Abstract
This study aims to assess the subject of earnings exploitation and the extent to which Shariah-compliant and non-Shariah-compliant firms are likely to engage in these practices in the MENA region during the period between 2005 and 2009. Our results show that Sharaih-compliant firms are less likely to do earnings management in comparison to non-Shariah-compliant firms. Our results are robust across the civil law and common law countries and across the crises and the normal periods. However, care should be observed while interpreting our results. We argue that lower earnings management may be due to the very characteristics of Shariah-compliant firms and may have nothing to do with Islamic values. We argue that most of these firms do no observe Islamic values as evident by the fact that they do not advertise themselves as observing Shariah compliance.
1. Introduction
The second half of twentieth century is known for rebirth of Islamic philosophy whereby the masses started looking at the existing social systems through Islamic lenses and proposed modifications and improvements. The Muslim scholars and philosophers challenged the world's ruling economic systems and exposed their weaknesses.
The last two decades showed a tremendous growth in Islamic finance, which proved that Islamic finance is not a mere theory rather it is a reality. Recent strand of literature, for example, documents shariah-compliant assets to be worth US $511 billion in the MENA region and US $61 billion in the non-Muslim markets (The Banker, 2007). In addition, Al-Salem (2008) estimates growth rate of approximately 50% in Islamic Finance in the next ten years. Given this importance, it is worthwhile to document whether shariah-compliant firms disclose properly or not. The forms of doing business in Shariah compliant firms absolutely differentiate from conventional compliant firms. This difference is based on Shariah based financial instruments that consist of outcome sharing of both return and risk. Shariah based transactions means the financing modes adopted by Islamic Financial Institutions on profit and loss sharing basis including Musharaka (partnership in capital) and Mudaraba (partnership of capital and skill). Under Shariah based modes of financing return of financiers are not fixed in advance rather it depends upon the outcome of the project. Shariah-complaints are not getting their due share in the operations; however, loss is to be shared according to capital contribution. Moreover, Shariah compliant firms include most notably the prohibition of Riba (including interest) and Gharar (intentional or incomplete discourse) and the avoidance of revenues from prohibited sources.
The majority of investment portfolios of most Muslim investors are contributed by Shariah compliant products. The return of those investments is not fixed and predetermined. Such investments ease the risks since it is under the principles of profit and loss sharing; where the loss is to be shared according to capital contribution (Salman, 2007). Overall, observant Muslims can invest in Shariah compliant indices with relative confidence that their financial future will not be compromised as a result of following their moral or religious principles. Those religious principles are based on Shariah characteristic products that will be discussed lately. Moreover, Islamic investing is faith-based and as such a core component of Islamic system of financial management is the requirement to invest in compliance with Shariah percepts and principles. Furthermore, a great proportion of the Muslim community was not involved in any stock market investments due to Islamic prohibition of certain business activities, until the seventieth century. In the nineteenth century, when Islamic equity funds have started to operate, a major breakthrough took place in religious rulings related to equity investment. It has recently been estimated that the Islamic financial markets have $230 billion to invest, an amount that is growing annually by 15% (Hakim and Rashidian, 2004). Since that time till date, Muslim investors in Shariah compliant firms are becoming more sophisticated. The investors will not only look at investment performance or Shariah compatibility alone. They will demand both Shariah compliance and good returns. In fact, using the label 'Islamic' or 'Shariah compliant' advocate that the product is already adhering to the Shariah principles. Any violation of this rule would mean a loss of confidence in the product, firm or even the system itself. Therefore, it is in the industry's interest to ensure that the Shariah supervision system in the Shariah firms is well managed.
This paper examines the disclosure behavior and earnings management of Shariah and non-Shariah compliant firms in the MENA region through the pre-crisis, crisis and post crisis period during the years from 2005 to 2009 and in two different law regimes; civil law and common law. Our sample selected from MENA region including; Morocco, Egypt, Saudi Arabia, United Arab Emirates, Jordan, Kuwait, Qatar and Bahrain. Our data in this empirical study obtained from Worldscope and classified according to Dow Jones Islamic index classification. Our results of this study show that any firm that has leverage ratios, account receivables ratios, and cash ratios similar to Shariah-compliant firms will have lower chances to manage earnings. Our Evidences indicate that it is not Islamic values that cause firms to be truthful in their disclosure; rather there are other motives behind lower earnings management of Shariah-compliant firms. Moreover, those firms that are characterized as Shariah-compliant in our sample do not advertise themselves as Shariah-compliant. Hence, these firms have motives issue regarding their better earnings disclosure other than religion matter. Also, we tested regression in civil and common low Countries and results showed that less earnings management in common low countries, that characterized by better investor protection and high information disclosure. Pertaining to earnings management between Shariah-compliant firms and conventional ones was low during the crisis period, that characterized by more monitoring by regulatory authorities and investors, relative to normal period.
The rest of the paper is organized as follows: Section 2 discusses motivation and background for this study, followed by section 3 that explains the data used in this empirical study. Section 4 is the proceeding section that presents the methodology along with the assessment of our hypothesis, carried on by section 5 which discusses our results, derived to section 6 that presents conclusions.
2. Motivation and background
Over last two decades, the Islamic finance emerged as a novel paradigm in international financial scene with philosophies and principles different than the conventional finance. The main beliefs and value of the Islamic finance is that all information should be truthfully disclosed and should truly reflect its financial earnings (Salman, 2008). In addition, the transactions must be free of interest and should be based on the concept of profit-loss sharing. The business philosophy of firms following Islamic principles is same as that of conventional firms that is, to make profit. However, achievement of the business goal is not based on the idea 'end justifies the means'. The means have to be founded on pure meta-ethics, i.e. without any involvement in trade or business prohibited by Islamic law.
Although, Islamic firms or Shariah-compliant firms are in their early stages compared with the conventional firms, they have become an important asset class in international financial markets due to increasing awareness of investors. Salman (2007) also documented that shariah-compliant firms have done fairly well all over the world with respect to popularity and financial stability. In addition, the recent episode of global financial crisis has also brought shariah-compliant firms into the limelight due to their more prudent behavior. This paper is an attempt to document earnings management behavior of shariah-compliant firms in the MENA region.
Earnings management [1] is not considered as a new financial aspect; it has been prominent in the literature over years and along with passage of time researches have been done, more attention has been drawn, and many scholars started the ball rolling in this direction and defined the term.
The firms' accounts are manipulated by managers to achieve some predetermined objectives and motives. Such motives are including higher compensation, privileged prices of securities, dropping contractual costs, hiding poor performance of management, congregating investors' perceptions and meeting the targets of analysts. Yet, the law requires Shariah and non-Shariah compliant firms to disclose their financial statements according to national GAAP or IFRS as well as their information on a semi-annual and annual basis. It remains to be observed whether these requirements guarantee high quality of information and whether investors can rely on it for their investment decisions.
Since the information disclosure centers all codes and statues of all corporate governance specially Shariah ones, Shariah compliant firms should disclose their information more fairly and honestly following Shariah principles of no Gharar (intentional or incomplete disclosure). Earnings figures should truly reflect the exact and accurate figures that are disclosed in the Shariah firm's financial statements. Moreover, the disclosure must be carrying more transparency and openness and required to ensure distributive justice under Shariah firms, due to the reason that Islamic beliefs inspire firms to be more ethical and socially responsible (Salman, 2007). Given that, Islam channels all aspect of life and business (Rice, 1999); Usmani (2002) confirms that Islamic beliefs and principles weight the trusteeship [2] (Amana), where the business should be measured as a consecrated trust through the managers. The managers are required to operate according to the shareholders' and owners' interest (Siddiqi, 2002). Furthermore, this is highly associated with lower agency problems; therefore, better disclosure practices and less earnings management. Conversely, the non-Shariah-compliant firms that weight more on maximizing profit though weight less on the trusteeship significance and social responsibility principle. That led to more agency problems accompanied with higher agency and less disclosure along with significant earnings management.
Ultimately, the Shariah corporate governance inherited the fair and honest disclosure of financial statements as a view of the social responsibility that should be followed in Shariah compliant firms. Where, Shariah compliant firms have the duty to disclose information on their activities in ways that enable others to weigh the degree of their truthfulness and their appliances of Shariah principles. Hence, Shariah-complaints with the Islamic value that they follow, they should have less earnings management and better disclosure practices performed by managers that they act according to shareholders' interest and not to themselves motives.
H1: Shariah-compliant firms engage in lower earnings management than non-shariah-compliant firms
In addition, we argue that if our arguments regarding earnings management of shariah-compliant firms are true, we should expect this difference to exist even between firms operating in different legal regimes. However, the difference between earnings management of shariah-compliant firms and earnings management of non-shariah-compliant firms should be less in common law countries in comparison to civil law countries. Ball et al. (2000) suggest that the demand for accounting earnings is different in civil law countries than in common law countries. Common law countries are characterized by better investor protection, high information disclosure, and high risk of litigation relative to civil law countries. As a result, earnings management is more prevalent in firms from civil law countries relative to common law countries. Leuz et al. (2003) argue that benefits of earnings management outweigh the expected costs for firms in civil law countries.
H2: The difference between earnings management of shariah-compliant firms and earnings management of non-shariah-compliant firms is lower in common law countries relative to their difference in civil law countries
Furthermore, this paper argues that the difference in earnings management between shariah-compliant firms and other firms will be low during the crisis period relative to normal period. It is because crisis period is characterized by more monitoring by lenders, regulatory authorities, and investors. As a result, there is more likelihood that capital market participants "see through" the earnings management, if any, done by firms. This will, therefore, result in lower earnings management by firms who would, otherwise, engage increasingly in earnings misreporting. We also argue that crisis exposes firms to bankruptcy risk. Therefore, management tends to abide by debt covenants and disclose information, in order 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, we should expect lower earnings management by firms during the crisis period. Contrary to the crisis period, normal period presents lower incentives for stock market participants to monitor firms. Our arguments are consistent with Rajan and Zingales (1998) who argue that stock market participants ignore corporate governance mechanisms during the normal periods. Therefore, we expect non-shariah-compliant firms, who are expected to be less prudent than shariah-compliant firms, to engage in 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. Therefore, we should expect high earnings management for non-shariah-compliant firms during the normal periods relative to shariah-compliant firms.
H3: The difference between earnings management of shariah-compliant firms and earnings management of non-shariah-compliant firms is lower during the crisis period relative to their difference in the normal period
3. Data
This paper documents the difference between earnings management of shariah-compliant firms and earnings management of non-shariah-compliant firms for 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, Qatar, and Bahrain as the representative stock markets for the MENA region because of their relatively more development. The following sub-sections will explain the data in greater detail.
3.1 Classification of shariah-compliant and non-shariah-compliant firms
This paper uses classification used by Dow Jones to classify firms as shariah-compliant or non-shariah-compliant. The process used by Dow Jones to classify firms as shariah-compliant consist of two screens. In the first screen, all those firms that conduct their business in those areas that are prohibited (i.e. Haram) by Islamic Shariah are removed. In other words, any firm that derives its revenues from alcohol, pork related business, arms manufacturing, gambling, and conventional financial services. We use classification provided by ICB to identify the sectors and sub-sectors in which a firm operates in. Any firm that is found to operate in any of the prohibited sectors is classified as non-shariah-compliant firm. After removing firms with prohibited business activities, the remaining firms are examined for compliance with certain financial ratios and that's the second screen. Dow Jones identifies three ratios - leverage ratio, cash ratio, and liquidity ratio - all of which have to be below certain limit if a firm is to be classifies as a shariah-compliant firm. 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. Dow Jones sets the limit of leverage ratio to be below 33%. The cash ratio is defined as the sum of a company's cash and interest-bearing securities divided by trailing 12-month average market capitalization. The cash ratio also has to be below 33% for a firm to be a 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%. The data used in this classification was obtained from the Worldscope. Table 1 documents the number of shariah-compliant firms and the number of non-shariah-compliant firms in our sample. Panel A documents the number for each year, while Panel B and Panel C document the number for each country and industry respectively. Our results show that across each year, across each country, and across each industry, our sample contains more shariah-compliant firms than non-Shariah-compliant firms. The only exception is Technology sector where we have more non-Shariah-compliant firms.
[Insert Table 1 here]
3.2 Choice of earnings management variable
Prior studies use total accruals to detect earnings management. Healy (1985), for example, uses total accruals as a measure of earnings management, while De Angelo (1986) uses total accruals of the previous period as a proxy for the next period's earnings management. Both Healy (1985) and De Angelo (1986) assume that changes in non-discretionary accruals are equal to zero between periods. Empirical tests prove that such assumption is far from reality (Kaplan, 1985). Further studies, therefore, developed 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-A for the detailed methodology to calculate earnings management variable. The data used in classification was obtained from the Worldscope. Table 2 documents average earnings management by shariah-compliant firms and by non-shariah-compliant firms in our sample. Panel A documents the average earnings management for each year, while Panel B and Panel C 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.
[Insert Table 2 here]
3.3 Control variables
This empirical study uses a number of firm-specific characteristics, such as market value (SIZE), total debt to total asset ratio (LEV), dividend payout ratio (PoR), sales growth (GROWTH), and whether a firm is a profit firm or not (PROFIT) as control variables. We obtain the date for the above mentioned variables from the Worldscope. Table 3 documents the descriptive statistics for our control variables throughout our sample period. Panel A documents the descriptive statistics for the control variables used in our analysis and Panel B documents the correlation between different variables. An interesting observation in Table 3, Panel A, is that dividend payout ratios of shariah-compliant firms are significantly more than dividend payout ratios of non-shariah-compliant firms. We report payout ratio of almost 41% for shariah-compliant firms and almost 28% for non-shariah-compliant firms. It indicates better governance structure of shariah-compliant firms. Prior literature considers high dividend payout ratios as a mechanism via which firms can build their reputation. This literature argues that high payout ratios improve agency problems through the reduction of free cash flow available to managers (Grossman and Hart, 1980). In addition, the results in Table 3, Panel B, show no severe multicollinearity between our control variables. Therefore, we can include all of the control variables together in our regression equations.
[Insert Table 3 here]
4. Methodology
The main question in our analysis is to document the difference between earnings management of shariah-compliant firms and earnings management of non-shariah-compliant firms. In order to test this hypothesis, we estimate a regression with earnings management (EM) as a dependent variable and a dummy variable representing whether a firm is a shariah-compliant firm or not (ISLAMIC) as an independent variable. The EM is calculated using modified Jones model, while the ISLAMIC is a 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.
(1)
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, prior literature suggests that leveraged firms engage in earnings management to avoid debt covenant default (DeFond and Jiambalvo, 1994; Beatty and Weber, 2003). Therefore, we add total debt to total asset (LEV) as a proxy for leverage in our regression equation. We also add a variable representing firm's payout ratio (PoR) to control for the effect that corporate governance may have on earnings management. Firms with high payout ratios are supposed to have better information environment (Grossman and Hart, 1980). As a result, they should engage in lower earnings management than other firms. Furthermore, two variables representing whether a firm is a profit firm or not (PROFIT) and its sales growth (GROWTH) were also added in our regression equation. AlNajjar and Riahi-Belkaoui (2001) document higher earnings management for firms with high level of growth opportunities. Our modified regression equation takes the following form.
(2)
The results of the above set of regression are reported in the following sub-sections. The first section documents the difference between earnings management of shariah-compliant firms and earnings management of non-shariah-compliant firms for the entire sample, while the second and third section document similar relationships for a group of firms operating in different legal regimes and across periods characterized by different market conditions respectively.
4.1 Difference between earnings management of shariah-compliant firms and non-shariah-compliant firms
The results of the above set of regression are reported in Table 4. Our results from both equations show that shariah-compliant firms engage in lower earnings management than other 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 0.1503 basis points less than non-shariah-compliant firms. We argue that shariah-compliant firms may be more prudent in their behavior and thus report earnings more truthfully than non-shariah-compliant firms.
[Insert Table 4 here]
4.2 Difference between earnings management of shariah-compliant firms and non-shariah-compliant firms for firms operating in different legal regimes
In this section, we re-estimate Equation (1) and Equation (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. 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 considers common law to be associated with stronger investor protection (La Porta et al., 1999). Stronger investor protection should lower the difference between earnings management of shariah-compliant firms and earnings management of non-shariah-compliant firms. However, if shariah-compliance is important determinant of firm's earnings management behavior, we should still see a significant difference between earnings management of shariah-compliant firms and earnings management of non-shariah-compliant firms. The results of this analysis are reported in Table 5. Our results from both equations show that shariah-compliant firms engage in lower earnings management than other firms only in civil law countries. We report negative coefficient estimate of ISLAMIC for both equations. Our results show that there is no significance difference between Shariah-compliant firms and other firms in their earnings management behavior in common law countries.
[Insert Table 5 here]
4.3 Difference between earnings management of shariah-compliant firms and non-shariah-compliant firms for normal and crisis periods
In this section, we re-estimate Equation (1) and Equation (2) during the normal and the crisis periods. For the purpose of this paper, we consider year 2008 as a crisis period. This was the year during which MENA stock markets experienced sustained downward movement (Onour, 2010; Moriyama, 2010). Examining earnings management behavior of shariah-compliant firms and non-shariah-compliant firms across periods characterized by different market conditions may provide insights that may be otherwise masked. The results of our analysis are reported in Table 6. As was shown before, our results show significantly lower earnings management for shariah-compliant firms relative to non-shariah-compliant firms. The coefficient estimates on ISLAMIC is significant and negative for all estimations. An interesting observation from table 6 is that the difference between earnings management of shariah-compliant firms and earnings management of non-shariah-compliant firms is less during the crisis period. For example, estimation of Equation (2) during the normal period shows that difference between earnings management of shariah-compliant firms and other firms is 0.1712 basis points, while this difference is only 0.0696 basis points during the crisis period. It may be because lenders understand financial difficulties of non-shariah-compliant firms (because of their high leverage) and therefore are more likely to "see through" earnings management. As a result, it becomes hard for firms to manage their earnings. In addition, if management tries to escape its covenants or hide information, it stands to lose its credibility with lenders and risk its position with respect to debt renegotiations or obtaining financing. It will also reduce chances of managing earnings during the crisis period. Another interesting observation is that the adjusted-R² goes up significantly high during the crisis period. For example, we report adjusted-R² of 17.3% for Equation (1) and 19.2% for Equation (2).
[Insert Table 6 here]
5. Discussion of results
The results obtained in this paper should be interpreted cautiously. A closer look at the way practitioners and academicians define shariah-compliant firms would reveal that any firm that has leverage ratios, account receivables ratios, and cash ratios similar to shariah-compliant firms will have lower chances to manage earnings. The following sub-sections summarize evidence regarding the effect of each the three ratios on earnings management. The evidence in the following sub-sections indicate that it is not Islamic values/beliefs that cause firms to be forthright in their disclosure, rather there are other motives behind lower earnings management of shariah-compliant firms. Therefore, Care should be observed while interpreting our results.
5.1 Cash ratio and earnings management
Prior literature indicates that earnings management is higher among firms with surplus cash. Bukit and Iskandar (2009) document a positive relationship between cash increase and earnings management. Previous studies indicate that firms with high surplus cash face major agency problems, particularly when the cash is high but investment opportunities are low (Chung et al., 2005, Gul, 2001). This strand of literature argues that managers of these firms act opportunistically for personal gain and tend to get involved in unprofitable projects, over investments, and misuse the funds. Chung et al. (2005) argue that activities of managers belonging to such firms may bring benefits for them at the expense of shareholders. These managers tend to accounting procedures that increase reported earnings to hide the negative impact of projects. Therefore, in order to conceal these activities, managers are forced to manage earnings via accounting discretions.
5.2 Leverage ratio and earnings management
Previous literature suggests that leveraged firms engage in earnings management to avoid debt covenant default. Sweeney (1994) and Press and Weintrop (1990), amongst others, find that firms closer to violating debt covenants manage earnings more aggressively. Becker et al. (1998) also support this view by documenting that managers respond to debt contracting by strategically reporting discretionary accruals. In addition, Richardson et al. (2002) also show that debt covenants (i.e. leverage) are the main motivation for aggressive accounting policies.
5.3 Account receivable ratio and earnings management
Prior literature documents a positive relationship between account receivables and earnings management. Kothari (2005), for example, shows increase in account receivables results in earnings manipulation by the management. He also argues that since collection of account receivables is related to increase in revenues, account receivables can also be used as a proxy for earning management. Intuitively, high level of account receivables provides management with more flexibility to manipulate accounting statements. Therefore, firms with high level of account receivables are more likely to engage in earnings management than other firms.
5.4 Are Shariah-compliant firms really Shariah-compliant?
An interesting observation that we find during this research was that overwhelming majority of those firms that are characterized as shariah-compliant in our sample do not advertise themselves as shariah-compliant. We, randomly, visited the website of almost 150 shariah-compliant firms and found out that only 3 of them mention that they conduct their business in accordance with shariah and Islamic values on the websites. This behavior of shariah-compliant firms is in contrast with their financial counterparts who aggressively advertise themselves as shariah-compliant. This behavior of shariah-compliant firms leads us to argue that these firms may be observing shariah compliance because of motives other than religion. If this is the case, then better disclosure of these firms may not be attributed to Islamic values. Therefore, we argue that it may not be the shariah or Islamic values that are causing these firms to be more truthful and forthcoming about their earnings disclosure, but the accounting characteristics that do not provide opportunity for these firms to engage in earnings manipulation.
6. Conclusion
This paper explores the popularity of Islamic compliant firms that has been growing not only for Muslims but also for non Muslims who are looking for safe compliant firms operations especially after the credit crunch of 2008. Our results show that non-Sharihah firms significantly managed their earnings during the period between 2005 and 2009 when compared to Shariah-compliant firms. However, we argue that lower earnings management of Shariah-compliant firms may not be due to the Islamic value; rather it is due to the very characteristics of these firms. Thus, those firms that are characterized as Shariah-compliant in our sample are not meant to be Shariah-compliant since they don't advertise themselves. Besides, any firm that has financial ratios; certainly, leverage, account receivables cash ratio, similar to Shariah-compliant firms will have lower chances to manage earnings and better disclosure behavior.
