Journal of Islamic Accounting and Business Research

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

compliant firms: Evidence from the MENA region
Omar Farooq, Allaa AbdelBari,
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and non-Shariah-compliant firms: Evidence from the MENA region", Journal of Islamic Accounting
and Business Research, Vol. 6 Issue: 2, pp.173-188, https://doi.org/10.1108/JIABR-07-2013-0021
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Earnings management behaviour Earnings

management
of Shariah-compliant firms and behaviour
non-Shariah-compliant firms
Evidence from the MENA region 173
Omar Farooq Received 1 July 2013
Department of Management, American University in Cairo, Cairo, Egypt, and Revised 1 April 2014
Accepted 15 April 2014
Allaa AbdelBari
School of Business Administration, Al Akhawayn University in Ifrane,
Ifrane, Morocco
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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

1. Introduction Journal of Islamic Accounting and

Do Shariah-compliant firms differ from other firms in the quality of information Business Research
Vol. 6 No. 2, 2015
disclosure? Can investors consider information disclosed by Shariah-compliant firms pp. 173-188
© Emerald Group Publishing Limited
1759-0817
JEL classification – G34, M14 DOI 10.1108/JIABR-07-2013-0021
 JIABR more truthful than information disclosed by other firms? The answers to these questions
6,2 are important for those investors who consider stock market transactions as un-Islamic
and as a cover for speculative activities (ElGari, 1993). These investors confuse risk with
gharar and gambling. Consequently, they also shy away from investing in stock
markets. To attract these reluctant investors, firms should take some credible actions,
such as compliance with Islamic Shariah/beliefs. Such actions can alter the perceptions
174 of these reluctant investors regarding stock market investment. Omran (2009) argue
that one of the reasons why investors invest in Shariah-compliant firms is the Islamic
image reflected by these firms. This paper argues that the Islamic image projected by
Shariah-compliant firms should also be reflected in the broader functioning of these
firms. One such aspect is information disclosure. Shariah-compliant firms should
disclose more truthfully than other firms. Failing to do so may result in vanishing of
trust that these Shariah-conscious investors pose in stock market investment, thereby
allowing them to exit stock market.
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This paper is an attempt to document quality of information disclosure of

Shariah-compliant firms relative to other firms in the MENA (Morocco, Jordan, Bahrain,
Egypt, Kuwait, United Arab of Emirates, Saudi Arabia and Qatar) region during the
period between 2005 and 2009. For the purpose of this paper, we measure quality of
information disclosure by the extent to which firms engage in earnings management.
Healy and Wahlen (1999) consider earnings management as the modification of firms’
reported economic performance by insiders to mislead stakeholders. Using a method of
classification provided by the Dow Jones, we show that Shariah-compliant firms engage
in lower earnings management than non-Shariah-compliant firms. Regression analyses,
for example, show that earnings management of Shariah-compliant firms is 0.0311 basis
points less than earnings management of non-Shariah-compliant firms. Our results are
consistent with our arguments suggesting that financial characteristics of
Shariah-compliant firms (low leverage, low account receivables and low cash) are such
that it provides lower chances to managers to misreport earnings. Prior literature
suggests that firms with low level of debt, low level of account receivables and low level
of cash reserves engage in lower earnings manipulation than otherwise similar firms
with high level of debt, high level of account receivables and high level of cash reserves
(Becker et al., 1998; Caylor, 2009; Bukit and Iskandar, 2009). Our results are an indication
that stock market participants can obtain more valuable information from financial
statements of Shariah-compliant firms than from financial statements of non-
Shariah-compliant firms.
Interestingly, we show that our results only hold true in the civil law countries and
during the normal time periods. We report 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 periods.
We argue that stronger investor protection provided in the common law countries
should result in better disclosure from both groups (La Porta et al., 1999). As a result, any
difference in earnings management between the two groups should disappear. In
addition, demand for accounting earnings is different in the civil law countries than in
the common law countries. Prior literature documents that the common law countries
are characterized by high information disclosure and high risk of litigation relative to
the civil law countries (Ball et al., 2000). As a result, firms are inclined to be more truthful
and forthright in information disclosure in the common law countries. It should,
 therefore, result in no significant difference between earnings management behaviour of Earnings
the two groups. In case of the crisis period, we argue that this period is marked by management
increased scrutiny from stock market participants. This, therefore, results in lower behaviour
earnings management by all firms. Consequently, the difference between earnings
management of Shariah-compliant firms and earnings management of non-Shariah-
compliant firms is minimized.
We believe that our results should not be taken as an evidence of how religion 175
influences decision-making in firms. Our arguments show that it is the financial
characteristics rather than the religion that affect earnings management. Prior literature
suggests that any firm that has characteristics similar to Shariah-compliant firms (low
leverage, low account receivables and low excess cash) should have lower chances to
manage earnings (Bukit and Iskandar, 2009; Sweeney, 1994). To complement the fact
that it is not the religion that influences earnings disclosure, we find that only three
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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.

2. Motivation and background

Recently, Islamic finance has emerged on international financial scene as a novel
paradigm. It advocates that Islamic Shariah should be the source of any decision that a
firm makes, and, in doing so, Islamic Shariah should take precedence over traditional
economic rationale whenever there is conflict between the two. Greater emphasis on
religion has prompted many investors, which were otherwise passive, to take active
interest in stock market investment. As a result, the market for Shariah-compliant
financial products grew at about 15-20 per cent during the past few years. Recent
evidence suggests that, worldwide, Shariah-compliant assets are worth US$822 billion
(Economist, 2009). Given the importance of Shariah-compliant assets, this paper aims to
document quality of information disclosure by Shariah-compliant firms in the MENA
region. We measure quality of information disclosure by the extent of earnings
management. Prior literature considers earnings management as a mechanism via
which modification of firms’ reported economic performance by insiders takes place to
mislead the stakeholders (Schipper, 1989; Healy and Wahlen, 1999). This strand of
literature argues that insiders engage in earnings management to hide their rent-seeking
and unscrupulous activities from outsiders. For example, insiders can use their
discretion to inaccurately reflect firm performance, thereby weakening the ability of
 JIABR outsiders to govern them. The following sub-section will briefly discuss why and how
6,2 Shariah compliance affects the extent of earnings management.

2.1 Financial characteristics of Shariah-compliant firms and earnings management

One of the requirements for a firm to be Shariah-compliant is to have low leverage, low
account receivables and low cash and interest bearing securities (see Section 3 for more
176 details on the requirement of Shariah compliance). Prior literature documents that all of
the three characteristics lead to lower earnings management. For instance, Richardson
et al. (2002) document that debt covenants are the main motivation for aggressive
accounting policies. Therefore, firms that do not have debt obligations are less inclined
to misrepresent their earnings. In another related study, Becker et al. (1998) show that
managers respond to debt contracting by strategically reporting discretionary accruals.
Press and Weintrop (1990) and Sweeney (1994) support the above findings by
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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.

2.2 Clientele effect and earnings management of Shariah-compliant firms

Muslims form almost one-quarter of the world’s population. Traditionally, vast majority
of Muslims have stayed away from stock market investment because they associated it
with gharar and gambling. However, emergence of Islamic finance has brought these
investors to the market (Omran, 2009). We argue that these investors constitute an
 important clientele of Shariah-compliant firms. Numerous funds have also sprung up Earnings
that only invest in Shariah-compliant assets. This new clientele of investors can management
constitute an important monitoring device. Brickley et al. (1988) note that institutional
investors, such as mutual funds and public pension funds, are effective monitors. They
behaviour
document that these institutional investors are willing to challenge the management and
have the expertise to monitor them. As a result, it becomes hard for the management to
engage in earnings manipulation. In another related study, Balsam et al. (2002) 177
document that institutional investors are able to quickly recognize earnings
management by firms. They argue that institutions, usually, have a large stake in firms.
As a result, there is significant economic incentive to monitor managers. Consistent with
this strand of literature, we argue that Shariah-compliant firms should manage lower
earnings than non-Shariah-compliant firms:
H1. There is lower earnings management in Shariah-compliant firms than in
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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.

3.1 Classification of Shariah-compliant and non-Shariah-compliant firms

We use the classification used by the Dow Jones to categorize firms as
Shariah-compliant or non-Shariah-compliant. The process used by the Dow Jones
consists of two steps. The first step classifies all those firms that conduct their business
in sectors prohibited by Islamic Shariah as non-Shariah-compliant firms. This step
classifies any firm that derives its revenues from alcohol, pork related business, arms
manufacturing, gambling and conventional financial services as a non-Shariah-
compliant firm. We use classification provided by Industry Classification Benchmark to
identify the sectors and sub-sectors in which a firm operates. In the second step, all firms
that were classified as those that operate in Shariah-compliant sectors are examined for
compliance with certain financial ratios. The Dow Jones identifies three ratios – leverage
ratio, cash ratio and liquidity ratio – all of which have to be below a certain limit for a
firm to be Shariah-compliant. The leverage ratio is defined as total debt divided by
trailing 12-month average market capitalization. According to Shariah, a firm should
ideally have no interest-based debt. The Dow Jones sets the limit of leverage ratio to be
below 33 per cent. The cash ratio is defined as the sum of a firm’s cash and
interest-bearing securities divided by trailing 12-month average market capitalization.
The cash ratio also has to be below 33 per cent for a firm to be Shariah-compliant. The
liquidity ratio is defined as accounts receivables divided by trailing 12-month average
market capitalization. This ratio also has to be below 33 per cent. The data used in this
classification were obtained from the Worldscope. Table I documents the number of
Shariah-compliant firms and the number of non-Shariah-compliant firms in our sample.
Table I documents the number for each year, while Table II and Table III document the
 JIABR number for each country and industry, respectively. Interestingly, we report more
6,2 Shariah-compliant firms than non-Shariah-compliant firms in our sample. These results
hold for all years and for most countries and industries. The only exception is Kuwait,
where we have more non-Shariah-compliant firms than Shariah-compliant firms.

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

Countries Shariah-compliant firms Non-Shariah-compliant firms

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

Industry Shariah-compliant firms Non-Shariah-compliant firms

Oil and Gas 26 26

Basic materials 67 49
Industrials 228 95
Consumer goods 99 53
Healthcare 15 3
Consumer services 62 37
Telecommunication 38 7
Table III. Utilities 7 7
Number of Shariah- Technology 4 8
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,
industries United Arab Emirates, Saudi Arabia and Qatar. The sample period is from 2005 to 2009
 3.2 Choice of earnings management variable Earnings
Prior studies use total accruals to detect earnings management. Healy (1985), for management
example, uses total accruals as a measure of earnings management, while DeAngelo
(1986) uses total accruals of the previous period as a proxy for the next period’s earnings
behaviour
management. Both Healy (1985) and DeAngelo (1986) assume that changes in
non-discretionary accruals are equal to zero between periods. Empirical tests prove that
this assumption is far from reality (Kaplan, 1985). Further studies, therefore, developed 179
models that distinguished between discretionary and non-discretionary component of
accruals. Jones (1991) uses an estimate of the discretionary component of total accruals
as a measure of earnings management. One of the limitations of Jones model is the
assumption that earnings are non-discretionary. The modified Jones model was built to
overcome this limitation. This paper uses the modified Jones model to come up with a
proxy for earnings management. See Appendix for the detailed methodology to
calculate earnings management variable. The data used in classification were obtained
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from the Worldscope. Table IV documents average earnings management of

Shariah-compliant firms and of non-Shariah-compliant firms in our sample. Table IV
documents the average earnings management for each year, while Table V and Table VI
document similar statistics for each country and industry, respectively. The results
show that Shariah-compliant firms consistently understate their earnings. The
discretionary accruals, our proxy for earnings management, are negative in all years, in
all countries and in all industries. Contrary to Shariah-compliant firms,
non-Shariah-compliant firms, on average, overstate their earnings. The discretionary
accruals are mostly positive for non-Shariah-compliant firms.

3.3 Control variables

This paper uses a number of firm-specific characteristics, such as market value (SIZE),
operational complexity (COMP), profitability (PROFIT) and sales growth (GROWTH)
as control variables. We obtain the data for the above-mentioned variables from the
Worldscope. Table VII documents the descriptive statistics for our control variables
during our sample period. Table VII documents the descriptive statistics for the control
variables used in our analysis and Table VIII documents the correlation between
different variables. An interesting observation in Table VII is that Shariah-compliant
firms and non-Shariah-compliant firms have approximately similar size, operational
complexity, profitability and growth. It shows homogeneity of the two groups.

Years Shariah-compliant firms Non-Shariah-compliant firms

2005 ⫺0.0004 0.0093

2006 ⫺0.0869 ⫺0.0035
2007 ⫺0.0303 0.0133
2008 ⫺0.0499 ⫺0.0256 Table IV.
2009 ⫺0.0623 ⫺0.0532 Earnings
management of
Notes: The following table documents average earnings management of Shariah-compliant firms and Shariah-compliant
earnings management of non-Shariah-compliant firms. The sample comprises firms from Morocco, and non-Shariah-
Jordan, Bahrain, Egypt, Kuwait, United Arab Emirates, Saudi Arabia and Qatar. The sample period is compliant firms in
from 2005 to 2009 different years
 JIABR Therefore, if one group has different earnings management from the other, their
6,2 distinguishing feature, i.e. Shariah compliance, may be responsible for that. In addition, the
results in Table VIII show no severe multicollinearity between our control variables.
Therefore, we can include all of the control variables together in our regression equations.

180 Countries Shariah-compliant firms Non-Shariah-compliant firms

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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Earnings United Arab Emirates ⫺0.0236 ⫺0.0116

management of
Shariah-compliant Notes: The following table documents average earnings management of Shariah-compliant firms and
and non-Shariah- earnings management of non-Shariah-compliant firms. The sample comprises firms from Morocco,
compliant firms in Jordan, Bahrain, Egypt, Kuwait, United Arab Emirates, Saudi Arabia and Qatar. The sample period is
different countries from 2005 to 2009

Industry Shariah-compliant firms Non-Shariah-compliant firms

Oil and Gas ⫺0.1054 ⫺0.0116

Basic Materials ⫺0.0001 0.0105
Industrials ⫺0.0373 0.0054
Consumer Goods ⫺0.0458 ⫺0.0271
Health care ⫺0.0344 0.0267
Consumer Services ⫺0.0577 ⫺0.0572
Telecommunication ⫺0.1552 ⫺0.1463
Table VI. Utilities ⫺0.0555 ⫺0.0967
Earnings Technology ⫺0.0634 ⫺0.0860
management of
Shariah-compliant Notes: The following table documents average earnings management of Shariah-compliant firms and
and non-Shariah- earnings management of non-Shariah-compliant firms. The sample comprises firms from Morocco,
compliant firms in Jordan, Bahrain, Egypt, Kuwait, United Arab Emirates, Saudi Arabia and Qatar. The sample period is
different industries from 2005 to 2009

Variables Shariah-compliant firms Non-Shariah-compliant firms

Size 7.1299 6.7814

Profit (%) 92.80 87.58
Complexity 0.1293 0.1157
Growth 14.6709 15.5187

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:

EM ⫽ ␣ ⫹ ␤1( ISLAMIC ) ⫹ 兺␤ Year(

YDUM ) ⫹ 兺␤ Ind(
IDUM )
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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:

Variables Size Profit Complexity Growth

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

Variables Equation (1) Equation (2)

Islamic ⫺0.0304*** ⫺0.0311**

Size 0.0190***
Profit 0.0514***
Complexiity ⫺0.1377***
Growth 0.0004*
Industry dummies Yes Yes
Year dummies Yes Yes
Country dummies Yes Yes
Number of observations 761 586
F-Value 4.91 6.06
Table IX. Adjusted-R2 0.091 0.144
Difference between
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 equations (1)
Shariah-compliant and (2). The sample comprises firms from Morocco, Jordan, Bahrain, Egypt, Kuwait, United Arab
and non-Shariah- Emirates, Saudi Arabia and Qatar. The sample period is from 2005 to 2009. The coefficient that are
compliant firms significant at 10% are followed by * , those at 5% and 1% by ** and *** , respectively
 believe that difference in earnings management of Shariah-compliant firms and the Earnings
other firms should be less pronounced during the crisis period relative to the normal management
period. It is because the crisis period is considered to have more monitoring by
lenders, regulatory authorities and investors. As a result, there is more likelihood
behaviour
that capital market participants are able to recognize the earnings management
done by firms. This will, therefore, result in lower earnings management by firms
who would, otherwise, engage increasingly in accounting misreporting. We also 183
believe that crisis exposes firms to bankruptcy risk. Therefore, management tends
to abide by debt covenants and disclose information to secure reputation and
credibility in front of investors and lenders. Any misreporting will make it hard for
firms to generate financing for themselves if something unexpected happens. As a
result, there should be lower earnings management by firms during the crisis period.
Contrary to the crisis period, the normal period presents lower incentives for stock
market participants to monitor firms. Rajan and Zingales (1998) argue that stock
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market participants ignore corporate governance mechanisms during the normal

periods. Therefore, we expect firms to engage in relatively more earnings
management during the normal periods. Furthermore, a casual look at our sample
period would show that the most part of the normal period was characterized by
high growth regime, implying that firms on average had positive earnings. Given
the economic upturn, it is likely that managers may engage in earnings management
that increase earnings to either sustain previous year’s earnings or to meet/beat
analyst forecasts. Consequently, we should expect high earnings management for
firms during the normal periods. However, we argue that this behaviour should be
less prominent in Shariah-compliant firms, who have such characteristics that do
not allow them to engage in earnings misreporting. The results of our analysis are
reported in Table X. Our results show significantly lower earnings management for
Shariah-compliant firms relative to non-Shariah-compliant firms during the normal
period. We report significantly negative coefficient estimates on ISLAMIC for both
equations during the normal period. Our result also show that difference between
earnings management of Shariah-compliant firms and earnings management of
non-Shariah-compliant firms is less pronounced during the crisis period. We show
that coefficient estimates on ISLAMIC becomes insignificant in equation (2) during
the crisis period. It may be because stock market participants understand financial
difficulties of firms and are more vigilant in monitoring. As a result, it becomes hard
for non-Shariah-compliant firms to manage their earnings, thereby eliminating the
difference in earnings management between the two groups.

5.2 Difference between earnings management of Shariah-compliant firms and

earnings management of non-Shariah-compliant firms in different legal regimes
In this section, we re-estimate equations (1 and 2) for a sample of firms operating in
different legal regimes. For the purpose of this analysis, we classify Bahrain, United
Arab of Emirates and Saudi Arabia as common law countries and Morocco, Jordan,
Egypt, Kuwait and Qatar as civil law countries (La Porta et al., 1999). The
motivation behind analyzing the difference between earnings management of
Shariah-compliant firms and earnings management of non-Shariah-compliant firms
in different legal regimes is based on prior literature that suggest that the demand
for accounting earnings is different in civil law countries than in common law
 JIABR Normal Period Crisis Period
6,2 Variables Equation (1) Equation (2) Equation (1) Equation (2)

Islamic ⫺0.0270** ⫺0.0345** ⫺0.0528** ⫺0.0281

Size 0.0196*** 0.0187**
Profit 0.0478** 0.0450
184 Complexity ⫺0.1172* ⫺0.2074**
Growth 0.0004 0.0002
Industry dummies Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes
Country dummies Yes Yes Yes Yes
Number of observations 582 451 179 135
F-Value 4.01 4.32 3.43 5.00
Table X. Adjusted-R2 0.087 0.123 0.138 0.257
Difference between
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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.

5.3 Is it religion that causes Shariah-compliant firms to engage in lower earnings

management than non-Shariah-compliant firms?
We also tried to investigate whether religion is the main source behind firms adopting
Shariah-compliant characteristics. To do so, we randomly visited the website of almost
150 Shariah-compliant firms and found out that only three of them mention that they
conduct their business in accordance with Shariah and Islamic values. This behaviour of
Shariah-compliant firms is in contrast with their financial counterparts who
 Common law Civil law
Earnings
Variables Equation (1) Equation (2) Equation (1) Equation (2) management
behaviour
Islamic ⫺0.0320 ⫺0.0127 ⫺0.0315** ⫺0.0415**
Size 0.0150** 0.0204***
Profit 0.0070 0.0717***
Complexity ⫺0.0209 ⫺0.1648***
Growth ⫺0.0008** 0.0003
185
Industry Dummies Yes Yes Yes Yes
Year Dummies Yes Yes Yes Yes
Country Dummies Yes Yes Yes Yes
Number of observations 246 214 515 372
F-Value 2.50 4.67 4.14 4.84 Table XI.
Adjusted-R2 0.082 0.063 0.086 0.159 Difference between
earnings
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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

aggressively advertise themselves as Shariah-compliant. This behaviour of

Shariah-compliant firms leads us to argue that these firms may be observing Shariah
compliance because of motives other than religion. If this was not the case, they would
have advertised themselves as Shariah-compliant to attract wider investor base.
Consequently, we argue that it may not be the religion that is causing Shariah-compliant
firms to be more truthful and forthright in their earnings disclosure. Instead, it may be
the accounting characteristics that do not provide opportunity to these firms to engage
in earnings manipulation.

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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Appendix: Construction of earnings management measure

The modified Jones calculates total accruals as follows:

( CCAt ⫺ CCLt ⫺ CCasht ⫹ CSTDt ⫺ Dept )

TAt ⫽ (A1)
At⫺1

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)

Where NDAt is non-discretionary accrual at t; CREVt is change in revenues at t, CRECt is change

in net receivables at t; and PPEt is property, plant and equipment (fixed assets at t). The values of
␤1, ␤2, and ␤3 are estimated by regressing total accruals against the inverse of one period lagged
total asset, PPE and CREV:
 JIABR
6,2
TAt ⫽ ␤1 共 兲
1
At⫺1
⫹ ␤2( CREVt ) ⫹ ␤3( PPEt ) ⫹ ␧t (A3)

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)

Discretionary accrual was used as a measure of earnings management in this paper.

Corresponding author
Omar Farooq can be contacted at: omar.farooq.awan@gmail.com
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