Earnings quality and sharia compliant financial firms during recent financial crisis: Degree of compliance, leverage, and country effect

This dissertation focuses on sharia compliant financial firms and divides the sample of banks into three types: Type 1 refers to full-fledged stand-alone Islamic banks, Type 2 refers to full-fledged Islamic banks that are subsidiaries to conventional banks, and Type 3 refers to conventional banks with Islamic windows. The paper aims to determine if there is a significant difference in the innate accruals quality (IAQ) and discretionary accruals quality (DAQ) among the three groups. It also aims to determine the effect of leverage and religion of bank's country of establishment on both components of earnings quality. The sample time frame is from 2007 till 2009. The Dechow-Dichev (2002) model is used to measure earnings quality, and the accruals derived from this model are then regressed on selected factors that represent a bank's innate characteristics. The predicted values provide an estimate of the innate accruals quality, and the standard deviation of the residuals provides an estimate of the discretionary accruals quality. The results indicate that there is no significant difference in the IAQ and DAQ among the three types of banks during the crisis period. The results also indicate that leverage (LEV) has no influence on the IAQ and DAQ in all three types suggesting the following: Types 1 and 2 carry low levels of debt within their capital structure, and it does not act as an incentive for those banks to manipulate their earnings or even to cause deterioration in their innate components. Type 3 banks had more debt within their capital structure, but it did not trigger manipulation in earnings or even deterioration in their business operations perhaps because there weren't enough earnings in the first place to allow manipulation and because those banks were large enough to prevent debt from impacting their innate components. As for the religion variable (REL), the results show that REL does not influence the IAQ and DAQ in all three types for the following reasons: Type 1 banks are mostly located in Muslim nations. For Type 1 banks located in non-Muslim nations, the results remain the same suggesting that Islamic banks adhere to their sharia principles regardless of where they are located. Type 2 banks are all located in Muslim nations which makes the REL variable irrelevant. In Type 3 banks, REL is not significant since most are in non-Muslim nations. Additional tests were conducted to eliminate the effect of small sample bias.