Mitigating Financial Uncertanties in the Practices of Shariah-Compliant Companies

Transcription

1 Mitigating Financial Uncertanties in the Practices of Shariah-Compliant Companies Zuraidah Mohd-Sanusi*, Yusarina Mat-Isa**, Normah Omar*** and Siti-Mazidah Hanif**** The Islamic jurisprudence (Shariah) advocates that Shariahcompliant companies must abstain from engaging in unlawful and unethical activities. This however, falls short of guaranteeing that all Shariah-compliant companies would abide by the stated rulings. The issue on whether Shariah-compliant companies involve in unethical conducts such as earnings management is still vague. The main purpose of this study is to examine whether Shariah-compliant companies practice earnings management by looking at the relationship between the risk of financial distress, leverage and free cash flow on discretionary accruals (discretionary accruals acts as a proxy for earnings management). This study employs 774 randomly selected samples covering a period from 2009 to Data are drawn from Bursa Malaysia website (annual reports) and Thomson Datastream (financial data). The data which were analyzed through correlation and regression analysis, concludes that the risk of financial distress, leverage and free cash flow have significant relationship on earnings management in Shariah-compliant companies. These results should be of interest to the stakeholders, shareholders, and regulatory bodies such as the Shariah Advisory Council and the Securities Commission to oversee the accountability of corporate financial reporting in the prevention of earnings management in Shariah-compliant companies. 1. Introduction There has been a growing concern by companies and individuals on the Shariah issues particularly relating to the concept of halal and haram (permissible and non-permissible). Technically, the aspects of halal and haram have a significant impact on business dealings. For instance, businesses are having issues with riba (interest) and gharar (uncertainties) in many business fields (Rosli & Azhar, 2010). These are among the two most significant issues that could segregate the classification of Shariah-compliant and non-shariah-compliant companies. There are various rulings issued by Islamic scholars that synchronize Shariah principles with the current business needs. As a result, Shariah principles have become a common condition in business transactions as it provides an overview and appreciation of full compliance with Islamic law. As Muslims realize the importance of Islamic law and its significant impact on businesses, investors begun to switch to Shariah-compliant investments (Falaika, 2002). When companies are classified as Shariah-compliant companies, this gives the perception that the companies are free from earnings manipulation, unethical transactions and matters which have adverse effects on a company's investment activities (Abdul Rahman, Rahman, & Courtney, 2010). Involvement in these activities constitutes fraud and they are clearly forbidden in Islam (Abdul Jabbar, 2010). Earnings management may involve manipulation of accounting records,

2 intentional omission or intentional misapplication of accounting principles. Earnings management is practiced by the management that often results in inaccurate and misleading financial reports (Aini, Takiah, Pourjalali & Teruya., 2006). In June 1997, the Malaysian Securities Commission introduced Shariah-compliant securities which fall under the jurisdiction of Shariah Advisory Council. In order to determine the Shariah status of the securities before it could be listed as Shariahcompliant securities, it must first followed the process based on a fundamental criteria guidance. Since then, the numbers of Shariah-compliant companies listed on Bursa Malaysia have increased rapidly. By 2011, about 89 percent of the companies listed on Bursa Malaysia are Shariah-compliant (Bursa Malaysia, 2011). The practice of earnings manipulation is very common among companies as a result of serious agency problems (Healy & Whalen, 1999). The nature of earnings manipulation ranges from earnings fraud to earnings management. Earnings fraud relates to fraudulent financial reporting which involves intentional misstatements or omission of amounts or disclosures in the financial statements to deceive financial statements users (MIA, 2002). Addressing the issues of earnings manipulation in Shariah-compliant companies, this study attempts to investigate on the relationships of risk of financial distress (z-score), leverage and free cash flows on earnings management in Shariah-compliant companies. Currently, there is a lack of research on the impact of earnings management and fraud in ensuring the credibility of a report which is in exact accordance to the criteria outlined by the relevant parties such as the Securities Commission for the selection of Shariah-compliant companies. Such research would be especially relevant in order for Malaysia to achieve its written agenda to be the main centre for Islamic international capital market. For example, the Securities Commission can understand further on the issues relevant to earnings management practice, especially for companies that apply to be Shariah-compliant companies. The following sections discuss the literature review, methodology, analysis and conclusion of the study. 2. Literature Review 2.1 Shariah Capital Market At present, Islamic business is gaining a worldwide momentum of acceptance. Currently, 50 countries or one-fifth of the total world population are engaged in Islamic business (Jamaluddin, 2003), in both domestic and international level. Nevertheless, Yousef (2001) stated that the common goal should be to adopt a moderate Islamic work ethic for job commitments and to achieve the satisfaction of all parties during the course of business conducted. Any instructions relating to the Islamic market, including operations and services, must then comply with the code of practice, principles and rules of Islam which is known as Shariah (IOSCO, 2004). Currently, the Islamic business laws have been prepared with proper guidelines and carry a lot of influence on the development of the Islamic business world itself. Al-Quran has long stated about the prohibition interest (riba). In addition, another example involving a prohibited business is

3 speculation (gharar). The prohibition is through the recorded authentic chain of narrations from the prophet Muhammad (peace be upon him) which stipulates that gharar is prohibited in Islamic transactions. Such are the difference between conventional and Islamic businesses. A study by Chapra (1992) stated that there are consensus views from Islamic scholars on riba and gharar affairs in business transactions and activities which have the same meaning. This was because both of them mean involvement in unfair business practices (Gambling & Karim, 1991). This is considered unfair because one party stand to gains at the premeditated and calculated loss of another party. In Islam, the Shariah protects the business and investors, consumers and producers, community and the nation from the unfairness of any deceitful and treachery business dealings. However, presently many companies are entwined and entrapped in those practices, whether or not such activity deliberately contributing to their wealth. Upon the availability of Shariah-compliant securities, there is a positive improvement in the business developments around the world. This could be due to increase in sense of responsibility and cautions by the management because it the investments now are religiously enthused. Such positive developments could be explained by the argument that stated the basis for civilized behavior could impact changes in accountability and moral basis (Schelling, 1968; Durant, 1950). Islamic Shariah had already set the proper and appropriate behavioral conduct code for a Muslim, which includes accountability in business dealings and transactions. All the people will be made responsible for their usage and consumptions of the resources as it will enable them to perform their duty to Allah in this world since generally, all the resources belongs to Allah (Sulaiman, 2003). Sulaiman s statement can be used in a broader perspective on the interpretation of accountability, which is associated with the concept of financial reporting responsibility of the management. According to the conventional system, a company's management is mainly focused on wealth maximization through profit generation and is only responsible in reporting to the shareholders on activities undertaken by the company. However in the Islamic perspective, greater obligations and conscious responsibility is to Allah the Judge, and then followed by other parties according to their due importance to a respective company. In Islamic perspective, accountability will lead to sound economy, healthy politics religious uprightness and nurtures a god-fearing (taqwa) society. In fact, the meaning of Shariah itself clearly described itself as the guideline of the legal system which draws the line clearly between truth and falsehood (baatil). Additionally, Islamic investors would only invest if they believe the investments do not conflict with the Shariah (Derigs & Marzban, 2008). In Malaysia, the Securities Commission is a corporate body that analyses company s information with reference to survey responses, the companies financial reports and to queries each chosen companies management. The inputs enable these companies to be included in the listed companies under Shariah-compliant classification. The Shariah Advisory Council is given the mandate in certain way that Islamic capital market shall remain in accordance with the Shariah principles. Shariah Advisory Council hold the scope of advising the Securities Commission on all related matters related to the comprehensive development of the Islamic capital

4 market and functions as a reference centre for Islamic capital market-related issues. The members of the Shariah Advisory Council consist of Islamic scholars/jurists and Islamic finance experts. 2.2 Earnings Management According to Healey and Wahlen (1999) earnings management occurs when managers choose reporting methods and estimations that did not accurately reflects their firms' underlying economics, while Leuz, Nanda and Wysocki (2003) defined earnings management as reported alterations in economic performance by insiders to mislead either stakeholders or to influence contractual outcomes. In addition, Sun and Rath (2008) suggested in their research that earnings management could be defined as when managers exercised any judgment for the purpose of hiding true performance in order to influence the stock performance, to benefit from the contractual terms between the firm and managers, to control regulations or to influence decisions. Although there were many definitions of earnings management, the basic concept of earnings management was changes in financial reporting information by the management. Many studies on earnings management defined it as various methods and concepts made by a company's management for composition of the information in the company s financial reports. There were several factors why managers tried to manage earnings. According to Healey and Wahlen (1999), companies managed earnings to ensure that the financial statements were seen as good or was also known as window dressing before offering the securities to the public. In fact, practice of earnings management also seemed to enhance the corporate manager s compensation, job security, to prevent violations of the contract for the loan, to reduce regulatory costs and to enhance the benefits on any regulations relating to the business of the company. Discretionary accruals, which also known as abnormal accrual, are the method often used by most researchers in detecting earnings management. Examples of previous researchers who utilized discretionary accruals to detect earnings management were Healy 1985, De Angelo Jones 1986 and 1991 (cited in Bartov, Gul, & Tsui, 2000). There were many other alternative models which were developed based on an accrual basis by previous researchers to detect earnings management, especially as information to investors on their properties. Therefore, the priority in the measurement of discretionary accruals was total accruals (Dechow, Sloan & Sweeney, 1995). Total accruals were then separated into discretionary and nondiscretionary components. In addition, this was a simple model for researchers and any party where discretionary accruals were measured as total accruals. There were also more sophisticated models and current models to separate total accruals into discretionary and nondiscretionary components (Dechow, Sloan & Sweeney, 1995). A new model for detection of discretionary accruals had been introduced which was known as discretionary allocation approach. This model was proposed by Kothari, Leone, & Wasley, (2005) after innovating Jones model by adding the performance factor into their model. Kothari, Leone & Wasley, (2005) also suggested measuring discretionary accruals, matching performance on return on assets to control the effects of the impact of each organization's performance. After getting the results,

5 performance matched discretionary accruals would be used to increase reliability for research conclusions in revenue management. These results proved the hypothesis being tested did not show any different revenue management performance, which meant it did not show a company had engaged in earnings management. 2.3 Shariah-compliant Criteria Currently, the utilized screening criteria are to look and to examine the activities of a company to ensure if they are in accordance with Shariah law. Based on certain conditions that have been earlier established and stated in the criteria set, scrutinized and monitored companies that are found not contradicting the Shariah will then be classified as Shariah-compliant securities. While the companies which did not comply with Shariah, would be classified as non Shariah compliant. Those companies may involve in activities such as gambling and gaming, unlawful sale, conventional insurance, non-shariah compliant entertainment activities, usury-related financial services and other activities not in accordance with Shariah (Securities Commission, 2011). Azhar, Mohd Azlan and Mohd Herry (2010) research was related to the screening process of Shariah-compliant securities. They discovered a method to calculate the difference in their analysis by comparing the Islamic Shariah Index of Kuala Lumpur Stock Exchange with the Dow Jones Islamic Market Index when examining a company for investment purposes under the Shariah-compliant criteria. However, the Kuala Lumpur Sharia Stock Index did not use the same methods and criteria which were used by Dow Jones Indexes Islamists Market during the screening process. From the comparison with the Dow Jones Islamic Market Index, it showed three additional financial characteristics which varied with the Kuala Lumpur Shariah Index. They are debt levels, liquidity levels and the level of interest income which were predetermined as the criteria that must be observed during the screening process for companies to be placed under Shariah listed companies. A test of the sample which used the criteria set by the Dow Jones Islamic Market Index to the Shariah-compliant companies in Malaysia had showed a high reliance on debt to finance in their capital. In addition, a group of researchers had studied the performance of the plantation industry in Malaysia under the list of Shariah-compliant companies. In their study, Mohd Dali, Mudasir and Abdul Hamid (2008) used multiple discriminant analysis (MDA) and multiple regressions to identify companies that practiced the use of financial ratios in their company. In their conclusion, they stated that the acquisition credit / days and inventory turnover ratio could be used to distinguish Shariahcompliant companies for the plantation industry. Their research discovered that more than half of the sample, which meant the companies which implemented Shariah compliance measures responded with good results in terms of performance and the companies position. Therefore, Shariah compliance measures could be used as a basis for a good look at the development of Shariah-compliant companies in the plantation industry performance. A study was conducted on Shariah property investment in Asia with the results showing more than 95% of the respondents agreeing that an essential requirement in terms of halal type of investment and investment structure was to choose companies compliant with Shariah law (Faishal, Eng & Ali, 2009). Compliance to

6 Shariah principles is fundamental and investors made the decision to invest only when compliance is ensured. Such results would be of special interest to the Muslim community who are now aware of the concerns and what types of investment they wanted to make as the current potential of Islamic investments in Asia is very high. 78% of the respondents felt that Southeast Asia had the highest potential in attracting Shariah compliant real estate investment. Abdul-Rahman, Rahman, and Courtney s (2010) study on the association between religion, ethical values and earnings management, measured the earnings management using abnormal accruals, which was a common method or the regular measurement to accounting quality (Dechow, Sloan, & Sweeney, 1995). The result showed a higher abnormal accruals which proved to be an indicator that a firm might be practicing earnings manipulaton. The results showed that Shariah-compliant companies had significantly lower levels of abnormal accrual compared to non- Shariah companies. Therefore, the relationship was negatively associated between earnings management and religious business norms which includes Shariah accountability. Thus, the results showed that when religious ethics were implemented in a company s policy, it might play a role in determining whether a company was practicising earnings management. 2.4 Hypotheses This study primarily focuses on discretionary-accrual-type earnings management by examining the relationship of risk of financial distress, leverage and free cash flow with the possibility of earnings management occurrences. H1: There is significant relationship between firm size and discretionary accruals of Shariah-compliant companies H2: There is significant relationship between leverage and discretionary accruals of Shariah-compliant companies H3: There is significant relationship between free cash flow and discretionary accruals of Shariah-compliant companies 3. Methodology 3.1 Sample Selection As of November 2011, there were 839 companies approved as Shariah compliant companies by the Securities Commission. Depending on data available in Thomson Data Stream, 774 companies were identified for the analysis. The secondary data consisting of the financial statements component were collected from DataStream. Data on Shariah status companies listed in Bursa Malaysia was gathered from the Securities Commissions latest listing of Shariah approved companies which were disclosed on the Securities Commission website.

7 3.2. Measurement of Dependent Variable There were a number of different models in estimating earnings management, however what was widely used as a proxy was discretionary accruals (Dechow, Sloan & Sweeny, 1995). Dechow, Sloan and Sweeney (1995) further stated that the model that performed the best was the modified version of the Jones model (Jones 1991). However, this research followed the model suggested by Khotari et al. (2005) because they argued that by using existing models an accurate estimation of discretionary accrual could not be achieved. Khotari et al. (2005) also suggested that performance-matched discretionary accruals measure would enhance reliability of inferences with respect to earnings management. Therefore, performance matched with discretionary accruals was selected for this study as Jones and Modified Jones model was not suitable when applied to a random sample. Thus, the performance matched discretionary accruals model was an alternative model to measure discretionary accruals based on a stratified random and representative sample. It was also one of the newer models proposed by estimating discretionary accruals that were introduced in 2005 as compared to the Modified Jones model which was reintroduced in This study estimated the amount of earnings management using Total Accruals (TACC). Total Accruals was an amount of non-discretionary component of accruals and discretionary accruals. This amount was occurred through normal business activities and relevant for managers to evaluate the outcome. Total Accruals were also estimated discretionary accruals used to obtain the amount involved in the study of earnings management. The accrual amount was divided into non-discretionary and discretionary accruals. In other words, the regression model consisted of nondiscretionary accruals which are expected accruals explained by selected variables and discretionary accruals were unexpected accruals not explained by variables selected according to the objectives of the study. Thus, the calculation of total accruals is as follows: TACCit = DACCit + NDACCit Where: TACCit DACCit NDACCit = the total accruals of firm i in year t = the discretionary accruals of firm i in year t = non-discretionary accruals of firm i in year t The heteroskedasticity of the regression was reduced by deflating each component in the total accruals by lagged total assets (Chung, Firth & Kim, 2005; Bukit & Mohd Iskandar, 2009). Therefore, total accruals are calculated as follows: TACC = (Δ Cash - Δ Current Assets) - (Δ in Current Liabilities + Δ Current portion of long term debt) Depreciation and Amortization Lagged total assets Where: Δ represents = the change from year t-1 to year t Lagged total assets = the total assets of firm i at the end of year t -1

8 To break down total accruals into the discretionary and non discretionary accruals, this study followed the Kothari Model. It includes ROA it or ROA it - 1, which stood for ROA current year and previous year to control the firm s performance. The model was included ROA was to compare the effectiveness of performance matching versus regression based approach (Kothari et al, 2005). The discretionary accruals regression model captured the components of total accrual and non discretionary accruals as follows: TACC it = α₀ + α₁ (1 / TA it 1) + α₂ (Δ SALES it / TA it - 1) + α₃ (PPE it / TA it-1) + α₄ ROA it (or it -1) + ε it Where: TACC it = the total accruals of firm i in year t TA it 1 = the total assets of firm i at the end of year t -1 Δ SALES = it sales change in net of the change of account receivable of firm i between years t and t 1 PPE = it the level of gross property, plant, and equipment of firm i in year t ROA it(or it -1) = ROA of firm i at the end of year t (ROA of firm i at the end of year t 1) ε = it regression residual Therefore, non discretionary accruals were defined by the fitted value obtained from the regression model. Whilst the discretionary accruals were defined by residual value obtained from the regression model. This value was the difference between total accruals and non discretionary accruals. This value would be used as the dependent variable of this study. 3.3 Measurement of Independent Variables The Z-score model was the chosen proxy of risk of financial distress in this study (Oluwo, 2007). They were working capital over total assets, retained earnings over total assets, earnings before interest and taxes over total assets, market value of equity over book value of total debt, and sales over total assets. The formula for the Z-score is: Where: Z = overall classification index x(1) = working capital over total assets x(2) = retained earnings over total assets x(3) = earnings before interest and taxes over total assets x(4) = market value of equity over book value of total debt x(5) = sales over total assets Z = 1.2x(1) + 1.4x(2) + 3.3x(3) + 0.6x(4) + 1.0x(5) In order to show that a company faced financial hardship, Altman s model was divided into three zones as a result of discrimination, which was, less than 1.81 (distress zone), between 1.81 and 2.99 (grey zone) and more than 2.99 (safe zone). The best discriminatory zone was above 2.88, which showed a company's financial situation was healthy. If a company was in the zone of discrimination of 1.81 and below, it would be considered to be under financial hardship and also considered as bankrupt. Discrimination zone between 1.81 and 2.99 were considered as zones of

9 ignorance in which a company had the possibility to misclassify their financial information. Then, the cut-off of account point of would decide whether a company had financial problems or not, and anything below that point, would be considered a business failure (Oluwo, 2007). Oluwo (2007) also noted that the model used as a tool and to learn and predict the financial health of the company. In this ratio the following equation was used to measure Debt to equity ratio (DTE) = Debt / Total Equity and Debt to Assets ratio (DTA) = Total Debt / Total Assets. Leverage ratios would give an indication of the level of long-term debt with long-term measures in a company's balance sheet. If available leverage was higher, then it had the potential for a company s management to violate the loan agreement and thus would result in a lack of ability to obtain additional capital through loans. Many previous studies suggested that the relative cash flow had a negative relationship with discretionary accounting accruals (Becker, DeFond, Jiambalvo & Subramanyam, 1998). If cash flow was very high this meant higher profits and would encourage companies to accept lower income discretionary accounting accruals to income smoothing. In order to control the potential impact on cash flow, this study included the indicator changes as relative cash flow. Free cash flow was measured by the cash flow for the year divided by total assets lagged (year t-1). It is same with the study done by Chung et al. (2005). Therefore, this study expected a negative sign on the coefficient of the other which would show a tendency flow with relatively high cash to practice dressing windows on account of particular income. 3.4 Measurement of Control Variables This study uses three control variables, return on assets, size and liquidity. The measurement to measure the profitability aspect ratio was return on assets (ROA) = Revenue/ Total Assets and Net profit for Revenue = Net profit / revenue. This is supported by Summers and Sweeney (1998) where there were expectations that a company s management would maintain or increase the level of past profits, no matter what their actual extent and that if the actual performance of the company was unable to meet investors expectations, then there was potential for managers to manipulate the information in the financial reports. In order to control the influence of size of the client in the quality of accruals (earnings management), this study measured the size of the client log of total assets. This was followed by a measurement advocated by Dechow & Dichev (2004) and Choi, Kim, Kim & Zhang (2010) research. The practice of earnings management in a company explained that firm size had a significant impact on discretionary accruals. The ratio used to measure liquidity was: Working Capital / Total Assets, Current Ratio = Current Assets / Current Liabilities and inventory to sales ratio = Total Inventory / Revenue. The purpose of this ratio was to measure the ability of a business to meet its financial obligations in the short term. The Financial Analysis report noted that the current ratio was one of the most important ratios to measure a company's liquidity (Kastantin, 2005). If a company showed a lower level of liquidity, then this would encourage their managers to engage in fraudulent financial reporting.

10 4. Analysis of Findings 4.1 Descriptive Analysis Usage of descriptive analysis made it possible for the current study to explore and provide a better understanding on the data collected and used. Hence, this section would present the summary of the descriptive statistics. Table 1 shows the summary of the statistics for the full sample consisting of earnings management. Table 1: Descriptive statistic for full sample Mean Minimum Maximum Standard Deviation Skewness Kurtosis DA Abs ROA LogAsset LQ ZSCORE LEV FCF Note: DA represents Discretionary accruals, Abs represents Absolute discretionary accruals, ROA represents profitability, LogAsset represents firm size, LQ represents liquidity, ZSCORE represents Risk of financial distress, LEV represents Leverage and FCF represents free cash flow. Overall, most of the variables had positive skewness and kurtosis, indicating that most of the data were distributed at positive values and clustered in the centre. The data was close to normal distribution and suggested that there was no violation of assumption of normality. 4.2 Pearson s Correlation Product Moment Table 2 illustrates the relationship between the dependent variables and the independent variables. The absolute discretionary accruals (DA) has a positive correlation with risk of financial distress of the firm, r = 0.139, p < This finding therefore, shows that high risk of financial distress leading to company bankruptcy provides a higher probability to engage in earnings management. Moreover, absolute discretionary accruals (DA) also correlated with leverage (r = , p < 0.01). This finding indicates the higher earnings management in higher leverage of the firm. The manager has higher intention to engage earnings management with higher leverage to avoid the debt covenant violation. Furthermore, the absolute discretionary accruals also significantly correlated with free cash flow (r = 0.192, p < 0.01). It shows the higher free cash flow, the higher of earnings management practice in the company. It indicates the manager intends to invest in the non-value investment and misused the fund for personal gain. Risk of financial distress have negative correlation with leverage of the firm, r = , p < This finding revealed that the higher level of risk of financial distress

11 would result in lower leverage in the firm. Besides that, risk of financial distress have positive correlation with free cash flow (r = , p < 0.01). Based on the result of this study, it shows that higher level of risk of financial distress would result on lower free cash flow in. Overall, the results suggested no multicollinearity problem in this model. None of the independent variables was rejected from this study as well. Table 2: Pearson s correlation between independent and dependent variables Variables Abs ROA Log Asset LQ ZSCORE LEV FCF Abs **.129 ** **.146 **.192 ** ROA **.289 **.390 ** **.395 ** Log Asset ** **.206 **.073 ** LQ ** **.159 ** ZSCORE **.270 ** LEV ** FCF 1 *Correlation is significant at 0.05 levels (2- tailed) **Correlation is significant at 0.01 levels (2 tailed) 4.3 Regression Analysis Regression results are presented in Table 3 for the pooled year for the first, second and third hypotheses respectively. This would be followed by the additional analysis as shown in Table 4 separated by years Regression Analysis of Pooled Data The regression results are presented in Table 3 for the pooled data to test the hypotheses respectively. Table 3: Results of regression analysis on earnings management for the year of 2009 until 2011 Unstandardized Coefficients Standardized Coefficients t Significant Beta Std. Error Beta (Constant) ROA **.002 LogAsset ***.000 LQ ***.001 ZSCORE ***.000 LEV ***.000 FCF ***.000 R Adjusted R F-Statistic *** ***Significant at the level (Sig 2 - tailed) ** Significant at the 0.01 (Sig 2 tailed) * Significant at 0.05 level (Sig 2 tailed)

12 It shows all variables had the influence for earnings management practices in their companies. It indicates a significant relationship between risk of financial distress and earnings management. Spathis (2002) and Barsky, Catanach and Rhoades- Catanach (2003) also obtained the same results in their study. Thus, the hypothesis 1 was accepted. A company might practice earnings management because of financial distress and discover if financial distress would cause managers in Shariahcompliant companies to practice earnings management. The relationship of leverage with earnings management could be seen. The relationship between leverage and discretionary accruals was generally expected to be positively associated. The second hypothesis (H2) was also accepted. For example, managers may be motivated to understate liabilities or overstate assets in order to ensure debt covenants was achieved if a company did not have the ability to obtain extra capital through borrowing. This meant that the higher the total debt of a company, the higher the possibility to practice earnings management. In Table 3 the results also show the significant relationship between the free cash flow and earnings management. This meant that a high level of free cash flow in a company would increase the probability of earnings management practice. For instance, the manager might be motivated to do earnings management to ensure the free cash flow balanced with total assets. Thus the result supported hypothesis 3. This finding was consistent with the studies by Gul (2001), Chung et al (2005), and Bukit and Takiah (2009) Regression Analysis by Years Regression analysis was conducted to explain the relationship of independent variables and control variables toward the absolute discretionary accruals as dependent variables by separating the years (2009, 2010 and 2011). Table 4 below presents the results of the multiple regressions in different years. The result that in 2010 the model had a better R square compared to the years 2009 and Therefore, this would enhance the explanation of dependent variable of earnings management by the independent variable. It showed the interaction after the original independent variable was controlled. Thus, the model explained the 24.9 percent of the variance of discretionary accrual which proxy for earnings management as compared to the year 2009 where it was only 18.7 percent and in 2011, 14.1 percent. F value showed the significant value (p< 0.001) for 2009 was , while in 2010, it was and in 2011,

13 Table 4: Results of regression analysis on earnings management for the year 2009 until Standardized Coefficients t Standardized Coefficients t Standardized Coefficients t (Constant) ROA * ** LogAsset *** LQ ** ** ZSCORE *** *** *** LEV *** *** *** FCF *** *** *** R Adjusted R 2 F-Statistic *** *** *** ***Significant at the level (Sig 2 - tailed) **Significant at the 0.01 (Sig 2 tailed) *Significant at 0.05 level (Sig 2 tailed) Hypothesis H1 predicted that there was a significant relationship between financial distress and discretionary accruals. The result showed that there was a significant relationship between financial distress and discretionary accrual for the three years. Thus, with reference to the results, hypothesis H1 was accepted. Hypothesis H2 also expected a significant relationship between leverage and discretionary accruals. The results for the years 2009, 2010 and 2011 supported the Hypothesis H2. Thus Hypothesis H2 was accepted. For the years 2009, 2010 and 2011, Table 4.5(b) shows a significant positive relationship with absolute discretionary accruals (β = 0.197, p < 0.05), (β = 0.495, p < and (β = 0.405, p < 0.001). Hypothesis H3 also predicted there was a significant relationship between free cash flow and discretionary accruals. Based on the results revealed with regards to the years 2009, 2010 and 2011, Hypothesis H3 was supported. For 2009, Table 4.5(b) shows a significant positive relationship with absolute discretionary accruals (β = 0.185, p < 0.05). For 2010, Table 4.5(b) also shows that log free cash flow also had a significant positive relationship with absolute discretionary accruals (β = 0.202, p < 0.001). Likewise, in year 2011, log free cash flow had a significant relationship with discretionary accruals (β = 0.154, p < 0.001). 5. Conclusions This study s examination of the characteristics of financial distress and leverage and its aim to discover whether these variables had a significant relationship on the probability of managers practicing earnings management could be said to be a contribution to current literatures with similar themes. In addition, the study further examined the financial distress factor in relation to Shariah-complaint companies in

14 Malaysia. This empirical research was conducted using a sample of Malaysian firms from all industries of Shariah-compliant companies in Bursa Malaysia from the years 2009 to The regression analysis used to test all the hypotheses was applied only to the final sample of 774 firms at the end of the sample period of 2009, 2010 and This study used as dependent variables the performance-matched discretionary-accrual approach as proposed by Kothari et al. (2005) as proxy for earnings management. Using the regression model mentioned above, the three hypotheses were tested. By using pooled data from the years 2009, 2010 and 2011, the result was obvious. It showed all Hypotheses were to be accepted. This meant that managers of firms with financial distress, high leverage and free cash flow would manage companies earnings. These results should be of interest to the stakeholders, shareholders, and regulatory bodies such as the Shariah Advisory Council and the Securities Commission to oversee the accountability of corporate financial reporting in the prevention of earnings management in Shariah-compliant companies.the findings of this study is optimistically hoped to be of help to the relevant authorities such as Shariah Advisory Council, Security Commission and other agencies in Malaysia in order to overcome or reduce the problems relating to earnings management. There were some limitations in this research which could have been the underlying factors for the rejection of some hypotheses. Firstly, this study used a sample of three years period, which could only be considered as moderate compared to the other studies. Secondly, the current study focused on Shariah Listed Companies from all types of industries in Malaysia. Nevertheless, Rashidah and Fairuzana Haneem (2006) included all industries except for financial institutions in their study. To focus on all sectors for more than three (3) years would result in a bigger sample and perhaps even more significant results. This study suggests that future researchers should consider extending the sample size for there is a good possibility a significant relationship will be discovered. It is also strongly encouraged that a larger sample be used and the time frame should also be extended to five (5) or ten (10) years, compared to just three (3) years as was done in this study because this might produce more significant results. The latest studies or newer models could also be used to detect earnings management (discretionary accruals) and to compare which model might give the best possible answer in detecting earnings management. This study could also be extended to include detailed information for other relevant factors such as asset utilization, audit fees, and properties, as well as plants and equipment. References Abdul-Rahman, R., Rahman, A., & Courtney, S. (2010). Religion and Earnings Management- Some Evidence from Malaysia. Abdul Jabbar S. F.(2010). Financial crimes: Prohibition in Islam And Prevention By The Shari'a Supervisory Board of Islamic Financial Institutions, Journal of Financial Crime, Vol. 17, Issue: 3, pp

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