Earnings management behaviour of Shariah-compliant firms and non-Shariah-compliant firms

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.