Corporate net income and payout smoothing under Shari'ah compliance

Abstract

This study examines if and to what extent adoption of Shari'ah Compliance Requirements (SCR) affects the payout smoothing policy of firms. We employ a variance decomposition strategy that enables to empirically analyse the adjustments of borrowings and investment policies to comply with payout smoothing to buffer net income fluctuations in the environment of Shari'ah compliance. We find that 37.25% of shocks to net income are absorbed via borrowing and 62.27% of shocks are absorbed through investment channels. We also document that borrowing and investment are primary channels in smoothing a large amount of fluctuations of the net income. The amount of shocks (1.3%) left unsmoothed is associated with a change in payouts. When, Shari'ah Compliant (SC) firms experience negative shocks in their net income, they would reflect the shocks in their payouts, instead of getting debt and paying smoothed dividends. This tendency gets stronger (1.3% to 3%) after the firms became SC. A novel approach in the literature, we also measure the extent of intertemporal payout smoothing across business cycles to test the permanent income hypothesis for firms. Accordingly, we can distinguish the impacts of temporary vs. permanent net income shocks on the payout policy of firms. We document that even though their payout ratios are mostly independent from the year by year net income growth, dividends are impacted deeply by long term net income growth.