CFA Institute Journal Review summarizes "Corporate Net Income and Payout Smoothing under Shari’ah Compliance," by F. Balli, A. De Bruin, H.O. Balli, and J. Karimov, published in Pacific-Basin Finance Journal, Vol. 60 (April 2020).
Shari’ah compliance affects managers’ ability to manipulate earnings and implement smooth payout policies. The study evaluates a sample of US stocks to understand how observed and unobserved shocks affect net income and how meeting Shari’ah compliance requirements impacts payout smoothing policies.
What Is the Investment Issue?
Islamic finance rules govern the way firms are managed in order to adopt and conform to Shari’ah Compliance Requirements (SCR). As a result, SCR stocks are suitable investment vehicles for Muslim investors.
SCR stocks have been perceived as more conservatively managed and less risky due to a number of constraints, such as limitations on leverage. The authors investigate how adhering to SCR impacts a firm’s payout smoothing policy.
How Did the Authors Conduct This Research?
The study focuses on US firms that recently established SCR and analyzes the impact and magnitude of shocks-to-earnings that are absorbed by borrowing and investment. The authors analyze a sample of 973 stocks that adopted SCR from 2011 to 2016, based on Ideal Ratings. The financial data for the stocks originate from Compustat over the period 1982–2016.
The authors calculate descriptive statistics and a correlation matrix to analyze the relationships between net income and debt and between investment and payout. Subsequently, the authors use a variance decomposition model to understand financial adjustments based on changes in earnings, and they focus on firms’ behavior changes after they claim SCR. The study explores intertemporal payout smoothing and distinguishes between smoothing of temporary and permanent economic downturns.
The conclusions are validated through use of additional controls, significance testing, and elimination of possible heteroskedasticity or autocorrelation issues. In addition, the study verifies the robustness of empirical results through industry-based analysis, confirming that the outcomes are consistent with firm-level analysis.
What Are the Findings and Implications for Investors and Investment Professionals?
Accrual accounting provides a means for managers to manipulate earnings, and a payout smoothing policy overcomes undesired income shocks by adjusting debt and investing.
In the event of an unfavorable income shock, the company may meet investors’ expectations for dividend payout by increasing debt or decreasing corporate investment or cash holdings. The authors note that SCR-imposed limitations on debt ratios significantly reduce the ability to use debt as a source of liquidity.
Based on the empirical analysis of activity after a company becomes Shari’ah compliant, the study confirms a 4% decrease in debt smoothing and a 3% increase in shock smoothing with dividend policy changes. This means that in the event of a negative net income shock, Shari’ah-compliant firms are more likely to pay smoothed dividends by decreasing dividend payouts rather than by increasing debt.
The authors conclude that after firms become Shari’ah compliant, payouts are more correlated with net income fluctuations. This may indicate lower risk and more transparent results, outcomes valuable not only to religiously motivated investors but to all financial professionals.