Shariah parameter for stock screening: A discussion on the impermissible income ratio
The next Shariah screening filter is a bit sensitive for both the company whose share is being screened as well as the Islamic finance industry.
For the company, it is because the parameter discourages it to invest in lucrative but Shariah-repugnant opportunities and for the industry, it is due to the desire to provide Halal earnings to investors.
AAOIFI defines this filter in its Shariah Standard No 21, articles 3/4/4 as follows:
“The amount of income generated from prohibited component does not exceed 5% of the total income of the corporation irrespective of the income being generated by undertaking a prohibited activity, by ownership of a prohibited asset or in some other way. If a source of income is not properly disclosed, then more effort is to be exerted for identification thereof giving due care and caution in this respect.”
Let me try to explain the aforementioned filter. First, a 5% ratio should not lead to the belief that the impermissible income is allowed up to that threshold. No, there is no compromise on the Shariah position of what earnings are Halal and what are not.
Similar to the permissible activities having been delineated, the allowed income too is clearly defined. However, I have explained in my opening article the reason for setting the screening filters which is that you cannot expect the companies in the western and eastern worlds (north and south included) to keep Shariah considerations while making the investment decisions.
The parameters are, in fact, a creative way to also let the Islamic investors enjoy the roller coaster ride of listed chips without feeling unsure about the Shariah permissibility while respecting the red lines so defined by the scholars for AAOIFI.
Coming to the explanation of the prohibitive income, these are of various sorts, starting from the interest earned on treasury, municipal or any other types of bonds, or the term, call or savings deposit placements on interest with the conventional banks and financial institutions, and also, the dividends or capital gains from shares of companies which do not meet the Shariah screening parameters (either owing to their activities or financial data).
Add to that is the income earned from gold and silver trading on a deferred basis. Readers should recall my explanation that gold and silver are quasi-money and, as per Shariah, must be exchanged hand to hand and are not allowed to be traded on a deferred basis.
Moreover, the income distributed by the conventional funds (mutual, REITs, commodity, futures, etc) falls outside the Shariah boundaries and must be added to the total Haram earnings made by the company during the period.
Next is the definition of total income, which I have underlined in the aforementioned AAOIFI clause. What is meant here by total income?
If you pick the audited financials of any listed entity, you will find different descriptions related to a company’s income. First is the gross income or gross profit which is the subtraction of the cost of revenue/sale from the total revenue/sale.
Then comes the income before tax. This is arrived at by deducting the selling, general and administrative expenses from the gross income. Expenses also include the non-cash charges, ie depreciation and amortization. A few auditors also lump the ‘other income’ in the same list but others show it separately but prior to the pre-tax profit. Finally, you get the net or distributable income of the company.
The big question is which income out of the above cascade should be considered as the total income for the purpose of providing the denominator to the Haram income in order to gauge the ratio? Who will guess? I will wait for your input.
The challenge to ascertain a company’s level of Shariah compliance on this particular parameter is to assemble the Haram income by dissecting the notes provided in the audited financials. Some of the auditors are generous in that they even provide the information not needed for our purpose but others give scant data, making it hard to achieve satisfactory screening.
One has the luxury to get in touch directly with the CFO of the company and get the exhaustive information if screening is required for private equity purposes. Nevertheless, it is very difficult to get clarity on the financials of a listed company since the finance team is averse to probing and expects you to rely on the already-disclosed statistics.
In my own experience, I have seen that the CFOs of the compliant listed companies do cooperate to some extent and share the data beyond the audited financials upon explaining the purpose of screening and the benefit the company’s shares may realize upon inclusion in the Islamic index, and staying there.
Before I end this article, a gentle reminder regarding my aforementioned question on which level of income you think is the total income mentioned in the said AAOIFI standard.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at sazubairi1979@gmail.com.
Next week: Discussion on Shariah screening parameters to continue.
