Earnings management in financial institutions: A comparative study of Islamic banks and conventional banks in emerging markets

Abstract

This study seeks to examine earnings management practices of Islamic banks and conventional banks in emerging markets. Built upon the notion that organisations with higher ethical considerations are likely to have less severe agency problems, this study hypothesises that Islamic banks with their emphasis on religious and ethical principles would engage in lower earnings management practices as compared to conventional banks. In addition, this study also examines the effects of ownership structure towards earnings management of Islamic banks and conventional banks. This study employs a unique hand-collected financial dataset of 53 Islamic banks and 111 conventional banks over the period of 2006 to 2011 with a total of 838 bank-year observations. Inconsistent with the study's expectation, the results indicate that Islamic banks employ higher earnings management practices through abnormal loan loss provisions (ALLP) as well as to report small positive earnings (SMPOS) compared to their conventional counterparts. These findings are not parallel with Islamic notions of accountability, fairness and justice ethical concepts that should be embedded in all aspects of Islamic banks business activities. The results also show that high ownership concentration exacerbates earnings management practices through ALLP which suggest the entrenchment effect of the controlling owners to hide their private benefit extractions. This study offers some useful insights that in order to uphold the authenticity of Islamic ethical values in Islamic banks business practices, bank regulators should monitor the number of debt-based financial instruments and at the same time encourage the use of profit and loss sharing (PLS) mode of financial products in Islamic banking operations.