Does Sharia Compliance Affect the Earnings Management of Companies in Muslim Majority Countries?

Abstract

Purpose – Sharia compliance states that the compliant company operates not only under regulations but also to the restrictions and permission of Islam. This research aims to reveal whether Sharia compliance enhances financial reporting quality. Design/methodology/approach – The sample is constructed from 15 Muslim majority countries, 2,300 companies for the periods between 2005 and 2017 with 23,810 firm*year observations. Financial reporting quality is measured with discretionary accruals and audit aggressiveness. Discretionary accruals is the absolute of Kothari, Leone, and Wasley’s (2005) “Performance Matched Discretionary Accruals Model”. Audit aggressiveness is calculated with absolute of Gul, Wu, and Yang’s (2013) model. Findings – This research reveals the behavioral differences on financial reporting quality between Sharia-compliant and non-compliant companies. According to the analyses, Sharia compliance increases the financial reporting quality by decreasing the discretionary accruals and audit aggressiveness. The robustness tests support this result. Practical implications – Sharia compliance is not limited to the business activity, financial restrictions, and Supervisory Board for Sharia-compliant companies. It also enhances the companies’ financial reporting quality. Robustness analysis also showed that IFRS increases the financial reporting quality by reducing discretionary accruals and audit aggressiveness. Originality/value – This research contributes to the accounting literature by providing insight into the use of Islamic financial instruments. The empirical results also show that the use of IFRS and Islamic financial instruments decreases the discretionary accruals and audit aggressiveness.