2-DAY COURSE ON ISLAMIC BANKING AND CAPITAL MARKET: PRODUCTS

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2-DAY COURSE ON ISLAMIC BANKING AND CAPITAL
MARKET PRODUCTS INSTRUMENTS22 -23 MAY 2007

• Accounting, Auditing and Governance
• for Islamic Financial Services

Dr. Syed Musa Alhabshi Principal Consultant
Amanie Business Solutions Sdn Bhd
Suite A-D, 14th Floor, Bangunan Angkasa
Raya Jalan Ampang, 50450 Kuala Lumpur Tel  603
2034 2545 Fax [phone] http//www.amanie.co
m.my
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Presentation Outline

• Nature of Islamic Financial Institution (IFI)
• Financial Reporting Framework for IFI
• Nature and Reporting Process of IFI
• Shariah Governance Auditing of IFI
• Governance for IFI
• Accounting and auditing standards for Islamic
  financial institutions (AAOIFI, MASB, IFSB etc.)
• Risk management
• Shariah review and audit
• Issues and challenges

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FINANCIAL REPORTING FRAMEWORK
USER GROUPS
SHARIAH PRINCIPLES
ISLAMIC FINANCIAL INSTITUTION
FINANCIAL REPORTING OBJECTIVES
ACCOUNTING PRINCIPLES
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The Need for Specific Accounting Standards in
Islamic Banking

• The fast development of Islamic banking demands
  for effective financial reporting framework and
  information disclosures useful for investors and
  stakeholders.
• Existing financial reporting standards for
  conventional financial institutions are not
  adequate to address the information needs of
  IIIFS.
• Nature of Islamic banking emphasizes importance
  of lawful and equitable banking business and
  financial activities - accounting treatments
  that capture unique features of IIFS activities
  are required

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Establishment of AAOIFI

• The Accounting and Auditing Organization for
  Islamic Financial Institutions (hereinafter
  referred to as AAOIFI) is an Islamic
  international autonomous non-profit making
  corporate body that prepares accounting,
  auditing, governance, ethics and Shari'a
  standards for Islamic financial institutions.
• AAOIFI was established in accordance with the
  Agreement of Association which was signed by
  Islamic financial institutions on 1 Safar, 1410H
  corresponding to 26 February, 1990 in Algiers.
  AAOIFI was registered on 11 Ramadan 1411
  corresponding to 27 March, 1991 in the State of
  Bahrain.

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AAOIFIs Objectives Role

• Develop accounting, auditing, governance and
  ethical thought relating to the activities of
  Islamic financial institutions taking into
  consideration the international standards and
  practices which comply with Islamic Shari'a
  rules.
• Disseminate the accounting, auditing, governance
  and ethical thoughts relating to the activities
  of Islamic financial institutions and its
  application through training seminars,
  publication of periodical newsletters,
  preparation of reports, research and through
  other means.
• Harmonize the accounting policies and procedures
  adopted by Islamic financial institutions through
  the preparation and issuance of accounting
  standards and the interpretations of the same to
  the said institutions.
• Improve the quality and uniformity of auditing
  and governance practices relating to Islamic
  financial institutions through the preparation
  and issuance of auditing and governance standards
  and the interpretation of the same to the said
  institutions.
• Promote good ethical practices relating to
  Islamic financial institutions through the
  preparation and issuance of

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Standard Setting Aproaches

• AAOIFI adopts the standard setting due process by
  reviewing existing Islamic banking reporting
  practices followed by formulation of discussion
  paper, exposure draft and reporting standard.
• Existing IAS standards are referred to where
  these are deemed relevant and not contravening
  the Shariah Principle.

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Accounting Standards

1. General Presentation and Disclosure in the
   Financial Statements of Islamic Banks and
   Financial Institutions
2. Murabaha and Murabaha to the Purchase Orderer
3. Mudaraba Financing
4. Musharaka Financing
5. Disclosure of Bases for Profit Allocation between
   Owners' Equity and Investment Account Holders and
   Their Equivalent
6. Salam and Parallel Salam
7. Ijarah and Ijarah Muntahia Bittamleek
8. Istisna'a and Parallel Istisna'a
9. Zakah
10. Provisions and Reserves
11. General Presentation and Disclosure in Financial
    Statements of Islamic Insurance Companies

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Accounting Standards

• Disclosure of Bases for Determining and
  Allocationg Surplus or Deficit in Islamic
  Insurance Companies
• Investment Funds
• Provisions and Reserves in Islamic Insurance
  Companies
• Foreign Currency Transactions and Foreign
  Operations
• Investments
• Islamic Financial Services offered by
  Conventional Financial Institutions
• Contributions in Islamic Insurance Companies
  (New)
• Deferred Payment Sale
• Disclosure on Transfer of Assets (New)
• Segment Reporting  (New)

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Auditing Standards

1. Objective and Principles of Auditing
2. The Auditor's Report
3. Terms of Audit Engagement
4. Testing by an External Auditor for Compliance
   with Shari'a Rules and Principles by an External
   Auditor
5. The Auditor's Responsibility to Consider Fraud
   and Error in an Audit to Financial Statements
   (New)

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Governance Standards Code of Ethics

• Governance Standards
• Shari'a Supervisory Board Appointment,
  Composition and Report
• Shari'a Review
• Internal Shari'a Review
• Audit and Governance Committee for Islamic
  Financial Institutions
• Ethics
• Code of Ethics for Accounting and Auditors of
  Islamic Financial Institutions
• Code of Ethics for the Employees of Islamic
  Financial Institutions

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Nature of Financial Reporting

• Financial Accounting Statements No. 1 2
• Objective of Financial Accounting of Islamic
  Banks and Financial Institutions
• Emphasizes the importance of contractual rights
  and obligations and Shariah compliance
• Concepts of Financial Accounting for Islamic
  Banks and Financial Institutions
• Addresses the issue of prohibited earnings
  expenditures as well as ensuring reasonable rates
  of returns to depositors

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Financial Reporting Objectives

• Shariah compliance (principles, rules and
  opinions)
• Distinguish disclose prohibited earnings
  expenditures
• Present entitys economic resources and
  obligations and related risks pertaining to its
  assets and liabilities

• Determine Zakat obligations of both depositors
  and shareholders
• Estimate cash flows related risk of banks
  financing assets
• Ensuring reasonable rates of returns to investors
• Disclose IBs discharge of social
  responsibilities.

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Distinguishing Features of IFIs Financial
Accounting Reporting Objectives

• Compliance with the principles and rules of
  Sharia Islamiyyah need to disclosed in terms of
  reporting accountability and decision usefulness
• Different contractual relationships require
  reporting requirements for both equity and asset
  based funding and financing contracts which are
• recognition principles
• measurement principles
• disclosure presentation principles

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Role of Financial Reporting Accounting
Information
FINANCIAL REPORTS
Economic Decision Usefulness
Reporting Accountability
Relevance
Reliability
Economic Agent Economic Consequences
Stewardship function Representational Faithfulness
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Characteristics of Useful Information

• Economic Decision Usefulness
• Relevant (Timely, Feedback, Predictive)
• Reliable (verifiable, faithful representation,
  neutral)
• Cost and Benefit
• Comprehensiveness
• Wealth maximization
• Safety, Liquidity Profitability of IFI

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Information for Decision Making

• Legitimate Decision
• Lawful Transactions
• fulfilling contractual conditions and
  requirements
• Lawful goods Services
• nature, type and purpose of goods and services
• Competitive price fair value
• market mechanism and market structures
• Equitable Distribution
• reasonable rates of returns to shareholders and
  depositors

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User Groups of Accounting Information

• Investors (potential existing) Lawful
  Equitable Investments
• Includes Shareholders and Depositors with
  different investment horizons
• Investors are not only concerned with profits but
  also its lawfulness, legality and equity
• Creditors (potential existing) Lawful Trade
  Assets
• Creditors exclude debt holders and confined to
  asset backed or trade assets.
• Not only concerned with default risk but also
  validity of contract and lawfulness of the asset.

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User Groups of Accounting Information

• Regulators
• Legislation to be enforced should make reference
  to the Shariah compliance
• Shariah Supervisory Boards Advisory Council
• Governance extends beyond audit committee to the
  Shariah governance
• Customers Lawful Goods Services
• Customers are concerned about lawful products
  facilities
• Others
• Any party that directly or indirectly make
  reference to the financial statement of IFI

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Impact of Shariah Contractual Conditions of
Transactions on Reporting Process
Shariah Conditions Reporting Process Impact
Existence Recognition Valid contracts
Lawful Recognition Lawful Activities
Performance Measurement Provision for uncertainty
Deliverable Recognition Provision for uncertainty
Equitable Distribution Reasonable rates of return
Accountable Presentation/ Disclosure True and fair view
Distinguishing contractual relationships render a
distinct reporting process to address the lacunae
of entity-based reporting
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Types of Financial Statements

• Balance Sheet
• Income Statement
• Statement of Owners Equity
• Cash Flow Statement
• Statement of Restricted Investments
• Statement of Sources Uses of Zakah
• Statement of Sources Uses of Qard Fund

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Elements of Financial Statements

• BALANCE SHEET
• Assets
• Fixed Assets
• Intangible Assets
• Investments
• Financing
• Liabilities
• Investment Deposits
• Equities

• INCOME STATEMENT
• Gross Income
• Distribution to Depositors
• Net Jointly Financed Income
• Fee based Income
• Expenses
• Net Income

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Shariah Governance By Whom? For Whom?
REGULATORS SC BNM SUPERVISION SHARIAH
ADVISORY COUNCILS
INVESTMENT ACCOUNT HODERS SHAREHOLDERS
IFI SHARIAH SUPERVISORY BOARD SHARIAH COMMITEE
EXTERNAL AUDITORS
BOARD OF DIRECTORS AUDIT GOVERNANCE COMMITEE
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Nature of Sharia Supervisory Board

• An independent body of specialised jurists in
  fiqh al muamalat (Islamic Commercial
  Jurisprudence), that is entrusted with the duty
  of directing, reviewing and supervising the
  activities of the Islamic Financial Institution
  in order to ensure that they are in compliance
  with Islamic Sharia Rules and Principles.
• Types of Sharia Supervision or Advisory?
• Sharia Product consultants (Advisory capacity)
• Sharia Supervisory Board/Shariah committee of
  Islamic bank (Constitutional Authority
  Advisory)
• Sharia Advisory Council of Bank Negara Malaysia
  and Securities Commission (Statutory Advisory

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Nature of Sharia Supervisory Board

• Scope of Supervision
• product and system development
• financial reporting and Sharia opinion
• Approval of Sharia financial services and
  products
• Approval of listed securities and investment
  funds.

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Duties Responsibilities of Shariah Committee

1. Advise BOD on business operations to be Shariah
   compliant
2. Endorse Shariah Compliance Manual
3. Endorse Validate pertinent documents
4. Assist related parties (such as auditors, legal
   counsel, consultants) that seek advice on Shariah
   Matters
5. Advise IFI to seek clarification or endorsement
   of unresolved or endorsed by SAC
6. Provide written Shariah Opinion
7. Assist SAC on reference for advice
8. Shall report to the BOD (act as independent body
   of IFI)

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Shariah Compliance Behavior
Levels Activity Assurance For Whom
Product Endorsement Lawful, Valid, Equitable Counter Party Interest
Transaction Endorsement Lawful Valid Counter Party Interest
System ICS Review Effective Reliable Management BOD
Entity Policy, Governance Opinion Lawful, Valid, Reliable Equitable Investors (Shareholders IAH) Stakeholders
National Policy Policy, Governance Regulation Sound, Stable, Sustainable International Acceptance Investors ( Shareholders IAH), Stakeholders Public Interest
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Shari'ah Review Internal Sharia Review

• Sharia review is an examination (by SSB) of the
  extent of an institution (IFIs) compliance, in
  all its activities, with the Sharia.
• Internal Sharia review shall be carried out by
  an independent division/department or part of the
  internal audit department, depending on the size
  of an institution (IFI). It shall be established
  within the institution to examine and evaluate
  the extent of compliance with Islamic Sharia
  rules and principles, fatwas and guidelines, and
  instructions issued by the Institution (IFI)
  Shariah Supervisory Board.

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Internal Sharia Review

• It forms an integral part of the organs of
  governance of the Institution (IFI) and operates
  under the policies established by the Institution
  (IFI).
• Reviewers should not have any executive authority
  or responsibility for the activities they review

• Integral Elements
• Independence Objectivity (organizational
  status, independent attitude tasks assigned)
• Direct and continuous communication to all
  parties with unlimited access to required
  documents.
• Professional Proficiency (including knowledge
  skills and training in Fiqh al Muamalat)
• Due professional Care

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Scope Role of Internal Sharia Reviewer

• Scope To examine and evaluate the adequacy and
  effectiveness of the institution system of
  internal Sharia control and the quality of
  performance in carrying out assigned
  responsibilities.
• Purpose To ascertain whether the system provides
  reasonable assurance that objectives set out are
  complied in an effective and efficient manner.
• Internal Sharia Review Work involves planning
  (include establishing shariah review
  objectives, obtaining and making reference to
  fatwas, guidelines, Sharia review results,
  writing internal Shariah review programs,
  communicating the procedures as well as results
  to parties concerns)

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Auditor SSB Relationship

• Auditor complements SSB of Islamic banks
• ASIFI No. 1 is to enable the auditor to express
  an opinion as to whether the financial statements
  are prepared, in all material aspects, in
  accordance with Shari'ah Rules Principles,
  AAOIFI International accounting standards

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Audit Report Sharia Opinion

• Independent samples and tests conducted by both
  auditor and SSB
• Audit opinion
• the financial statements as a whole are free from
  material misstatement based on accumulated audit
  evidence, refers to the whole audit process and
  comply with Islamic Shari'a Rules and Principles

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Audit Report Sharia Opinion

• Sharia Opinion will be on matters pertaining to
• contracts, transactions and dealings
• equitable allocation of profit losses
• earnings (lawful/prohibited)
• Zakah

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Audit Governance Committee

• AGC is to assist in achieving institutions
  objectives by enhancing greater transparency and
  disclosure as well as public confidence on
  institutions application of Sharia rules and
  principles.
• Comprise of non-executive directors with sound
  understanding of the business and Sharia
  supervision

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Audit Governance CommitteeRole Functions

• Preserving integrity of financial reporting
  process
• Safeguarding interests of investors and
  stakeholders
• Assurance on financial information reliability
• Link between management and stakeholders

• Review of internal controls
• Review of Accounting practices and audit plan
• Review of interim and annual accounts and
  financial reports
• Review of compliance with Sharia rules and
  principles

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Reporting Communication Channels
Audit Governance Committee
Express Shariah Opinion on IFI
True Fair Opinion
Shariah Board/Shariah Committee
Internal Audit
External Auditor
Formulate Policy
Shariah Endorsement
ATTEST
INTERNAL CONTROL SYSTEM
Shariah Review
Islamic Financial Institution
Testing for Shariah Compliance
Internal Shariah Review
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Islamic Financial Services Board (IFSB)

• The Islamic Financial Services Board (IFSB) ,
  based in Kuala Lumpur, inaugurated on 3rd
  November 2002 and commenced on 10th March 2003
• It serves as an international-standard setting
  body of regulatory and supervisory agencies that
  have vested interest in ensuring the soundness
  and stability of the Islamic financial services
  industry (banking, capital market and insurance).

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IFSB Purpose Role

• IFSB promotes the development of a prudent and
  transparent Islamic financial services industry
  through introducing new, or adapting existing
  international standards consistent with Islamic
  Shari'ah principles, and recommend them for
  adoption.
• IFSB complements that of the Basel Committee on
  Banking Supervision, International Organization
  of Securities Commissions and the International
  Association of Insurance Supervisors

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IFSB STANDARD, GUIDELINES PRINCIPLES
GUIDING PRINCIPLES ON CORPORATE GOVERNANCE
GUIDING PRINCIPLES OF RISK MANAGEMENT
DISCLOSURE PRINCIPLES TO PROMOTE TRANSPARENCY
MARKET DISCIPLINE
INSTITUTIONS OFFERING ISLAMIC FINANCIAL SERVICES
(IFSI)
CAPITAL ADEQUACY STANDARDS
GUIDANCE ON KEY ELEMENTS SUPERVISORY REVIEW
PROCESS
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IFSB Standards

• Guiding Principles on Risk Management
• Capital Adequacy Standard
• Guiding Principles on Corporate Governance
• Disclosure Principles to Promote Transparency and
  Market Discipline
• Guidance on Key Elements Supervisory Review
  Process

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Unique Risks of Islamic Financial Institutions

• Rate of return risk relates to market factors
  affecting rate of return on assets in comparison
  with rate of return for investment account
  holders
• Displaced commercial risk relates to market
  factors affecting rate of return on assets in
  comparison with rate of return for Shareholders
• Equity investment risk relates to risk
  characteristics of equity investments in the form
  of Mudaraba and Musharaka (including
  transformation of risks at various stages of
  investment life cycle)
• Operational risk in the form of fiduciary risk
  that relates to Shariah non-compliance

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Anatomy of Asset Risk Exposures
Financing Type Contract Type Risk Exposure
Sales type Murabaha Bai Muajjal Credit Risk
Sales type Salam Istisnaa Non-delivery Credit Risk
Equity Mudaraba Musharaka Credit/Market risk Equity investment Risk
Leasing Ijarah Ijarah Muntahia Biltamleek Market risk Credit risk
Financing or Investment?
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Income Distribution to PER, IRR, SHF IAH
Income Attributable to IAH
Income distributed to Shareholders Investment
Account Holders Based on PSR
Less Transfer of Profits to IAH PER
Less Transfer of Profits to SHF PER
Income Distributable to IAH
Income Attributable to SHF Other Deposit funds
Less Transfer of Profits to IAH IRR
Return on Unrestricted IAH
Return on Equity
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ANATOMY OF FUNDING RISK EXPOSURES
Source of Funds Risk Exposures Guarantee/ Reserves
Deposits Liquidity risk Deposit Guarantee
Unrestricted Investment accounts Liquidity risk Rate of return risk ROA vis-à-vis ROUIAH Profit Equalization Reserve Investment Risk Reserve
Shareholders Funds Displaced Commercial Risk Solvency Risk ROA vis-à-vis ROE Profit Equalization Reserve
Restricted Investment Accounts Rate of return risk Profit Equalization Reserve Investment Risk Reserve
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Illustration of IFSB CAR (Standard Formula)
CAR
Eligible Capital
Total Risk-Weighted Assets (Credit Market
Risks) Plus Operational Risks less Risk Weighted
Assets funded by PSIA(Credit Market Risks)
Credit and Market risk for on and off balance
sheet exposures PSIA balances include PER and
IRR
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FINANCIAL REPORTING, AUDITING GOVERNANCE
FRAMEWORK
AUDIT COMMITTEE
SHAREHOLDERS
AAOIFI
IFSB
INVESTMENT ACCOUNT HOLDERS
SHARIAH SUPERVISORY BOARD
ISLAMIC FINANCIAL INSTITUTION
OTHER STAKEHOLDERS
GOVERNANCE COMITTEE
REGULATORY AUTHORITIES
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Multi-Disciplinary Perspectives on Role of
Shariah Review, Audit Governance
Prudential Guidelines Standards Promulgated By
IFSB to Ensure Risk Management
Disclosure Framework Related to Capital Adequacy,
Corporate Governance Market Discipline
Shariah Goals, Opinions Rulings Propounded by
Shariah Scholars
Financial, Statements, Reports and other Useful
Information Required by AAOIFI Relevant
International Financial Reporting, Auditing
Governance Standards
SHARIAH COMPLIANCE BEHAVIOR
Regulatory requirements by Central
Banks, Monetary Authorities or Supervisory
Agencies
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Shariah Governance Assurance Framework
Shariah rulngs basis Approved Products
Services
Promulgate National Shariah Rulings, Opinions
Policies
SC BNM SAC
Specific Guidelines Reports on Shariah
compliance
Conduct supervision of IFI on Shariah compliance
SC BNM Supervisory Review
Comprehensive Shariah Supervisory Report
Formulate and review IFI Shariah opinions and
policies
SHARIAH SUPERVISORY BOARDS SHARIAH COMMITTEE
External Audit report
Undertake financial audit to express true and
fair opinion
EXTERNAL AUDITORS
Structure, internal control processes and
activities of IFI are Shariah Compliant
Statement of Corporate Governance
BOARD OF DIRECTORS AUDIT GOVERNANCE COMMITTEE
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THANK YOU WASSALAM