INTRODUCTION
The screening procedure is intended to discover aspects that contravene Shariah law's principles and guidelines based on the Quran and Prophet Muhammad's teachings. Usury (riba or interest), gambling (maysir), and uncertainty (gharar) are all prohibited under Shariah law. Many conventional financial activities contain these components. This entails indirectly participating in prohibited acts for a Muslim, which is a grave sin.
Unlike in the conventional market, transactions on the Islamic Capital Market are conducted exclusively in ways that do not violate Shariah law. A specialized stock screening procedure must be developed to identify and list Shariah-investable companies. Shariah Stock screening is the term for this procedure.
The Securities Commission of Malaysia has developed Shariah-compliant Securities Screening Methodology. It's worth noting that the Securities Commission's Shariah Advisory Council (SAC) has endorsed the Shariah screening. The screening approach aids investors in determining which Bursa Malaysia shares are Shariah-compliant. The Malaysian Securities Commission recently developed a Shariah screening assessment toolbox to help identify the status of unlisted micro, small, and medium businesses. This is a positive development because the newly released toolkit broadens the investing options available to investors beyond Shariah-compliant listed equities or assets.
Companies having unsatisfactory amounts of conventional debt, liquidity, interest-based investment, or impure income are excluded from the Shariah stock screening indices. Companies should ideally not borrow based on interest rates, invest in debt-bearing instruments, or generate revenue through other Shariah unlawful actions. On the other hand, such limits would eliminate the vast majority - if not all - of the equities accessible on the market, including those listed in Islamic nations. Based on this requirement, Shariah scholars attempted to develop a set of Shariah indices that could be used to evaluate current businesses and categorize them as Shariah-compliant. To date, Shariah-compliant companies have been identified by conducting a Shariah screening process on assets such as common stock, warrants, and transferable subscription rights traded on stock exchanges. The Shariah screening indices utilized by authorities around the world, on the other hand, differ from one another.
AAOIFI
The first institutions that involved in this shariah screening process is AAOIFI. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was founded in Manama, Bahrain, with the goal of establishing a standard of accounting and auditing processes for Islamic financial institutions. AAOIFI is one of the most significant organizations in creating standards for Islamic finance practice across jurisdictions, despite the fact that it is not a regulatory entity. For the market and institutions implementing Islamic financial operations, it has issued over a hundred standards in the fields of Shariah, accounting, auditing, ethics, and governance.
AAOIFI has a number of institutional members from over 45 countries, including central banks and regulatory authorities, financial institutions, accounting and auditing organizations, and law firms. The Shariah stock screening approach used by AAOIFI examines the company's major business activities and excludes any interest-based activity, any trade or transaction involving uncertainty, gambling or games of chance, or the manufacturing or dealing of forbidden items or services.
In the business ratio screening process, AAOIFI set the standard that they will only approved if the company does not state in its memorandum of associations that its objective is to deal with interest, or in prohibited goods or materials such as pork, liquor and others. And to note that the company is shariah compliant if the total amount of income generated from such prohibited activities such as gambling and selling tobaccos should not exceed 5% of the total income of the corporation.
While for the financial ratio screening process, there are four conditions that the companies should pass as shariah compliant companies. The first one is the total long-term and short-term debt divided by market capitalizations is less than 30%. Short-term debt is a debt that is expected to be paid off within one year, one of the examples of the short-term debt is tax. And credit lines, bank loans, and bonds with obligations and maturities greater than one year are some of the most common forms of long-term debt instruments used by companies.
The second ratio for financial screening process by AAOIFI is the total interest bearing securities divided by the market capitalization is less than 30%. Interest bearing securities is a type of financial instrument in which the investors effectively lends money to a corporation or institution in exchange for interest paid in a certain manner over a predetermined length of time. Next, the third ratio for the financial screening process is, the interest income divided by total income or total revenue must be less than 5%. And lastly, the cash and receivables divided by the total assets must be less than 70%.
Securities Commission Malaysia
The Securities Commission Malaysia (SC) was established on 1 March 1993 under the Securities Commission Act 1993 (SCA). The screening methodology was first introduced by Securities Commission Malaysia in 1995 and has been revised in line with current developments in the Islamic banking and finance industry. The SAC uses a two-tier quantitative technique to determine the Shariah status of listed shares, using business activity standards and financial ratio benchmarks. As a result, if the securities' commercial activities and financial ratios fall below these new updated shariah benchmarks, they will be designated as Shariah-compliant.
For the business screening ratio process under Securities Commission Malaysia, there are two thresholds for the business activity, which are 5% and 20%. Companies passed as a shariah compliant company if they generate less than 5% revenue or profit before tax from those specific sectors. And those sectors that are involved in this business screening ratio are as follows.
Conventional banking including insurance
Gambling
Liquor and liquor-related activities, pork and pork-related activities, non halal food and beverages.
Shariah non-compliant entertainment
Interest income from conventional accounts and instruments
Tobacco and tobacco related activities
Other activities deemed shariah non compliant
If these companies operate these kinds of activities, they need to make sure that the company’s revenue or profit before tax must be less than 5% of the company’s total profit. If not, the company cannot be listed as a shariah-investable company. However, there is another 20% benchmark which applicable to the companies that generate part of their revenue or profit before tax from the following activities that they need to pay attention:
Hotel and resort operations
Share trading and stock-broking business
Rental received from shariah non compliant activities
Other activities that are deemed shariah non compliant
In practice, any company holding a subsidiary with a mixed business activity that for example, involves hotel and resort operations, share trading, stockbroking, and rental received from Shariah non-compliant activities. They need to make sure that the profit or profit before tax must be less than 20%. If not, it fails the filtering procedure if it is higher than 20%.
While for the financial business screening ratio side, the financial ratios must include two financial activities which are:
Cash divided by total assets should be less than 33% where cash includes only those placed with conventional accounts and instruments, and cash placed with Islamic banks will not form part of it.
Total debt divided by total assets should be less than 33% where debt will include interest bearing debt and islamic financing or sukuk will not be part of the calculation.
The purpose of finding these ratios is intended to measure riba and riba-based elements within a company’s statements of financial position.and anything at 33% or above would render the stock Shariah non-compliant. In addition to the two-tier quantitative criteria mentioned above, the SAC considers the qualitative component of public perception or image of the company's actions in light of Islamic teaching.
Dow Jones Islamic Market (DJIM)
Dow Jones Islamic Market (DJIM) World was the world's first global Shariah-compliant benchmark when it was established in 1999. Thousands of broad-market, blue-chip, fixed-income, strategy, and theme indexes have passed Shariah compliance screenings in the Dow Jones Islamic Market Index series. To determine their eligibility for the indices, stocks are screened to ensure that they meet the standards set out in the published methodology. Companies must meet Shariah requirements for acceptable products, business activities, debt levels, and interest income and expenses. The screening methodology is subject to input from an independent Shariah supervisory board. By screening stocks for consistency with Shariah law, the indices help to reduce research costs and compliance concerns Muslim investors would otherwise face in constructing Islamic investment portfolios.
In business screening ratio under Dow Jones Islamic Market Index series, the company revenue must not exceed 5% under these following activities which are alcohol, pork related products, conventional financial services, entertainment including hotel, gambling, cinema, pornography, music, tobacco, weapons and defense. While under the financial screening ratio, there are three main points that need to be passed by these companies.
The first one is, total debt must be divided by trailing average market capitalisation and the ratio should be less than 33%. The total debt includes short term debt plus current portion of long term debt plus long term debt. Secondly, in order to pass the shariah screening under financial, cash and interest bearing securities divided by the average market capitalization it must be less than 33%. And lastly, the account receivables divided by trailing average market capitalisation should be less than 33% where the receivables here must include current receivables plus long term receivables.
Thompson Reuters Ideal Ratings Islamic Indices
Since 2006, Thompson Reuters IdealRatings has provided financial institutions with Shariah fund management services. Its Islamic indices are defined by quarterly compliance with Shariah based on study. Thompson Reuters IdealRatings conducted a screening in compliance with AAOIFI (Accounting and Auditing Office of the International Federation of Accountants). And the Islamic Financial Institutions Auditing Organization) adherent. The Indices are intended to act as liquid, broad-based, and comprehensive investment vehicles. Benchmarking and investment tools for investment professionals and analysts. Shariah-compliant common stock on a local, regional, or global basis countries.
In business screening ratio, Thompson Reuters Ideal Ratings Islamic Indices identified non-halal food production, tobacco, alcohol, gambling, advertisement, hotels, non-Islamic banks, financial institutions and insurance companies, entertainment and music production, trading of gold and silver, as well as weaponry as forbidden. From a business screening ratio standpoint, a company is only considered compliant if the total revenue from non-compliance operations and non-operating interest income does not exceed 5% of total sales.
While under financial ratio, it is conducted by using the following three financial ratios which are:
Interest-bearing debt should not exceed 30% of the previous 12-month average market capitalization.
The sum of cash, deposits, and interest-bearing investments should not exceed 30% of the preceding 12-month average market capitalization.
The sum of cash, deposits, and receivables should not exceed 67% of total assets.
These companies need to follow the standard requirement by Thompson Reuters Ideal Ratings Islamic Indices. If they failed to do so, then they are not passed as a shariah compliant company.
MSCI Global Islamic Indices
The MSCI Global Islamic Indices are derived from MSCI’s country indices. The MSCI Islamic Index Series Methodology screens the securities of the MSCI country indices against certain business activities and financial ratios. A dividend adjustment factor is also applied to any non-Sharia compliant income.
The MSCI Islamic Index Series (the “Islamic Indexes”) follow Sharia investment principles. An Islamic Index is based on an MSCI Equity Index (or any combination of MSCI Equity Indexes), but excludes all the non‐compliant securities in accordance with the MSCI Islamic Index Series Methodology (the “Islamic Index Methodology”). The Islamic Index Methodology has been approved by MSCI’s Sharia advisors’ committee of Sharia scholars, as Sharia compliant.
Following Sharia investment principles, MSCI excludes securities using two types of criteria: business activity and financial ratios. Securities for which sufficient financial information is not available to determine the business activity information and financial ratios described in the following sections are considered non‐compliant with the Islamic Index Methodology.
MSCI's screening process starts with a business activity screening, which means excluding any company that earns more than 5% of its revenue from any of the following business activities: traditional financial services, alcohol, pork-related products, tobacco manufacturing and sales, weapons and defence, gambling and casinos, hotels and cinemas, and pornography and adult entertainment.
In addition, corporations' stocks are financial vetted using a set of financial ratios. Investments in companies that derive more than a major portion of their income from interest or corporations with high debt are prohibited under Shariah investment standards. Stocks are screened for compliance using the total debt to total assets ratio, the sum of cash and interest-bearing securities over total assets ratio, and the sum of accounts receivable and cash over total assets ratio. MSCI allows 33.33% for each of the financial ratios listed above. For new additions to the MSCI Islamic indexes, however, a lower 30% requirement is used.
FTSE Shariah Global Equity Index Series
The FTSE Shariah Global Equity Index Series is designed to be used as the basis of Shariah compliant investment products which meet the requirements of Islamic investors globally.A few years ago, FTSE launched its worldwide Islamic index. It has inked a cooperation agreement with Yassar Research Inc, a Shari'ah advisory business, to seek advice for the Global Islamic Index series (A.Hussein, 2009). The FTSE Singapore exchange Shariah index series, the FTSE Dubai International Financial Exchange (DIFE) Shari'ah index series, and the Bursa Malaysia index series have all been included in the company's product portfolio (Kamal Ali, 2008& Security Commission Malaysia, 2009). Kamal Ali (2008) goes on to say that the FTSE Shariah indices are screened according to the criteria established by Yassar's Shariah board.
In response to the growing demand for Shariah-compliant investment products, FTSE has developed a new suite of Shariah indexes that employ a more sophisticated methodology and provide a more comprehensive Shariah index solution for Islamic investors. The FTSE Shariah Indexes now comprise the FTSE NASDAQ Dubai Index Series, FTSE Bursa Malaysia EMAS Index, FTSE Set Shariah Index, FTSE TWSE Taiwan Shariah Index, FTSE/JSE Shariah Indexes, FTSE SGX Shariah Index Series, and FTSE Developed Minimum Variance Shariah Index.
Every company that engages in any of the following activities will be filtered out as Shariah non-compliant under the FTSE screening methodology. Overall interest and non-compliant income should not exceed 5% of total revenue, according to business activity screening. Conventional finance, alcohol, pork-related items, cigarettes, guns, and entertainment are the key sectors of commercial activity screening. While the original index design tended to use an absolute exclusion from any of these forbidden activities, more subsequent methodology has tended to use a 5% of total revenue-based cut-off when employing these categories. The FTSE screening process is based on whole sector exclusion, but admission of companies in other sectors where non-compliant revenue accounts for less than 5% of total revenue.
Following that, the remaining businesses are screened on a financial basis. Companies must meet the financial ratio to be declared Shari'ah compliant. FTSE employs total assets for financial screening, with a 33% cap on the criterion for characteristics like total debt to total assets, cash, and interest-bearing securities over total assets. The amount of a company's accounts receivable and cash over total assets must be less than 50% of total assets.
Russell Jadwa Shariah Indexes
The Russell Jadwa is the most recent addition to the range of Shari'ah compliant indices. It consists of a suite of indices classified mostly by geographical area. Its underlying investable universe is the Russell Global Index Universe, and it has its own Shari'ah supervisory board that sets the screening criteria and controls the process. The following screening criteria are used by the Russell Jadwa Shariah Index:
Every revenue generated from illegal activities and interest income should be less than 5% of total income for business screening of Russell Jadwa Shariah Indexes. Any corporation that engages in any of the following acts is excluded from the index.
Financial institutions such as traditional banks that deal with interest or financial instruments that violate Shariah rules, traditional insurance companies.
Production and distribution of alcohol, tobacco, and weapons
Production and distribution of meat not slaughtered according to Shariah rules.
Production and distribution of pork and its derivatives.
Management of casinos, gambling halls and production of games such as slot machines.
Production and distribution of pornographic films, books and magazines, satellite channels and cinemas.
Restaurants, hotels and places of entertainment that provide prohibited services such as the sale of alcohol.
Trading of gold and silver as cash on a deferred basis.
Weapon manufacturing and selling.
Stem cell/human embryo, genetic cloning (research firms, therapy clinics, and so on).
Anything not Shari’ah compliant as determined by the Russell Jadwa Shariah Board.
The companies that remain are then further evaluated on a financial basis. Companies having significant exposure to interest and other kinds of unlawful income, as well as forbidden assets, are excluded from the financial-based screens. After the industry screen is completed, the companies that remain are filtered using the following financial ratios, each of which must be met:
Total cash, deposits and receivables divided by the immediately preceding 12-month average total market capitalisation exceeds 70%.
Interest-bearing debt divided by the immediately preceding 12-month average total market capitalisation exceeds 33%.
Total cash, deposits and interest-bearing securities divided by the immediately preceding 12-month average total market capitalisation exceeds 33%.
Standard & Poor’s Shariah Index
In 2006, S&P Dow Jones Indices established S&P Shariah Indices to accommodate the growing demand for Shariah-compliant stocks. Rating Intelligence Partners (RI) provided the Shariah screens and filtered the equities based on these screens for the indices. The S&P Shariah Indexes are a collection of indices created for investors who want to follow Shariah principles. Each index tries to represent a similar investable portfolio while adhering to explicit, transparent selection criteria as mandated by Islamic law. Each index is representative of each market and has good correlations to its benchmarks.
Each firm's most recent financial statement is assessed as part of S&P's Shariah screening process to ensure that the company is not engaged in any non-Shariah compliant activity, regardless of whether the most recent statement is a quarterly, semi-annual, or annual statement. If the most recent statement is provided for all three of these frequencies, the annual statement will most likely be selected because it is more likely to be audited. Those that are found to be non-compliant are screened out.
Business screenings exclude shares of all such companies engaged in activities strictly prohibited (haram) in Islam. These include companies whose major line of business is dealing with financial transactions involving interest (riba’), gambling activities (maysr), intoxicants (khamr) such as alcohol or similar drugs that can obscure one’s judgment, pork, pornography, tobacco, trading of gold and silver as cash on deferred basis, embryonic or stem cell research and cloning and advertising and media.
Following the removal of organizations with non-compliant business activities, the remaining companies are reviewed for financial ratio compliance. Leverage, cash, and the share of income coming from non-compliant activities are three areas of focus. All of these are being evaluated on a regular basis. The following is a list of S&P's Shariah screening indices:
Business Activity - any involvement (exclude companies which have any involvement in impermissible activities).
Liquidity Ratios – less than 49% of account receivable divided by 36-month market average market capital and less than 33% of cash plus interest bearing securities divided by 36-month average market capital.
Debt Ratio – less than 33% of total debt divided by 36-month market average market capital.
CONCLUSION
After doing all these findings, we find out that shariah screening methodology is important in order to make sure that the company’s stock is safe and shariah compliant and all of them have a different ratio in order to evaluate the stocks. And the most important thing is the backbone of the Islamic capital market is shariah stock screening. The key to having a robust criteria for stocks is to have an effective and practical Shariah screening technique which can convince more of the investors. Not only that, shariah screening methodology is important because based on this criteria, stocks are classified either as Shariah compliant or non-compliant. The more theoretically robust and practically viable the Shariah screening criteria is, the more investors, corporations, regulators, and other actors in the Islamic capital market have faith in the market.
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