Can Inclusion in Religious Index Membership Mitigate Earnings Management?

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.

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.

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.

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

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).

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).

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).

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).

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

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

We thank an anonymous reviewer for this insight.

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