariah pronouncements. This is the risk of IFIs being challenged on religious grounds and IFIs and Shariah Committees revert their decisions. For example, in November 2007 when Sheikh Taqi Usmani, the chairman of AAOIFI’s Shariah Board then made a statement that more than 85 percent of existing sukuks are not Shariah-compliant and few months later retracted the statement without any official reason. To mitigate this issue, in Malaysia, the SAC (Shariah Advisory Committee) at the Central Bank has been conferred the legal authority to make the final decision that the IFIs cannot refute. For example, in Malaysia, the Central Bank of Malaysia Act 2009 clearly states that Shariah Advisory Council’s rulings are binding to both court and arbitration. This not only allows consistency but also mitigate the problem of challenges and rejections of decisions by Shariah committees in the IFI. This is similar to the case of UAE, where all decisions made by the higher Shariah authority are binding and mandatory to all IFIs.

A proper governance mechanism to manage the non-compliance risk is essential to keep the reputation of the Islamic Finance Industry. For consistency, the internal review of transactions in IFIs should be linked to external auditing and issuance of opinions on compliance of the transactions. On a country basis, it is easier to manage if we have a centralized agency with legal authority like the “Malaysian – Model”. On a global scale, the differences in economic, political, cultural, religious ideology, historical perspective of the jurisdiction of the IFI pose great challenge to practice the AAOIFI and IFSB guidelines. Unless there is a consensus to designate a joint transnational authority to ensure compliance and harmonization. Then there will be issue of costs and responsibility to manage this supposedly impartial or independent agency. Though the initiatives towards Shariah harmonization is expected to address the issues of efficiency, effectiveness and consistency and enhance the entire process and improve the time to market products and solutions, the differences in Schools of thoughts and the preference of different jurisdictions to different schools of thought on similar issues will challenge the standardization and harmonization efforts. Islam allows for these differences as long the main precepts are not contravened. Furthermore, there is a possibility that harmonization and standardization would create more rigidity and stifle product development growth initiatives and the Islamic finance Industry globally.

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CONCLUSION The role of Shariah Committees has taken new importance and perspective in the light of recent turmoil in the financial markets. For example, in the early years of the resurgence of Islamic finance about five decades ago, Shariah committees focused on the format of intermediation, then followed by the focus to product design and development and now the focus has matured towards Shariah governance. Over the decades, the role and decisions of Shariah scholars in the committees has come to close scrutiny and criticism especially with respect to their independence from management influence. Effective Shariah governance that inculcates


transparency, trust, ethical behavior, credibility, underlying faith and belief and ethics (Nathan & Ribieri, 2007) will provide credibility to the IFIs that will help spur a healthy growth of the Islamic finance industry. This paper discussed some challenges faced by Shariah Committees in Islamic Banks in Malaysia in particular in performing their responsibilities to ensure all activities of the IFI are shariah compliant. Other issues of concern are the varying degrees of leniency of Shariah committee’s deliberations due to differences in interpretations, intensity of competition and accepted practices. The other issue is over-stretching of the excuse of ‘in the interest of society’ to allow products and services that are closer to non-compliance. This requires a strong legal and operational Infrastructure with political commitment to allow Islamic finance industry to grow in the future. Malaysia being the hub of Islamic finance has committed to provide the required infrastructure and has successfully supported this growth industry domestically and internationally over the last 5 decades. As discussed above, Malaysia has taken pro-active initiatives to address the governance issues on both national scale and micro-scale with its Islamic Finance Blue Print. It is important that other countries learn from Malaysian experience and shorten their learning curve in establishing an Islamic finance industry in their own country. On a global scale, the guides by agencies like AAOIFI and IFSB could help in dealing with international markets, however, there is operational difficulty to enforce their suggestions over different jurisdictions. This is also the probable reason most IFIs in other countries opt for conventional guidelines. To ensure the continued growth of the industry, both the financial institutions and regulators need to work together, in the sense that regulators provide market-smart guidelines and the financial institutions ride on these guidelines to prosper and spearhead the growth of the Islamic finance Industry.


REFERENCES AAOIFI. (2005). Governance Standard for Ills, No. 1-5. Bahrain: AAOIFI. AAOIFI. (2010). Governance Standards No. 7: Corporate Social Responsibility, Conduct and Disclosure for Islamic Financial Institutions. Bahrain: AAOIFI. Ahmed El-Nagar et al., One Hundred Questions & One Hundred Answers Concerning Islamic Banks (Cairo: Islamic Banks International Association, ig8o), p. 20. Ali, S. S. (2007). Financial Distress and Bank Failure: Lessons from Closure of Ihlas Finance in Turkey. Islamic Economic Studies, 14, (1 & 2), 1-52. Askari, H., Iqbal, Z., & Mirakhor, A. (2008). New Issues in Islamic Finance and Economics: Progress and Challenges, John Wiley & Sons (Asia). Askari, H., Iqbal, Z., & Mirakhor, A. (2010). Globalization and Islamic Finance: Convergence, Prospects and Challenges, John Wiley & Sons (Asia). Abdullah, D. V. & Chee, K. (2010). Islamic Finance, Why it Makes Sense, Marshall Cavendish International (Asia) Pte Ltd. Bakar, D. and Engku Ali, E. R. A. (2008). Essential Readings in Islamic Finance. Kuala Lumpur: CERT. Bank Negara Malaysia (BNM) (2010). Shariah Governance Framework for Islamic Financial Institutions. Available at http://www.bnm.gov.my. Accessed on 1st October 2014. Brown, D. (1996). Rethinking Tradition in Modern Islamic Thought, Cambridge: Cambridge University Press. Grais, W. & Pellegrini, M (2006) Corporate Governance and Shari ah Compliance in Institutions .Offering Islamic Financial Services. World Bank Policy Research Working Paper No 4054. Hasnan, A. (2011). Fundamentals of Shariah in Islamic Finance. Kuala Lumpur IBFIM. IFSB. (2006). Guiding Principles on Corporate Governance for Institutions Offering Only Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds. Kuala Lumpur: IFSB. IFSB. (2008). Survey on Shari ah Boards of Institutions Offering Islamic Financial Services across Jurisdictions. Kuala Lumpur: IFSB.

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IFSB (2009). Guiding Principles on Shari ah Governance System in Institutions Offering Islamic Financial Services. Kuala Lumpur: IFSB.

Rammal, H. G. (Spring 2006). The Importance of Shari ah Supervision in IFIs. Corporate Ownership and Control, 3, (3), 204-208.

Igbal, Z, & Mirakhor, A.(2004). Stakeholders Model of Governance in Islamic Economic System. Islamic Economic Studies. 11, (2), 43-64.

Usmani, Muhammad Taqi, Sukuk and their Contemporary Applications, Bahrain: AAOIFI.

Iqbal, Z, & Mirakhor, A. (2007). An Introduction to Islamic Finance: Theory and Practice. Singapore: John Wiley and Sons (Asia) Pte. Ltd.

Warde, I. (1998). The Role of Shariah Boards: A Survey, IBPC Working Papers (San Francisco, CA: IBPC).

Kahf, M. (2004). Islamic Banks: The Rise of a New Power Alliance of Wealth and Sharia’ Scholars. In Clement M. Henry &Rodney Wilson, (Eds.), (2004), The Politics of Islamic Finance, 17-36. Edinburgh: Edinburgh University Press Ltd.

Warde, I. (1997). “Comparing the Profitability of Islamic and Conventional Banks,” IBPC Working Papers (San Francisco, CA: IBPC).

Kahf, M. (1978). The Islamic Economy. Plainfield: Muslim Student Association (US-Canada).

Yaacob, H. (2010). The New Central Bank of Malaysia Act 2009 (Act701): Enhancing the Integrity and Role of the Shariah Advisory Council (SAC) in Islamic Finance, Research Paper (No: 6/2010), ISRA.

Kramer, G. (1977) “Islamist Notions of Democracy,” in Joel Beinin and Joe Stork (eds.), Political Islam: Essays from Middle East Report (Berkeley, CA: University of California Press), p. 77.

Warde, I (2010). Islamic Finance in the Global Economy, 2nd Edition, Edinburgh University Press.

Michel Galloux, Finance Islamique etpouvoirpolitique: le cas de l’Egypte moderne (Paris: Presscy Universitaires de France, 1997), pp. 39-45. McMillen, M. J. T. (2006). Islamic Capital Markets: Developments and Issues. Capital Markets Law Journal, 1, (2), 136-172. Mortimer, E. (1982). Faith and Power: The Politics of Islam. New York: Random House, p. 123. Muhammad, A. (2007). Understanding Islamic Finance, Singapore: John Wiley & Sons (Asia). Nathan, S. & Ribiere, V. (2007). From Knowledge To Wisdom: The Case Of Corporate Governance In Islamic Banking. The Journal of Information and Knowledge Management Systems, 37, (4), 471-483. Emerald Group Publishing Limited. Okeahalam, C. C. (1998). The Political Economy of Bank Failure-and Supervision in the Republic of South Africa: African Journal of Political Science, 3, (2), 29-118. Parker, M. (2005). Scandal-Hit Bank Islam Malaysia Declares Huge Losses. Arab News. Retrieved from http://www.arabriews:com/page=6§ions&artide=7 4908&d=19&m=12&y=2005 Accessed: 7 September 2009.

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Governance, Performance and Risk Management Issues in Malaysian Islamic Financial Institutions

Chapter 10 Governance, Performance and Risk Management Issues in Malaysian Islamic Financial Institutions Gulzhan Musaeva, Mohamad Eskandar Shah Mohd Rashid, Shamsher Mohamad and Zulkarnain Muhamad Sori

systematic documentation of past research and findings in this area could help researchers identify and select research areas of inadequate coverage and those that will guide a more structured development of this industry in the future. The surveyed literature of 114 papers covering the period from 1989 to 2013 is sourced from reputable English-language resources on the topic of Islamic banking in Malaysia. The paper starts with a brief introduction followed by a summary of published papers and identification of gaps, and concludes by charting the possible directions for future research in the Malaysian Islamic banking sector in view of the planned government initiatives as the benchmark.

INTRODUCTION

Literature Survey

The body of literature on Islamic banking has expanded significantly in the recent decades. A cursory overview of it paints a picture of an uncertain future for the industry. Admittedly, Islamic banking has experienced some success globally, with an annual double digit growth rate (an average of 15% to 20% annually) in the last decade. But to maintain the momentum, the industry has to improve on a number of pertinent aspects. For instance, establishing a common regulatory, legislative, tax, and legal foundation, addressing cost-efficiency and integration issues for all Islamic financial markets in general and the Islamic banking sector in particular. Retrospectively, Malaysia – a rapidly developing vibrant economy– has positioned itself as an international hub for Islamic banking and finance. The country’s current share of Islamic banking assets is at a significant level of 16%, which makes it a leading Islamic banking player amongst its counterparts (Bank Negara Malaysia [BNM], 2012). Naturally then the research interest in this area has been intensive, although piecemeal, and the literature on Islamic banking in Malaysia abounds. This paper takes stock of the past documented research on the Malaysian Islamic banking sector and suggests the most objective future directions in consonance with the Malaysian government’s initiatives in the Islamic banking industry as gazetted in the Financial Sector Blueprint 2011-2020 and the Financial Services National Key Economic Area [NKEA]. A

The discussion of survey findings is classified based on the main issues addressed by the research papers. This provides a better understanding of the research focus over the years and facilitates the identification of gaps that will be benchmarked against the government initiatives to chart the future research directions. Governance Issues Governance issues relate to the expected norms and practices that Islamic banks need to comply with in their activities. In an Islamic bank, there are two facets of governance – Shari’ah governance and corporate governance. The first is the unique feature of Islamic banks, and the second is the traditional feature of conventional banks, but both are absolutely crucial in facilitating the functioning of Islamic banks. The Shari’ah governance ensures the Shari’ah compatibility of Islamic banking operations and conduct, while corporate governance promotes accountability, robust performance and efficiency. Therefore, governance in the Islamic banking context is holistic and covers a wide range of issues. Hassan and Christopher (2005) who appraised the influence of the religious factor on corporate governance practices of Islamic banks visà-vis their conventional competitors bereft of the same factor. They discovered that, despite the religious nature of Islamic banks and their being

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managed by mainly Muslim individuals, Islamic banking institutions were not distinguished by better corporate governance records. Satkunasingam and Shanmugam (2004) were of the same opinion and hence called for greater corporate disclosure requirements for Islamic banks, citing the prevalence of exceedingly poor corporate governance standards at the time. The importance of religiously-enhanced corporate governance in Islamic banking organisations was also recognised by Alnasser and Muhammed (2012). An important part of corporate governance in Islamic banking institutions is the establishment of a relevant accounting policy. The absence of harmonised accounting regulations for Islamic banking, in the light of weak adoption of the Accounting and Auditing Organisation for Islamic Financial Institutions [AAOIFI] standards, as commented Shariff and Abdul Rahman (2003), affects the quality and comparability of accounting information pertaining to Islamic banking transactions across different political jurisdictions. The comparison of reporting standards issued by BNM (specifically, Financial Reporting for Licensed Islamic Banks (GP8-i)) and AAOIFI was performed by Abdullah (2012). Of the top 20 countries in the Islamic financial industry, only five (namely Bahrain, Qatar, Sudan, Pakistan, and Syria) use AAOIFI standards, while the rest uses International Financial Reporting Standards [IFRS] or a combination of both sets of standards. The main reason for the jurisdictional preference for IFRS is greater investor acceptability, for these standards are internationally accepted and hence increase the potential market size for Islamic financial instruments. Fulfilment of social obligations such as paying zakah is another key element of Islamic corporate governance. As a legal entity that conforms to the Shari’ah, an Islamic bank is obligated to pay zakah, argued Alhoul (2011); the author discussed the importance of this act and offered solutions to the common juristic and practical issues faced by institutions when dispensing this responsibility. Perhaps the most essential component of sound Shari’ah governance is the Shari’ah compliance of individual Islamic banking products and services. Much controversy surrounds this topic; for example, Chong and Liu (2009) held that Islamic banking was not any different from

conventional banking due to the low usage of profit-and-loss sharing mechanisms in the former. This finding infers not the unavailability but the choice not to use Shari’ah-based alternatives available in Islamic banking. Nonetheless, there exist many genuine Shari’ah compliance issues of a lesser scale. Of great interest is the compliance status of Islamic financing products; Abdul Razak and Ismail (2010), for example, discussed how diminishing musharakah (an equity-based financing product) was considered to be more Shari’ah compliant and conducive towards the fulfilment of Shari’ah goals than other debt based financing products. One of the most common types of the latter is BBA, on which commented Dahlan and Alias (2011) by opining that, because of the way BBA was practiced in Malaysia (in particular, its evoking of gharar or uncertainty situations), it could be deemed nonShari’ah compliant. Of the Shari’ah issues in BBA, Smolo (2010) argued that in truth the product constituted a legal device and threatened the Shari’ah integrity of Islamic banking by allowing the material convergence of Islamic banking practices with conventional banking practices. Smolo and Hassan (2011) further suggested the use of musharakah mutanaqisah over alternative financing methods of BBA and murabahah on the basis of the Shari’ah-sense superiority of the former. Haneef et al. (2011) studied the legal issues existent in musharakah mutanaqisah (such as those related to ownership registration and properties under construction) but offered no suggestions for their resolution. A similar expositional paper on the same topic was written by Naim (2011). A critical analysis of the existing home financing products was done by Hasan (2011) who then proposed a new financing model that meets the norms of equity, fairness and Shari’ah compliancy. With regard to criticisms levied on Islamic financing products, Abdul Khir (2010) highlighted the significance of hilah (that is, a legal device used to avoid difficulty in one’s commitment to Shari’ah rulings in economic matters), specifically in the application of permissible hiyal in Islamic banking and outlined the parameters of its acceptability. In view of the different aspects of Islamic banking transactions in the light of Maqasid al Shari’ah, Azli et al. (2011) encouraged the contractual parties involved to have a clear understanding of Shari’ah objectives; in

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a subsequent paper, Azli et al. (2012) looked at legal cases on BBA from the viewpoint of Maqasid al Shari’ah, or rather the non-fulfilment of the same, in real legal cases. Laldin (2010) analysed the related concept of maslahah (that is, consideration of public interest) and its importance in the context of Maqasid al Shari’ah for Islamic banking regulators and corporate entities. On a more objective note, Ahmed (2011) offered a classificatory system to ascertain whether an Islamic banking product was ‘Shari’ah compliant’, ‘Shari’ah based’ or ‘pseudo-Islamic’, based on their fulfilment of the maqasid. In the case of an Islamic credit card, Laldin and Furqani (2012) and Kenjebaev (2012) held the product to be noncompliant because of its heavy reliance on bay al inah and tawarruq. The Shari’ah integrity of another local financing product – al ijarah thumma al-bai (or AITAB) was questioned by Abdullah and Dusuki (2004). They criticised the product (primarily due to its atypical but still conventional character) but foresaw positive future prospects due to the strong customer backing and the upcoming legislative support for the product in the form of the Islamic Hire Purchase Act. The use of wa’d (or unilateral promise) and muwa’adah (or bilateral promise) principles in products such as AITAB and others (murabahah for a purchase orderer, diminishing musharakah, etc.) was researched by Hasan and Muhammad (2011). A certain Shari’ah compliancy aspect of mudarabah financing – the issue of capital guarantee by a mudarib – was discussed by Abdul Khir (2012) who suggested its permissibility in case it was a voluntary initiative. Another issue of concern is proper pricing of financing products, as currently the most widely used pricing benchmark is the conventional interest rate, which arguably renders the products non-Shari’ah compliant. Yusof et al. (2011) suggested an alternative benchmark in the form of a market rental rate; the authors maintained that the rental price, aside from being Shari’ah compliant, better reflected the economic fundamentals and was more resilient to short-term volatility. Another pertinent area of concern is related to Islamic deposits; among papers on this topic was that of Sawari et al. (2011) who doubted the Shari’ah compliancy of a wadiah based deposit product of Bank Simpanan Nasional, arguing that its prize-giving feature was not permissible. Othman

et al. (2010) discussed the Shari’ah-motivated issues and criticised the application of conventional UCP 600 rules to the Islamic letter of credit in trade financing. The growing popularity of Islamic microcredit products calls for a special review. This was recognised by Abdul Khir (2011) who studied the rahn based microfinancing product for Shari’ah compatibility; to rectify the issues uncovered, the author suggested the embedding of various takyif fiqhi models into the existing product. For the Shari’ah governance framework to be effective, a vigorous Shari’ah audit and review system needs to be in place. Besar et al., (2009) investigated the quality of Shari’ah review processes in selected Islamic banks in Malaysia and concluded that a more methodological approach had to be adopted to ensure the Shari’ah Supervisory Boards discharged their responsibilities more objectively. This is in line with the recent BNMissued Shari’ah Governance Framework which makes it compulsory for Islamic banks (and other Islamic financial institutions) to perform regular internal Shari’ah auditing checks. Yussof (2013) looked at the necessity for Islamic banks to develop an internal Shari’ah audit infrastructure and to train professionals qualified in both finance and the Shari’ah law. Abdul Rahman (2011) detailed the efforts by ISRA [the International Shari’ah Research Academy in Islamic Finance] to complement BNM’s Shari’ah Governance Framework by preparing and issuing the Shari’ah Audit Framework; the authors also suggested some institutional arrangements to ensure effective implementation of the mentioned framework. Relatedly, Kasim and Sanusi (2012) highlighted some of the challenging issues in the field of Shari’ah auditing, such as that of self-review and independence, and recommended the regulators to revise the existing Shari’ah audit guidelines accordingly and to devise mandatory professional certification for Shari’ah auditors. Meanwhile, a new format of disclosure guidelines was proposed by Ameer et al. (2012) to increase the Shari’ah-connected disclosure of profit sharing investment accounts. Rosly (2010) urged the Shari’ah audit to be conducted in an integrated manner by ensuring the Shari’ah adequacy in the four parameters of Maqasid al Shari’ah, financial reporting, legal documentation, and contract.

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Acknowledging the achievements of the national regulator, Hasan (2010) observed that the passing of the Central Bank of Malaysia Act 2009 substantially improved the Shari’ah governance framework for Islamic banks in Malaysia by creating a central Shari’ah governance body and thus unifying the Shari’ah pronouncements across the industry. BNM also issued a number of product-specific Shari’ah parameters aimed at harmonising Islamic banking market practices in Malaysia; one such parameter, on musharakah, was critically reviewed by Arshad and Abdul Ghafar (2010). In the similar context, Wilson (2009) discussed the merits of a centralised Shari’ah governance system – based on the Malaysian experience – versus its institutional relegation alternative. In summary, the importance of sound Shari’ah governance in Islamic banking institutions, has been duly recognised by the academia, the industry and research community. Though much progress has been made in Malaysia towards raising the standards of Shari’ah governance, there is much room for improvement. Conducting an independent Shari’ah audit is among the current challenges for the regulator and the Islamic banks, for it is in the interests of all stakeholders to amplify the trust of Islamic banking customers in the complete Shari’ah compliancy of their banks through enhanced Shari’ah governance review procedures and disclosure practices. Many other Shari’ah and corporate governance issues have also been extensively discussed but greater focus needs to be on practical solutions and definitive outcomes. In the long-term, more initiatives must be undertaken continuously to improve the quality and compliance of Islamic banking practices.

One of the most pertinent issues in Islamic banking is operational performance, especially the relative operational performance of Islamic banking institutions vis-à-vis their conventional counterparts, especially in countries like Malaysia with a dual-banking system. In the banking context, ‘performance’, ‘efficiency’, and ‘profitability’ are used interchangeably to denote various measures employed in assessing banking operations. One of the earliest performance studies documented in the area of Islamic banking in Malaysia by Ariff (1989) studied the performance of

Bank Islam Malaysia Berhad [BIMB] – Malaysia’s first Islamic bank – during the first six years of its operations. Highlighted were some of the bank’s achievements, such as the absolute increase in deposit accounts, the relative rise in investment deposit accounts, and the gradual growth in rates of return to the accountholders. Amongst the criticisms of the bank were its overwhelming dependence on BBA and ijarah in financing (at the expense of mudarabah- and musharakah-based equity financing) and its provision of uncompetitive return rates (in comparison to conventional banking institutions) to both groups of investment account holders and shareholders. BIMB appeared to be absolved of its shortcomings to some extent given its nascent development stage at that time but impelling efforts in intra-bank research activities were encouraged to fix the bank’s flaws. An analogous study on BIMB of Wong (1995) once again disclosed its overdependence on credit based financing. A similar study on BIMB – with a focus on its comparative banking efficiency in fund sourcing and utilisation by Samad (1999) – found that BIMB lacked in terms of managerial efficiency in comparison to conventional competitors but discovered mixed results in terms of productive efficiency. Samad and Hassan (2000) added that BIMB was relatively more liquid and less risky than most conventional banks in the country. The introduction of the Islamic Banking Scheme [IBS] in 1993 (that allowed existing conventional banks operate Islamic banking windows or subsidiaries) ended BIMB’s monopolistic existence in the Islamic banking industry in Malaysia. Studies on performance of BIMB alone will make not much contribution as it will not represent the overall industry performance. However, Rosly and Abu Bakar (2003) analysed the comparative performance of IBS banks (or banks that had Islamic windows) in the country and reported that they had a higher return on assets (explicated by their overheads being carried by their parent companies) but lower asset utilisation and investment margin ratios, implying that IBS banks, due to their heavy reliance on interest-like credit finance, could not possibly effectively compete in terms of efficiency with conventional banks that had a larger market size and greater maturity to their advantage. In contrast, Abdul Majid et al. (2003) asserted that there were no significant differences in efficiency scores between Islamic banks (IBS banks and fully-fledged

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Islamic banks taken together) and conventional banks. Batchelor and Wadud (2004) analysed IBS banks from the perspectives of technical and scale efficiencies, and reported that IBS banks under foreign conventional banks exhibited greater efficiency than those under domestic conventional banks. It was also suggested that overall IBS banks in Malaysia were more efficient than the two fully-fledged Islamic banks of that time. Financial liberation of the Islamic banking industry envisioned in the Financial Sector Master Plan 2001 entailed the granting of licences to qualified IBS banks to set up fully-fledged Islamic banks. Mokhtar et al. (2006) analysed this new competitive environment and showed that the average efficiency of Islamic banks increased over the years, while that of conventional banks remained stable but was still comparatively higher; it was also revealed that fully-fledged Islamic banks were more efficient than IBS banks, with domestic IBS banks, in turn, slightly less efficient than foreign Islamic windows. Contrary to the findings of Mokhtar et al. (2006), Sufian (2007) established that IBS banks were technically more efficient than fully-fledged Islamic banks. During the same time period, Sufian (2006) studied the efficiency characteristics of domestic Islamic banks versus foreign Islamic banks and related the latter’s relatively higher technical inefficiency and higher scale inefficiency in the former. From a perspective of efficiency, Kamaruddin et al. (2008) examined the cost and profit efficiencies of fully-fledged Islamic banks and the same of IBS banks and found that fully-fledged Islamic banks were comparatively more cost efficient (stemming from resource management), while IBS banks exhibited greater profit efficiency (due to economies of scale). Sufian (2010) researched the impact of foreign banks’ entry on incumbent Islamic banks in Malaysia and estimated that domestic Islamic banks were more profitable in the post-entry period, inferring from this a positive impact of foreign banks’ existence on the Islamic banking industry. Masruki et al. (2011) made a comparative performance analysis of BIMB and Bank Muamalat Malaysia Berhad [Bank Muamalat] with mainstream banks; they expectedly asserted that the mentioned Islamic banks were less profitable (due to lower net financing figures and lower asset quality) than sampled conventional banks. Ahmad and Abdul Rahmat (2012) revealed that conventional commercial banks outperformed Islamic

commercial banks in all efficiency measures due to greater managerial effectiveness and technological advancements in the former group. On the contrary, Yahya et al. (2012) showed no significant performance differences between the two segments of the banking sector. Ismail et al. (2013) suggested that conventional banking institutions in Malaysia were more technically efficient (that is, in their use of technology), while Islamic banking institutions were more advanced in terms of allocative efficiency (that is, in their use of resources). Wasiuzzaman and Gunasegavan (2013) compared Islamic and conventional banks based on a number of bankspecific variables and came up with contrasting results, with conventional banks being more profitable and Islamic banks – more operationally efficient and liquid. Sapuan et al. (2013) then extended the subject matter of bank-specific variables in an empirical study which established that bank profitability and bank-specific variables (including financial structure) shared a common long-term path. Finally, in the light of past and recent financial shocks, Kassim and Abdul Majid (2010) discovered that Islamic banking was as vulnerable to financial shocks as was conventional banking, despite the popular allegations of Islamic banking’s being relatively more resilient. In a related study, Abdul Karim et al. (2012) tested the impact of the subprime mortgage crisis (that led to the financial meltdown of 2008) on the performance of Islamic banks in Malaysia and concluded that Islamic financing, but not Islamic deposits, was susceptible to financial crises. In summary, the empirical literature on the performance of Islamic banks in Malaysia is ample and covers predominantly performance, efficiency, and profitability issues. Overall, this research focused on the inter-industry differences in performance between Islamic and conventional banks; the intra-industry differences in performance between fully-fledged Islamic banks and Islamic banking windows or subsidiaries; and the differences in performance between domestic and foreign Islamic banks. With few exceptions, the findings of most studies are consistent: conventional banks are more profitable given their market size and maturity; efficiency scores– in all test groups (that is, conventional and Islamic banks; fully-

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fledged Islamic banks and Islamic windows or subsidiaries; domestic and foreign Islamic banks) are rather inconclusive; and Islamic banks are as vulnerable to financial shocks as conventional banks.

The nature of banking business is such that, irrespective of being conventional or Islamic, it is inherently risky. Islamic banks, due to their peculiar foundational base, face a unique amalgam of risk challenges. The common risks Islamic banks encounter are market, credit, liquidity, and operational risks. Risks that may be considered exclusive to Islamic banking are Shari’ah non-compliance, fiduciary, and rate of return (including related displaced commercial) risks. The most consequential element of market risk for most Islamic banks is arguably the interest rate risk, notwithstanding the imperative interest free nature of Islamic banking. The interest rate risk in the Islamic banking context translates into the rate of return risk for Islamic banking institutions. Haron and Ahmad (2000) maintained that Islamic banks, in their setting of profit rates for investment account holders, were strongly influenced by the level of interest rates used by conventional banks for investments of equivalent risk profiles. A similar finding was disclosed by Kaleem and Isa (2005) who suggested that deposit rates offered by conventional banks could be used as predictors of deposit returns in Islamic banks. On the same issue but with a comparative twist, Rosly and Zaini (2008) studied the differences in yields between deposits or investment accounts and capital in conventional and Islamic banks. They discovered that, while in conventional banks the variance in yields was adequate, in Islamic banks it was significantly smaller and hence did not reflect their risk properties. A related perspective was brought in by Bacha (2008) that shows the profit rates prevalent in Malaysia’s Islamic Interbank Money Market [IIMM] were highly correlated with conventional money market rates, which lead the author to conclude that the IIMM, due to its being operated in a dual-banking environment, could not possibly sterilise itself from the interest rate risk. To that end, Abdul Kader and Leong (2009) and Zainol and Kassim (2010) confirmed that inevitably, on account of the rate of return risk,

Islamic banks were threatened by the distressing magnitude of displaced commercial risk, which, in turn, put their capital base and their solvency in jeopardy. On the topic of insolvency, Abdul Rahman et al. (2009) noted that real estate lending reduced the insolvency risk exposure of Islamic banks and increased the same for conventional banks; therefore, the authors advised that appropriate amendments in capital adequacy regulations should be made to alleviate the disproportionate stress put on Islamic banks. Another element of market risk is foreign exchange risk. One of the tools currently utilised for its management is the Islamic FX Swap with the necessary Shari’ah parameters (Dusuki, 2009). Kunhibava (2009) provides a summary of the various Islamic derivatives that are available for risk management. For research on credit risk, Bacha (1996) reasoned that mudarabah was unpopular in trade financing because of the excessive agency costs involved, depicted in the framework of the signalling theory and the control hypothesis in corporate finance. Ahmad and Ahmad’s (2004) exploratory study found that for Islamic banks major risk determinants were managerial efficiency and amount of risk weighted assets, while for conventional banks they were loan exposure and loan loss provision. It was thus recommended that a specialised approach in managing credit risk in Islamic banks should be promoted by regulators and adopted by risk managers in Islamic banks. The issue of conflicts of interests in Islamic banks in the present system of prudential standards was highlighted by Musa (2010). In an associated study on Islamic financing by Zakaria and Ismail (2008), it was established that Islamic banks’ increased involvement in securitisation activities resulted in a fall in their financing activities but an overall riskier portfolio composition, implying the need for stricter regulatory control of securitisation practices. Most Islamic financial contracts contain a myriad of various risks, posing a special challenge to risk managers at Islamic banks. Muneeza et al. (2011) theorised that salam was the most risk susceptible contract, thus explaining its non-utilisation in Islamic financing. However, they held salam to be a viable financing alternative and therefore proposed a new model of salam financing for agrarian ventures.

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With regard to operational risk, Abdullah et al. (2011) noted that conventional risk measurement and risk management practices needed substantial adaptation to suit the specific characteristics of financing and investment activities in Islamic banks. Therefore, the authors contended the applicability of the Basel II methodology for Islamic banks. In the same area of interest, Abdul Rasid et al. (2011) reported that a typical Islamic bank in Malaysia (unlike most conventional banks) would normally develop and adopt an integrated enterprise system which boded well for the bank’s operational efficiency. Ariffin (2012) estimated that the average exposure of Islamic banks to liquidity risk was stable and below that of comparable conventional banks; it was also affirmed that the extent of liquidity risk had a positive correlation with financial performance. These findings were earlier validated by How et al. (2005) who noticed that Islamic commercial banks had significantly lower liquidity risk that their conventional counterparts. To establish an effective Islamic liquidity management system, Ibrahim and Mokhtar (2012) advocated regulatory efforts in building linkages among Islamic financial markets, developing joint funds, strengthening information sharing and human talent management, as well as creating a relevant private-sector-driven association. On a currently pertinent liquidity-related issue – the adoption of Basel III regulations – Dongcheol (2012) warned against the implementation of the new liquidity rules in their original form without the incorporation of Islamic banking specific features. In summary, the studies conducted on various risk related topics in Islamic banking in Malaysia are of reasonable rigour and standard; most of the pertinent issues have been addressed, and for each risk exposure the mitigating solutions have been offered. The unique risks faced by Islamic banking institutions have been readily recognised and widely studied. The main existent issues of concern that have been identified by researchers include the lack of harmonised regulatory standards, the absence of suitable risk methodologies, the dearth of allowable risk mitigation techniques, and the insufficient risk disclosure levels.

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Trends This section identifies trends in the surveyed literature (Table 10.1). The trend issues are classified into several research areas; their coverage is evaluated on a subjective scale and graded as either one of the following: ‘Exorbitant’ (implying excessive focus with more than 10 more journals on the topic), ‘Adequate’ (implying ample focus with five to 10 journals on the topic), ‘Average’ (implying satisfactory focus with three to five journals on the topic), or ‘Poor’ (implying insufficient focus with fewer than three journals on the research areas). Table 10.1 Trends in the surveyed Islamic banking literature. Area

Governance

Primary issues

Topics covered

Coverage assessment Average

Shari’ah governance model

Centralised versus decentralised models, Central Bank of Malaysia Act 2009

Shari’ah audit

Framework, independence, qualified experts

Average

Shari’ah compliance of products

Financing and deposit products

Adequate

Maqasid al Shari’ah

Strategic alignment with Average Maqasid al Shari’ah

Corporate governance

From an Islamic perspective

Average

Disclosure and transparency

Information asymmetry, corporate governance statement disclosure, Shari’ah review disclosure

Average

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Table 10.1 cont’d Efficiency

Profit, cost, technical, and scale efficiencies

Adequate

Profitability

In the absence of or Adequate during financial crises or shocks

Performance Performance determinants

Bank-specific variables

Average

Comparative performance

Islamic versus conventional banks; domestic Islamic versus foreign Islamic banks

Exorbitant

Regulation

Basel II, Basel III, prudential requirements, supervision

Average

Credit risk and management

Factors of influence, comparative analysis between Islamic and conventional banks

Adequate

Market risk and management

Exposures, rate of return Adequate risk, interest rate and displaced commercial risks

Liquidity risk and management

Government Funding Act Average 1983, IIMM

Operational risk and management

Management accounting Poor systems, Basel III

Islamic hedging instruments

Shari’ah compliancy, product innovation

Average

Judicial jurisdiction

Shari’ah versus civil

Average

Risk management

It is evident from the above classification summary that the research focus has been skewed in favor of some areas compared to others: as such issues on Shari’ah governance, performance, and marketing have been 166

given much more attention to than those on product innovation and risk management. Governance themed papers made up 30% of the reviewed literature, followed by performance at 24%, marketing (23%), risk management (17%), and finally papers on economic growth and policy transmission represented just 6% of all studies. It has been learned that the surveyed literature consisting of 114 published papers was written by a total of 171 authors, among whom 136 authored just one paper each, 28 penned two to three studies, and only seven academics are attributed four to six publications. These results show that only a relatively small number of academics are actively engaged in quality Islamic banking research. However, this situation is expected to change for the better in view of government’s initiatives on knowledge based economic transformation. Naturally, a number of common parallels run through the research activities in both conventional and Islamic finance, due to their belonging to the shared orbit of finance. In the aftermath of the global financial downturn, these common features relate to, first and foremost, the encouragement of prudential aptitude balanced with the pursuit of commercial viability. A call regularly voiced out through research on this topic is that for regulatory (and supervisory) accommodation of current challenges without harming the profitability and the growth prospects of individual financial institutions. Albeit the similarities, research in conventional finance reflects the maturity of its subject matter and is hence free from many perennial issues highlighted in Islamic financial research. One such issue is the standardisation and harmonisation of rules and regulations (including those on the interpretive Shari’ah law and on accounting) across Islamic financial institutions inside and outside of national borders. Also frequently featured are the human talent shortcomings in Islamic banking and finance and the specificities of risk management practices in this area. In contrast, topical themes in conventional financial research are corporate governance (with the increased accent on self-regulation), technological and product innovation, competition, and prudential regulation.

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Possible research directions


To yield practical benefits, this analysis of published literature on Islamic banking in Malaysia has been benchmarked against the relevant parts of BNM’s second 10-year Financial Sector Blueprint which is designed to reinforce the government’s initiatives to achieve a fully-developed nation’s status by 2020. Additionally, the applicable sections of the Financial Services NKEA – one of the 12 identified drivers of growth and economic activity under the ETP – are also considered. The nine focus areas of the Blueprint are (PwC, 2012): effective intermediation for a high value-added and high-income economy; deep and dynamic financial markets; financial inclusion for greater shared prosperity; regional and international financial integration; internationalisation of Islamic finance; regulatory and supervisory regime to safeguard the stability of the financial system; electronic payments for greater economic efficiency; consumer empowerment; and talent development to support a more dynamic financial sector. The 10 Entry Point Projects [EPPs] – or the high impact projects involving specific action plans – of the NKEA are (ETP, 2011): revitalising capital markets; transforming development finance institutions; creating an integrated payment ecosystem; insuring most of the population; accelerating the growth of the private pension industry; and spurring the growth of the nascent wealth and asset management industries. The first focus area for research is the moulding of a more seamless legislative and regulatory environment. This will provide a stable environment for Islamic banking institutions to grow, unhampered by unjustified legislative or regulatory constraints but instead supported by flexible effective regulation and supervision, and market transparency. Indeed, country experiences show that accommodative legislation and regulatory clarity are key to accelerating growth and increasing market share in Islamic banking. Among regulators’ and legislators’ plans is the reinforcement of the populace’s financial inclusion and literacy, and the consumer protection framework. Research in this area could propose further amendments to the current Islamic banking legislation, introduce new Islamic banking regulation

and better supervisory methods (in particular, through cross-border coordination with regional regulators for local banking institutions already operating or aspiring to set up business abroad), ways of improving corporate governance standards in Islamic banking institutions to achieve greater market transparency and disclosure, and also modes of educating the populace. The second focus area for research concerns the strengthening of the industry’s core business activities. The top priority of the government and the regulators is to ensure that Islamic banking and other financial institutions achieve and maintain competitive vibrancy and efficiency. This relates to the issues of economics of scale and economics of scope of commercial banking in Malaysia. A crucial aspect concerning the industry depth is in enhancing liquidity in the markets (including the global Islamic liquidity management). Alongside this objective goes the strategy for active development of innovative products and services (especially if equity- or hybrid-based), together with the evolvement of permissible risk management tools and technological operative advancements (such as e-payment and e-banking gateways). This research could develop new Islamic banking products as well as novel ways of Shari’ah compliant risk hedging. In risk management, a significant area of study may be related to the imperative modification for Islamic banking institutions based on the Basel III requirements that are planned for the period between 2013 and 2019; in like manner, managing new risk challenges stemming from greater regionalisation and internationalisation of Malaysian Islamic banks will also be pertinent. Creative recommendations on liquidity management and on Islamic banking e-systems (for example, on BNM-endorsed topics such as ASEAN-wide ATM networks, expanded use of the Internet and mobile banking, and IT security reinforcement) would be a value-added to research in this area. The third focus area for research is the fostering of regional Islamic bank champions. A major theme of BNM’s and SC’s blueprints is the regional and international expansion of home-grown Islamic banks, in a meaningful and prudent manner, by taking advantage of the ever accelerating global economic integration (with focus on mainly ASEAN,

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Greater China and South Asia). This will allow for much needed broadening of Malaysia’s Islamic banking industry (that is currently highly dependent on domestic resources) and consequently will also help manage risk through international diversification. Malaysia’s global share of Islamic banking assets is expected to increase from 8% in 2009 to 13% in 2020; also, at least one Islamic banking institution (hoped to become Malaysia’s first mega-Islamic bank) is forecasted to reach the global top 10 by asset size by 2020. This research may relate to competitive strategies that could inspire local Islamic banks to go global. Due to the currently negative international perception of Islamic banks (because of their originating from emerging economies and their being Islamic organisations), this has to be done strategically under the guise of socially responsible or ethical banking. Of special highlight is the search for niche or specialist capabilities by new foreign or existing local banking institutions. The fourth focus area for research concerns the codification and standardisation of Shari’ah guidelines. This is part of BNM’s ongoing issuing process of Shari’ah parameters for standard documents. The goal of this process to achieve uniform understanding of Shari’ah principles, which will ensure consistent interpretation of Shari’ah contracts and enable more consistent product development and therefore globally acceptable Islamic banking products and services that will also contribute to the liquidity and depth of this industry. The research could be on the mechanisms of implementing the mentioned standardisation, since coordinating the interests of multiple parties (such as those of different Islamic schools of jurisprudence) has invariably been a delicate act of financial diplomacy. Strategic initiatives could include the promotion of cross-border regulation and supervision, of greater financial integration through international liquidity management (via the International Islamic Liquidity Management [IILM], among others) and risk management schemes, and of mutual research interdependence. The fifth focus area for research could be the promotion of global convergence and mutual recognition of Islamic banking standards. This is central to unleashing the full potential of Islamic banking and finance on a global scale. Such convergence and recognition of standards can be

facilitated through the governments’ supporting of international standardsetting bodies, such as the Islamic Financial Services Board [IFSB], the Accounting and Auditing Organization for Islamic Financial Institutions [AAOIFI], the International Islamic Financial Market [IIFM], etc. These agencies have existed for some time now but no real efforts have been forthcoming to promote the global convergence of Islamic banking standards. The research could devise strategies aimed at enhancing international cooperation within the banking fraternity that would require creation of transnational agencies acceptable to all stakeholders. Studying the various available options in amplifying the significance of multilateral standard-setting organisations in Islamic banking and finance and advising policymakers in their harmonisation endeavours (through enhancing financial linkages between different jurisdictions, for instance) would be commendable. The sixth focus area for research is the motive to be the reference centre for Islamic banking and finance research, development and education. The government’s role in further promoting Malaysia as the international hub of intellectual excellence in Islamic banking and finance is set to continue. The priority areas are legislation (specifically considered matters include the re-engineering of the KL Regional Arbitration Centre into a global arbitration centre with specific expertise in Islamic banking and finance, and the expansion of the legal framework to accommodate more innovative Islamic products); human capital (specifically considered matters include the creation of globally recognised accreditation and certification programmes, the increase in scholarship and research grants, and the grooming of talent pool well-grounded in both finance and the Shari’ah that is currently the responsibility of the International Centre for Education in Islamic Finance [INCEIF], a university of Islamic finance set up by BNM); research, development and innovation (by leveraging on research and innovation capabilities of institutions such as ISRA among others). The research could be on initiating practical propositions for the mentioned issues, with the ambition of promoting the Malaysian Islamic banking industry as the benchmark for best global practices in Islamic

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banking in terms of legislation, regulation, governance, education, and research. In the area of human capital, as an illustration, it would be interesting to assess the consequences of impending talent shortages and to suggest strategies for Islamic banks and regulators for the management of the issue. The seventh focus area for research could be the developing of new integrated growth sectors. This encompasses the closer integration of Islamic banking with other Islamic financial sectors such as Islamic money and capital markets, takaful (including retakaful), waqf (or trust) and Islamic fund (asset and wealth) management, through mutual cooperation within the liquidity framework and joint product and service offerings (such as bancatakaful and mortgage securitisation transactions) to retail and corporate customers. The research could recommend exactly how Islamic banking institutions can leverage on the development of other sectors in Islamic banking and finance in a mutually beneficial way. This could be done by identifying niche complementary areas in the various Islamic financial sectors and initiating the most potent ones for Islamic banking and devising collaborative policies and individual bank strategies accordingly.

CONCLUSION Seven focus areas of Islamic banking in Malaysia – ranging from core strengthening and international expansionary activities to advancement of educational and knowledge bases – have been highlighted with details of research needs for each area. This guide to future research is in consonance with the commitment to develop the industry and promote Malaysia’s reputation as the global hub for Islamic banking and finance. The crux of research suggestions relates to a call for greater practicality in research exercises and greater innovation in the industry. An important consideration should also be given to active championing of the social and ethical identity of Islamic banking in addition to naturally sought betterment of its operational mechanisms.

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The Editors Siti Zaidah Turmin is a senior lecturer at the Department of Accounting and Finance, Faculty of Economics and Management, Universiti Putra Malaysia. She obtained PhD in Accounting from the International Islamic University Malaysia in 2013. She earned Master of Accounting and Bachelor of Accounting from Universiti Kebangsaan Malaysia. Her research concern is in the area of Corporate Internet Reporting and Financial Reporting, but she always giving her the space to learn and get involved in other research areas. Currently, she teaches undergraduate courses in financial accounting and management accounting. Mohammad Noor Hisham Osman is a lecturer in Accounting at Faculty of Economics and Management, University Putra Malaysia. He has been a member of Accounting and Finance Department since 1999. At the present time, he teaches Financial Accounting and Management Accounting courses for non-accounting students. His research interest is on audit quality with focus on Going Concern Opinion, and he always open his heart to new and interesting areas for future research endeavor. Zulkarnain Muhamad Sori is a Professor in the School of Graduate Studies at the International Centre for Islamic Finance (INCEIF), the Global University of Islamic Finance, Malaysia. He is an accountant with consulting, research and teaching experiences in accounting, corporate governance, Shariah governance, accounting for Islamic financial transactions, auditing and entrepreneurship. He received his Bachelor of Accounting and MSc. (Accounting/Finance) from University Putra Malaysia, and Ph.D. in Auditing & Corporate Governance from Cardiff University, United Kingdom. He has actively published in academic and professional journals, supervised doctoral theses, and edited and published many books. Prior to joining INCEIF, he was a Professor, Senate Member and the Deputy Dean of the Malaysian Graduate School of Entrepreneurship & Business, University Malaysia Kelantan (UMK) and the Head of the Department of Accounting and Finance, the College


Principal and the Internal Auditor of UPM Cooperative Berhad at University Putra Malaysia. He is a member of the Malaysian National Professor Council Inc. and a Chartered Accountant registered with the Malaysian Institute of Accountants. He is actively participated in the industry, where he was appointed by the Minister of Finance as a Council Member of the Malaysian Institute of Accountants for 2 terms (20082010/2010-2012). He also had served on various working committees of Malaysian regulatory and professional bodies. Currently, he is the advisor for Bachelor of Accounting and Diploma in Accounting programs at UNISEL (2 Terms). He has examined more than 30 doctoral and master theses at various public and private higher learning institutions and universities in Malaysia and abroad. Ahmed Razman Abdul Latiff is a Director of Non-Thesis Program (MBA & MM) and also in charge of Entrepreneurship in the Putra Business School. He holds a Bachelor Degree of Accounting and Finance (Honours) from Lancaster University, United Kingdom, a Master Degree of Accounting from Nanyang Technological University, Singapore and a Master Research Degree in Accounting and Financial Management from Lancaster University, United Kingdom. He also holds a PhD in Corporate Governance from Liverpool John Moores University, United Kingdom. He has presented and published numerous papers at various conferences and journals. He is one of the editorial board of Asian Journal of Case Research and he is also the Vice President of Case Writers’ Association of Malaysia. His current areas of research interest include entrepreneurship, innovation, corporate governance, ethics and human governance. He is also an IP Evaluation Panel for UPM, which involves in identifying the potential commercialization of UPM inventions. He is currently in the board of directors of a startup specializing in technological products in healthcare.

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