Financial Risk Ratios and Earnings Management: Reducing Uncertainties in Shariah-compliant Companies

Abstract

This study examines whether Shariah-compliant companies practice earnings management by investigating the relationship among the risk of financial distress, leverage, and free cash flow in discretionary accruals, which function as a substitute for earnings management. This empirical research is conducted on a sample of Malaysian Shariah-compliant companies from all industries in Bursa Malaysia from 2012 to 2014. Results show that Shariah-compliant companies are highly influenced by the risk of financial distress, leverage, and free cash flow. This study argues that working as either Shariah-compliant or non-Shariah-compliant does not affect the level of earnings management through financial distress, high leverage, and free cash flow by managers. Results should be of interest to stakeholders, shareholders, and regulatory bodies (i.e., the Shariah Advisory Council and the Securities Commission) that oversee the accountability of corporate financial reporting to prevent earnings management in Shariah-compliant companies. Findings can also aid relevant authorities (i.e., the Shariah Advisory Council and the Security Commission) in Malaysia in overcoming or reducing problems related to earnings management. This study is one of the most significant works in Malaysia in terms of sample size and methodology. It argues that the three elements of earnings management (i.e., financial distress, high leverage, and free cash flow) influence better disclosure of reported earnings.

Keywords

• Earnings management
• Free cash flow
• Financial distress
• Shariah-compliant companies
• Malaysia