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Abstract
Purpose – This paper aims to answer the following questions by using the data from the MENA region
(Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait and Bahrain): Do Shariah-compliant
firms differ from other firms in the quality of information disclosure? and Can investors consider information
disclosed by Shariah-compliant firms more truthful than information disclosed by other firms?
Design/methodology/approach – Using regression analysis, this paper examines the relationship
between earnings management and Shariah compliance during the period between 2005 and 2009.
Findings – Results show that Shariah-compliant firms engage in lower earnings management than
non-Shariah-compliant firms. This paper argues that financial characteristics of Shariah-compliant
firms (i.e. low leverage, low account receivables and low cash) provide lower chances to managers to
misreport earnings. It is also shown that external conditions can minimize the difference in earnings
management between the two groups. Results show no significant difference between earnings
management of Shariah-compliant firms and earnings management of non-Shariah-compliant firms in
the common law countries and during the crisis period. This paper considers high risk of litigation in
common law countries and enhanced monitoring of stock market participants during the crisis period
main factors behind these results. This paper argues that external governance mechanisms can result
in improving disclosure practices of non-Shariah-compliant firms to a level that minimizes the impact of
Shariah compliance on earnings management.
Practical implications – Results have implications for investors and regulators functioning in the
MENA region. These results indicate that non-Shariah-compliant firms, being more prone to earnings
misreporting, need more scrutiny from regulators than Shariah-compliant firms.
Originality/value – The authors believe that this paper is the first attempt to argue that it is the
financial characteristics of Shariah-compliant firms (i.e. low leverage, low account receivables and low
cash) that result in better disclosure of reported earnings.
Keywords Islamic finance, Emerging markets, Earnings management, Shariah-compliance
Paper type Research paper
Shariah-compliant firms mention on their websites that they conduct their business in
accordance with Shariah. We argue that, if religion was the driving force behind
compliance and disclosure decision, Shariah-compliant firms should have advertised it
on their websites to attract a wider investor base.
Our results have implications for investors and regulators functioning in the MENA
region. Our results indicate that non-Shariah-compliant firms, being more prone to
earnings misreporting, need more scrutiny from regulators than Shariah-compliant
firms. For investors, our results indicate that they can obtain more value-relevant
information from financial statements of Shariah-compliant firms than from financial
statements of non-Shariah-compliant firms.
The remainder of the paper is structured as follows: Section 2 briefly discusses
motivation and background for this study. Section 3 summarizes the data used in this
study and Section 4 presents assessment of our hypothesis. Section 5 discusses our
results, and the paper ends with Section 6 where we present conclusions.
documenting that firms with high leverage engage in earnings management to avoid
debt covenant default. They show that firms closer to violating debt covenants manage
earnings more aggressively than other firms. This strand of literature, therefore,
considers the extent of leverage as a main driver for earnings management by firms. We
argue that Shariah-compliant firms, being low on leverage, have lower probability than
their non-Shariah-compliant counterparts to manage earnings.
Prior literature also documents a positive relationship between account receivables
and earnings management. Marquardt and Wiedman (2004), for example, show that the
increase in account receivables results in earnings manipulation by the management. In
another related study, Caylor (2009) document that managers use accounts receivable
and deferred revenues to report positive earnings surprises. This strand of literature
also argues that high level of account receivables provide more flexibility to
management to manipulate accounting statements. Consistent with the above findings,
we believe that Shariah-compliant firms manage lower earnings than non-Shariah-
compliant firms.
The last characteristic of Shariah-compliant firms, amount of cash, is also considered
as an important determinant of earnings management in the prior literature. Bukit and
Iskandar (2009), for example, document that earnings management is higher among
firms with surplus cash. Gul (2001) and Chung et al. (2005) argue that firms with high
surplus cash face significant agency problems. They note that managers of firms with
high surplus cash act opportunistically for personal gains and tend to get involved in
unprofitable projects, over investments and misuse of the funds. They also document
that managers of these firms (firms with high surplus cash) tend to adopt accounting
procedures that increase reported earnings to hide the negative impact of projects.
Therefore, to conceal these activities, managers are forced to manage earnings via
accounting discretions. Consistent with this strand of literature, we argue that
Shariah-compliant firms should manage lower earnings than non-Shariah-compliant
firms.
non-Shariah-compliant firms.
3. Data
This paper documents the difference between earnings management of
non-financial Shariah-compliant firms and earnings management of non-financial,
non-Shariah-compliant firms listed at the MENA stock markets during the period
between 2005 and 2009. We select Morocco, Egypt, Saudi Arabia, United Arab
Emirates, Jordan, Kuwait and Bahrain as the representative stock markets for the
MENA region due to the availability of data. The following sub-sections will explain
the data in greater detail.
178
Years Shariah-compliant firms Non-Shariah-compliant firms
2005 76 41
2006 115 38
2007 127 58
Table I. 2008 140 56
Number of Shariah- 2009 112 97
compliant and non-
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Shariah-compliant Notes: The following table shows the number of Shariah-compliant firms and non-Shariah-compliant
firms in different firms for our sample. The sample comprises firms from Morocco, Jordan, Bahrain, Egypt, Kuwait,
years United Arab Emirates, Saudi Arabia and Qatar. The sample period is from 2005 to 2009
Bahrain 16 –
Egypt 133 106
Jordan 48 13
Kuwait 89 72
Morocco 42 22
Qatar 49 16
Table II. Saudi Arabia 146 37
Number of Shariah- United Arab Emirates 47 24
compliant and non-
Shariah-compliant Notes: The following table shows the number of Shariah-compliant firms and non-Shariah-compliant
firms in different firms for our sample. The sample comprises firms from Morocco, Jordan, Bahrain, Egypt, Kuwait,
countries United Arab Emirates, Saudi Arabia and Qatar. The sample period is from 2005 to 2009
Bahrain ⫺0.1058 –
Egypt ⫺0.0170 0.0035
Jordan ⫺0.0952 ⫺0.0072
Kuwait ⫺0.1274 0.0517
Morocco ⫺0.0600 ⫺0.0701
Qatar ⫺0.0573 ⫺0.0705
Table V. Saudi Arabia ⫺0.0156 0.0102
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Table VII. Notes: The following table documents descriptive statistics for the control variables used in
Descriprive statistics regression. The sample comprises firms from Morocco, Jordan, Bahrain, Egypt, Kuwait, United Arab
for control variables Emirates, Saudi Arabia and Qatar. The sample period is from 2005 to 2009
4. Methodology Earnings
The main question in our analysis is to document the difference between earnings management
management of Shariah-compliant firms and earnings management of
non-Shariah-compliant firms. To test this hypothesis, we estimate a pooled regression
behaviour
with earnings management (EM) as a dependent variable and a dummy variable
representing whether a firm is a Shariah-compliant firm (ISLAMIC) as an independent
variable. The EM is calculated using modified Jones model, while the ISLAMIC is a 181
dummy variable that takes the value of 1 if a firm is Shariah compliant and 0 otherwise.
We also include country dummies (CDUM), industry dummies (IDUM), and year
dummies (YDUM) in our regression equation. Our basic regression is formulated as
follows:
Year Ind
(1)
⫹ 兺
Ctry
Ctry(
CDUM ) ⫹
However, there may be concerns that some of the firm-specific characteristics can
be driving the results obtained from equation (1). For example, larger firms have more
visibility to analysts, investors and regulating authorities. As a result, they may manage
lower earnings than other firms. Kim et al. (2003) also document that large firms manage
their earnings less than small firms. Therefore, we add log of firm’s market
capitalization (SIZE) as a proxy for size in our regression equation. In addition, we also
add sales growth (GROWTH) of a firm in our regression equation. AlNajjar and
Riahi-Belkaoui (2001) document higher earnings management for firms with high levels
of growth opportunities. Furthermore, we also add two variables representing
profitability of a firm (PROFIT) and its operational complexity (COMP). More profitable
firms should attract more interest from stock market participants and thus should have
lower earnings management, while firms with more operational complexity should
provide more leverage to management to manipulate accounting statements and thus
should have higher earnings management. For the purpose of this paper, PROFIT is
defined as a dummy variable that takes the value of 1 if firm is profitable and 0
otherwise, while COMP is defined as the ratio of salary expenses to total operating
expenses (Abdel-Khalik, 1993; Knechel et al., 2008; Hay and Davis, 2004). Our modified
regression equation takes the following form:
Size 1.000
Profit 0.2843 1.000
Complexity ⫺0.2117 ⫺0.0748 1.000
Growth 0.0731 0.0896 ⫺0.0770 1.000
Notes: The following table documents descriptive statistics for the control variables used in
regression. The sample comprises firms from Morocco, Jordan, Bahrain, Egypt, Kuwait, United Arab Table VIII.
Emirates, Saudi Arabia and Qatar. The sample period is from 2005 to 2009 Correlation matrix
JIABR EM ⫽ ␣ ⫹ 1( ISLAMIC ) ⫹ 2( SIZE ) ⫹ 3( COMP ) ⫹ 4( PROFIT ) ⫹ 5( GROWTH )
(2)
6,2 ⫹ 兺
Year
Year(
YDUM ) ⫹ 兺
Ind
Ind(
IDUM ) ⫹ 兺Ctry
Ctry(
CDUM ) ⫹
The results of the above set of regression equations are reported in Table IX. Our results
from both equations show that Shariah-compliant firms engage in lower earnings
182 management than non-Shariah-compliant firms. We report negative coefficient estimate
of ISLAMIC for both equations. For example, the results of equation (2) show that
earnings management of Shariah-compliant firms is 0.0311 basis points less than
earnings management of non-Shariah-compliant firms. Consistent with our hypothesis,
we argue that characteristics of Shariah-compliant firms are such that they manage
lower earnings than their non-Shariah-compliant counterparts. Lower the level of debt,
account receivables and cash makes sure that managers do not engage in earnings
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manipulation (Becker et al., 1998; Caylor, 2009; Bukit and Iskandar, 2009). Our results
are an indication that stock market participants can obtain more value relevant
information from financial statements of Shariah-compliant firms than from financial
statements of non-Shariah-compliant firms.
5. Discussion of results
5.1 Difference between earnings management of Shariah-compliant firms and
earnings management of non-Shariah-compliant firms during normal and crisis
periods
In this section, we re-estimate equations (1 and 2) during the normal and the crisis
periods. For the purpose of this paper, we consider 2008 as the crisis period. This was the
year during which the MENA stock markets experienced sustained downward
movement (Onour, 2010). Examining earnings management behaviour of
Shariah-compliant firms and non-Shariah-compliant firms during periods characterized
by different market conditions can provide insights that may be otherwise masked. We
earnings Notes: The following table documents the difference between earnings management of
management of Shariah-compliant firms and earnings management of non-Shariah-compliant firms using equation
Shariah-compliant (1 and 2) during the normal and the crisis periods. The sample comprise of non-financial firms from
and non-Shariah- Morocco, Jordan, Bahrain, Egypt, Kuwait, United Arab Emirates, Saudi Arabia and Qatar. The crisis
compliant firms period is considered as the year of 2008, while the other years (2005, 2006, 2007, and 2009) are considered
during the normal as the normal period. The coefficient that are significant at 10% are followed by * , those at 5% and 1%
and the crisis periods by ** and *** , respectively
countries (Ball et al., 2000). Common law countries are characterized by better
investor protection, high information disclosure, and high risk of litigation relative
to civil law countries (La Porta et al., 1999). As a result, earnings management is
more prevalent in firms from civil law countries relative to common law countries. In
common law countries, we should expect convergence in earnings management of
Shariah-compliant firms and earnings management of non-Shariah-compliant firms
in common law countries. However, if Shariah-compliance is important determinant
of firm’s earnings management behaviour, we should still see a significant
difference between earnings management of Shariah-compliant firms and earnings
management of non-Shariah-compliant firms in common law countries. The results
of this analysis are reported in Table XI. Our results from both equations show that
significant difference between earnings management of Shariah-compliant firms
and earnings management of non-Shariah-compliant firms hold only in civil law
countries. We report insignificant coefficient estimate of ISLAMIC in common law
countries. Our results indicate that external governance mechanisms can result in
improving disclosure practices of non-Shariah compliant firms to a level that
minimizes the impact of Shariah compliance on earnings management.
Notes: The following table documents the difference between earnings management of management of
Shariah-compliant firms and earnings management of non-Shariah-compliant firms using equation Shariah-compliant
(1 and 2) for firms headquartered in different legal regimes. We classify Bahrain, United Arab Emirates, and non-Shariah-
and Saudi Arabia as common law countries, and Morocco, Jordan, Egypt, Kuwait and Qatar as civil law compliant firms in
countries. The sample period is from 2005 to 2009. The coefficient that are significant at 10% are different legal
followed by * , those at 5% and 1% by *** and ***, respectively regimes
6. Conclusion
This paper documents earnings management behaviour of Shariah-compliant firms and
non-Shariah-compliant firms in the MENA region (Morocco, Egypt, Saudi Arabia,
United Arab Emirates, Jordan, Kuwait and Bahrain) during the period between 2005 and
2009. The results of this paper indicate that Shariah-compliant firms engage in lower
earnings management than non-Shariah-compliant firms. We argue that characteristics
of Shariah-compliant firms are such that it provides lower chances to managers to
misreport earnings. For instance, low level of cash at hand decreases agency problems
by decreasing the ability of managers to expense resources of unprofitable projects.
Lower agency problems, eventually, lead to better disclosure and low earnings
misreporting (Chung et al., 2005). Interestingly, we also show no significant difference
between earnings management of Shariah-compliant firms and earnings management
of non-Shariah-compliant firms in the common law countries and during the crisis
period. We consider high risk of litigation in common law countries and enhanced
monitoring of stock market participants during the crisis period as a main factor behind
JIABR these results. We argue that external governance mechanisms can result in improving
6,2 disclosure practices of non-Shariah compliant firms to a level that minimizes the impact
of Shariah compliance on earnings management.
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Where TAt is total accruals, CCAt is change in current assets at t, CCLt is change in current
liabilities, CCasht is change in cash, CSTDt is change in short-term debt, Dept is depreciation and
At-1 is one period lagged total assets.
According to modified Jones model, the total accruals comprised two components:
discretionary and non-discretionary components of total accruals. The non-discretionary
component or the inherent part of total accruals is not influenced by any managerial decision. It
represents the accruals that are affected by the changing economic conditions of the firm. The
non-discretionary component of accruals is estimated as follows:
NDAt ⫽ 1 共 兲
1
At⫺1
⫹ 2( CREVt ⫺ CRECt ) ⫹ 3( PPEt ) (A2)
Discretionary accruals are accruals resulting from direct manipulation of estimates by managers.
The discretionary component of accruals (DA) is obtained by subtracting equation (A2) from
equation (A1):
188
DAt ⫽ TAt ⫺ NDAt (A4)
Corresponding author
Omar Farooq can be contacted at: omar.farooq.awan@gmail.com
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