Earnings Management and Internal Governance Mechanisms: The Role of Religiosity

Motivated by the managers’ social norms and religious orientations, this study offers new avenues for investigating the effect of internal governance in curbing earnings management. We comparatively assess whether internal governance mechanisms (i.e., boards of directors and audit committees) employed by Islamic and conventional banks could differentially mitigate earnings management. We take a step further to assess this association under the extended governance mechanism (i.e. Shari’ah supervisory board) employed by Islamic banks. For a global sample of 14 countries operating on a dual banking system between the years 2007-2015, we find that, on average, having effective boards and audit committees enhance the quality of financial reporting in banking industry. Conditional on bank type, we find that large and independent board of directors (and audit committees) are negatively associated with earnings management for Islamic and conventional banks. There are no structural differences across the two bank types for the effectiveness of these traditional governance mechanisms. We also find that Shari’ah supervisory board (i.e., non-traditional governance) can significantly reduce earnings management. This finding is more evident when this board is large; its members have financial expertise and serve on multiple banks’ boards. Our results provide important implications for regulators governing dual banking systems by highlighting the explicit role of religiosity on managerial opportunism and the impact of double governance in promoting high financial reporting quality for global banking.