Earnings Management to Avoid Earnings Decreases and Losses: Empirical Evidence from Islamic Banking Industry

Abstract

We use earnings distribution approach (EDA) to investigate whether and why Islamic banks manage reported earnings. First findings confirm the assumption that Islamic banks manage earnings to avoid reporting losses (with statistical tests) and earnings decreases (with visual evidence but without statistical tests). However, earning management phenomenon is not as obvious in Islamic banking institutions as in other non-Islamic institutions. That is, Islamic banking institutions practice earnings manipulations but not as well as non-Islamic institutions. Additionally findings show that prospect theory can explain the trade-off between risk and return, i.e., Islamic banks above the earnings threshold are found to be risk averters while banks below the earnings threshold are found to be risk seekers. Therefore, we have accepted the hypothesis that prospect theory explains Islamic banks’ motivation in managing earnings to exceed thresholds.

Keywords: Earnings Management, Earnings Distribution Approach (EDA), Prospect Theory, Islamic Banking Institutions.