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Can Inclusion in Religious Index Membership Mitigate Earnings Management?

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Abstract

This paper investigates whether religious-based index membership is important in mitigating earnings management. Using a large sample of firms domiciled across 12 European countries, our empirical results show that firms included in the Shariah-compliant index, as a proxy for religious index, are more likely to engage in accruals manipulation vis-a-vis non-Shariah-compliant firms. Our results are robust using the Heckman two-stage treatment effect model, weighted least squares model, alternative earnings quality metrics and after controlling for the potential effects of home-country characteristics. Furthermore, our empirical results indicate that corporate governance of Shariah-compliant firms does not constrain managerial opportunistic behaviour in misreporting earnings, and firms that with low scores of board functions, shareholder rights and vision and strategy are more likely to engage in earnings management. Further, Shariah-compliant firms domiciled in Coordinated Market Economies are more likely to manipulate earnings than those in Liberal Market Economies. Taken together, our findings suggest that the Shariah index membership does not indicate good corporate governance that can mitigate earnings management, and it may serve as a legitimacy mechanism to conform to stakeholders’ expectations. Our findings support arguments that the religious-based index membership is plausibly used as a ‘label’ and an impression management tool to attract investment.

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Notes

  1. To be considered as a Shariah-compliant firm, Muslim scholars have introduced Shariah-screening process that detects any unacceptable activities according to Shariah principles. This screening process is usually conducted by a board called Shariah supervisory boards to ensure a firm’s activities to conform to the moral codes of Islam. The screening processes are set up in two groups which are (i) business compliance, and (ii) financial ratios (FTSE Russell 2019). The business compliance screening process relate to both main activities and revenue allocation of firms. That is, a firm should not engage in prohibited activities such as conventional finance (whose activities are interest-based), alcohol, weapons, arms and defence manufacturing, tobacco, non-halal food production, and some entertainment business, e.g. casinos and gambling. A firm that belongs to the legitimate industries is also examined on the terms of its revenue allocation. For instance, if a firm that has a business activity in non-halal segments, it is also considered as inappropriate according to Shariah principles. In addition, even when a firm’s activities are acceptable but it engages in trade debt either as a borrower or lender is deemed unacceptable. Financial ratio is the second Shariah-screening process and it is aimed at detecting the non-Shariah compliant financing and earnings. That is, Shariah forbids interest or the use of cash as assets. In so doing, the financial ratio screening concentrates on a firm’s leverage, liquidity, interest and non-permissible income.

  2. The following financial ratios must be met for firms to be considered Shariah-compliant (FTSE Russell 2019): (i) debt is less than 33.333% of total assets, (ii) cash and interest bearing items are less than 33.333% of total assets, (iii) accounts receivable and cash are less than 50% of total assets, (iv) total interest and non-compliant activities income should not exceed 5% of total revenue.

  3. The tolerance level of non-permissible activities is introduced be scholars as a result of the complexity of the existing capital market in which most of firms are involved in the trading debt owing to the existence of cash deposits, loans or credits.

  4. For a detailed discussion on the rationale for financial ratios please see Obaidullah (2005) and Derigs and Marzban (2008).

  5. Consistent with the Islamic accountability perspective, managers should safeguard the investors’ investments as results of trust between them, and in so doing, conduct business activities in an ethical and transparent manner along the principles of equity, justice and benevolence (Beekun and Badawi 2005).

  6. For instance, as a result of functional division of roles between the principals and agents, managers are the company’s agents whose responsibility is to achieve the corporate goals as well as balance the interests of various stakeholders. However, they are not entirely accountable for all their own decisions’ outcomes. This may result in suboptimal behaviour and decisions that managers might make to serve their self-interests at the expense of other capital holders (Oh et al. 2011).

  7. The incentives and objectives of capital holders are different from those of managers, for example, mangers will be concerned with a firm’s total risk whereas diversified shareholders will only be concerned with a firm’s systemic risk (Munari et al. 2010).

  8. In term of the representativeness, as of 2019, the FTSE Global Shariah Index has more than 1400 Shariah compliant constituents with a market capitalization of over 17 trillion US dollars (FTSE Russell 2019).

  9. For a detailed discussion on the Shariah based screening criteria adopted by major index providers please see Ashraf (2016).

  10. Becker et al. (1998) content that, on average, managers have greater discretion over current accruals as compared to total accruals.

  11. We thank an anonymous reviewer for this insight.

  12. We also run the VIF factor to check for multicollinearity among explanatory variables. The untabulated results show there is no VIF above 2.0.

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Acknowledgements

The author wishes to thank section editor Harry Van Buren III and two anonymous reviewers for their helpful comments and suggestions in developing this paper.

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    Abdullah Alsaadi

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Appendix A

Appendix A

Variables definitions

Variables

Description

Definition

Main variables

 \(EM1\)

The absolute value of current discretionary accruals

Discretionary accruals are calculated through the cross-sectional modified Jones model adjusted for performance

 \({\text{Shariah}}\)

Shariah index membership

An indicator variable that takes a value of 1 if the firm is included in FTSE Shariah Index, 0 otherwise

Firm-level controls

 \({\text{CG}}\;{\text{scores}}\)

Corporate governance scores

The scores of Corporate Governance obtained from ASSETS’s.

 \({\text{SIZE}}\)

Firm size

The natural logarithm of the market value of the equity

 \({\text{Growth}}\)

Firm growth

Market-to-book equity ratio measured as market value of equity divided by book value of equity

Profitability

Profitability

Measured as income before extraordinary items divided by the total assets

 \({\text{Leverage}}\)

Leverage

calculated as long-term debt scaled by total assets

 \({\text{Ownership}}\)

Ownership concentration

The percentage of closely held share as reported by WorldScope

 \(Big4\)

The Big 4 auditors

An indicator variable, which takes a value of 1 when a firm is audited by the Big 4 auditors, and 0 otherwise.

 \({\text{Age}}\)

Firm size

The natural logarithm of the firm age in years

Country-level controls

 \({\text{Disclosure}}\)

Disclosure scores

Country-level disclosure scores as reported in La Porta et al. (2006). Higher scores indicate a better disclosure and a greater transparency

 \({\text{Governance}}\)

Governance scores

Country-level governance scores as reported in Bushman et al. (2004). Higher scores indicate a better governance and greater transparency

 \({\text{AntiDirRight}}\)

Anti-director rights

Country-level scores for anti-director rights as reported in Atwood et al. (2012). Higher scores indicate less director-related rights

 \({\text{CivCom}}\)

Civil versus common law

Country-level index for civil versus common law as reported in La Porta et al. (1998), measured as a dummy variable equal to one for civil law and zero for common law countries

 \({\text{OwnCon}}\)

Ownership concentration

Country-level scores for ownership concentration as reported in La Porta et al. (1998). It is computed as the average percentage of common shares owned by the three largest shareholders in the 10 largest nonfinancial, privately owned domestic firms in a given country. The higher the scores is the more concentrated ownership

 \({\text{IFRS}}\)

IFRS adoption

An indicator variable equal to one for the period of mandatory adoption of IFRS (after 2005), and zero otherwise

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Alsaadi, A. Can Inclusion in Religious Index Membership Mitigate Earnings Management?. J Bus Ethics 169, 333–354 (2021). https://doi.org/10.1007/s10551-019-04280-y

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  • DOI: https://doi.org/10.1007/s10551-019-04280-y

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