Earnings Management: Evidence Concerning Shariah-approved Companies in Malaysia

Abstract

This study addresses the uniqueness of the Malaysian capital market in which the Islamic Capital Market (ICM) runs parallel with the conventional capital market. Little research has been carried out on the determinants of earnings management, particularly in the ICM. This study extends this line of research by using Agency Theory as a basis for the occurrence of earnings management and investigating the relationship between earnings management and corporate governance characteristics in the Malaysian ICM, where there is no reason to suspect systematic management of earnings since such activities are not permitted by Shariah law. Selected corporate governance practices (board of directors, audit committee and institutional investors’ characteristics) are examined along with specific characteristics of Shariah-approved companies (size, leverage, growth, profitability and industry) as factors that influence earnings management. Using three established earnings management models (the Jones Model, the Modified Jones Model, and the Performance Matched Model); this study finds that there is income-decreasing earnings management in Shariah-approved companies that are listed on Bursa Malaysia. This study reveals a significant negative relationship between earnings management and the holding of multiple directorships. The results also indicate that there is a positive statistical relationship between the audit committee characteristics of independence and expertise with earnings management. Further analysis shows that having one audit committee member with financial expertise, as suggested by the Malaysian Code of Corporate Governance, does act as a control mechanism and is effective in reducing earnings management. In addition, a significant relationship between board size and earnings management is found. Consistent with previous studies, there is a significant relationship between firm size, leverage, performance and growth, and earnings management. Furthermore, companies in the Property and Construction sectors are found to be more likely to manage their earnings as compared to companies in other industry sectors. This study provides early evidence that a stronger corporate governance mechanism is needed to enhance the quality of financial reporting in the Malaysian context. It is expected that the results of this study will give further direction to the Malaysian regulatory bodies regarding the mechanisms of corporate governance in the country. As the Malaysian ICM is new and unique, subject to Shariah law as well as ‘conventional’ rules and regulations, the result of this study may not be generalized to Islamic markets worldwide as the application of accounting standards and practices in Islamic finance may not be uniform in all Islamic jurisdictions.