Shariah parameters for stock screening: Treatment of impermissible income
Without waiting any longer for the input from readers to my question of last week as to what is the total income while ascertaining the Haram income in a listed company’s financials, I will go ahead with my explanation as follows.
AAOIFI has used the term ‘total income’ in the provision in Shariah Standard No 21, which I had quoted in my last article; nonetheless, you do not find ‘total income’ in the income statement appearing in any audited financials. So what is this mysterious figure?
In my opinion, by using the term ‘total income’, AAOIFI has provided a wide range for interpretation to the Islamic index providers, and to the Islamic funds and to individual investors in the private equity landscape.
Based on my own personal experience when I first started to use the screening parameters for listed stocks a ‘century’ ago for an Islamic fund manager company, the practice was to apply the 5% impermissible income ratio on the gross profit figure. As you would know, the gross profit is arrived at by deducting the cost of goods sold from the total sales figure (net of sales return).
This provided a big window to include many companies in the Islamic universe to the fund manager’s delight. Imagine applying the 5% ratio on the net profit figure, which is after subtracting the selling, general and administrative expenses, depreciation, amortization, provision for bad and doubtful debts, interest expense and several other outlays. You get only a handful of companies passing through the tunnel.
Well, if that is the case, then what to do with the companies which do not sell anything and you cannot arrive at their gross profit amount? These could be the companies providing services. To me, this seems another reason for AAOIFI to use the term ‘total income’ without defining whether it is gross profit or net profit.
The companies which offer services have the most basic profit and loss statement. Since they do not sell any product, their income statement does not contain cost of goods sold and comprises a basic breakdown of income and expenditures and the difference between them becomes the operating income.
While screening a services company’s financials, I used to apply the aggregate of all the impermissible income over the first head of the income statement, ie the revenue, and found very few companies breaching the 5% barrier.
After having explained the Haram income ratio, I would now like to discuss the Shariah treatment meted out to such amounts. As stated in the last article, the 5% permissibility does not make the Haram income as Halal. Haram remains Haram no matter what you do and the principles to define Haram and Halal have stood tall among all the temptations and mouthwatering prospects.
The Shariah guidance provided for the treatment of Haram income during a financial period is called purification (Shariah term ‘Tazkia’). An Islamic fund manager is responsible for Tazkia in that he has two options. First, is to deduct the Haram income at the source and distribute only the purified dividend to investors with the information as to the amount or percentage of gross dividend and the Haram income deducted from it.
The amount so collected from all investors is then donated by the fund manager to an authentic charity organization approved by the fund’s Shariah board. A reputed scholar of our times summed it up beautifully to me. He said that the money in itself is not Haram or Halal and is neutral in nature. However, what makes it as such is how and where it is applied.
Therefore, a conventional bank lending money on interest to a client to buy a car earns Haram income whereas an Islamic bank purchasing a car from a dealer and selling it to the customer at profit derives Halal income.
Deducing from this principle, if the Haram income is retained by the Islamic fund manager, it will mix with the Halal income and make the entire dividend dubious. Nevertheless, if the Islamic fund manager donates the Haram income to a charity organization which uses it to help the needy, this will not be Haram for the recipient since it was not the owner or the manager of the principal amount invested to generate the Haram income.
The second option with the Islamic fund manager is not to deduct the Haram income from the dividend amount but simply inform the investors as to the level of Haram income present there and advising them to donate it to charity upon realization of the dividend cheque. This is by far the industry practice since not all investors in an Islamic fund are expected to be individual Muslims or Islamic financial institutions. Giving the investors the right information about the inclusion of Haram income in the payout absolves the fund manager from the Shariah responsibility.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Next week: Discussion on Shariah screening parameters to continue.