Corporate governance and accounting conservatism in Islamic banks

• Author: Ali R. Almutairi,Majdi A. Quttainah
• Published date: 01 September 2019
• Date: 01 September 2019
• DOI: http://doi.org/10.1002/tie.22063

RESEARCH ARTICLE

Corporate governance and accounting conservatism

in Islamic banks

Ali R. Almutairi

1

| Majdi A. Quttainah

2

1

Department of Accounting, College of

Business Administration, Kuwait University,

Safat, Kuwait

2

Department of Management and Marketing,

College of Business Administration, Kuwait

University, Safat, Kuwait

Correspondence

Majdi A. Quttainah, Department of

Management and Marketing, College of

Business Administration, University of Kuwait,

P.O. Box 5486, Safat 13055, Kuwait.

Email: majdi.quttainah@ku.edu.kw

Abstract

We examine whether Islamic banks are more likely to be conservative in their finan-

cial reporting than conventional banks, as well as how Islamic banks' unique corpo-

rate governance system affects accounting conservatism behaviors. Using a large

sample of Islamic banks and their matched non-Islamic banks; based on total assets

and geographic location, in 15 countries, we find Islamic banks are more likely to

deploy accounting conservatism as measured by loss avoidance, abnormal loan loss

provisions, and C-score, respectively. Islamic banks are about 95% more likely to be

more conservative in accounting practices than their counterparts, depending on dif-

ferent model specifications. In addition, we report several board characteristics, such

as size, independence, reputation, tenure, and diversity, are important determinants

of accounting conservatism in Islamic banks. This relationship indicates certain board

traits lead to greater monitoring roles, consequently reducing unethical behavior and

increasing the degree of conservatism in accounting practices.

KEYWORDS

accounting conservatism, ethics, Islamic Bank, Shari’ah

JEL CLASSIFICATION

G15 ; G21; M41

1|INTRODUCTION

Following the high-profile downfalls of corporate managers due to

ethics violations (e.g., Enron, Adelphia, and WorldCom), and the pas-

sage of the SOX Act in 2002,

1

researchers are paying more attention

to corporate governance.

2

In particular, regulators, practitioners, and

academics have pressed for more sophisticated accounting practices,

among which is conservatism. Conservative accounting practices may

improve the veracity of financial statements and, therefore, regain

public trust and confidence in the financial reporting system. Account-

ing conservatism is defined as “accounting policies or tendencies that

result in the downward bias of accounting net asset value relative to

economic net asset value (Ruch & Taylor, 2015).”

Executive managers can implement two types of accounting con-

servatism: unconditional or conditional (Beaver & Ryan, 2005). Unlike

unconditional conservatism, conditional conservatism depends on

economic news events. Conditional conservatism refers to timely rec-

ognition of negative news to positive news of economic events in

accounting earnings (e.g., goodwill impairment, asymmetry in gain/loss

contingencies, long-lived asset impairment, and inventory recorded at

the lower of cost or market). Unconditional conservatism occurs

through the consistency of recording low book values of net assets

relative to their fair values (e.g., immediate expenses R&D, accelerated

depreciation methods, allowance for bad debt expenses, and warranty

allowance) (Ruch & Taylor, 2015).

Existing literature focuses on commercial banks (hereafter, CBs)

and their accounting conservatism. However, this article compares

accounting conservatism between Islamic banks (hereafter, IBs) and

CBs, and it analyzes IBs' sophistication in accounting practices due to

their distinct nature. IBs are interest-free banking and their banking

DOI: 10.1002/tie.22063

Thunderbird Int. Bus. Rev. 2019;61:745–764. wileyonlinelibrary.com/journal/tie © 2019 Wiley Periodicals, Inc. 745

transactions are based on different financing modes of sharing the

basis of payment obligations with revenue accrual, removing the

major sources of instability in a free market. Thus far, their distinct

nature dictates they will need to follow a strict accounting conserva-

tism (Quttainah, 2012).

To better understand religion's effects on accounting behaviors,

we need to analyze environments that could influence accounting

decisions. Culture does affect accounting practices (Askary,

Pounder, & Yazdifar, 2008). Soll (2014) notes “financial accountability”

gets even better when accounting is viewed as part of culture values

not just part of a business transaction. Historically, religion has a sig-

nificant role in shaping and affecting cultural values, such as fairness

and honesty (Lewis, 2001). Lewis (2001) argues if culture indeed has

such an effect, then religion that influences cultural values does affect

accounting practices. Mutch (2016) explores the impact of religion on

Scottish accounting texts in the eighteenth century using a sample of

five administrative units of the Church of Scotland. He notes account-

ing practices are broadly shaped by the religious context of the

Church of Scotland.

Thus, Shari'ah affects the principal-agent relationship based on

converting cash into assets that may be worth more or less in the

future, which is of prime importance and is the source of profit or loss.

Hence, most IBs are rich in cash due to strict adherence to rules

regarding what products and services banks offer (Quttainah, 2012).

Such strict adherence is also reflected in accounting behavior in

accounting behavior (Quttainah, Song, & Wu, 2013). Hence, the inten-

sity of adherence to Shari'ah, which is the cornerstone of conducting

business and financial deals in IBs, reflects differences in accounting

conservatism between IBs and CBs.

As Shari'ah is one of the most important determinants of internal

governance for IBs, this article asks two questions. First, are IBs more

conservative in their accounting reporting compared to CBs? Second,

do board characteristics such as size, reputation, tenure, and diversity

enhance accounting conservatism practices in IBs?

Following prior studies such as Francis, Hasan, and Wu (2013),

Leventis, Dimitropoulos, and Owusu-Ansah (2013), Talebnia and

Javanmard (2011), García Lara, García Osma, and Penalva (2009), and

LaFond and Watts (2008), we use three proxies to measure account-

ing conservatism in the banking industry: loss avoidance, abnormal

loan loss provisions (LLPs), and C-score. We control for major bank

characteristics, size, growth opportunities, the change in cash flow,

and allowance for loan losses, all of which may affect accounting con-

servatism. Additionally, we control for potential risk differences

between IBs and CBs (Quttainah & Almutairi, 2017). CBs and IBs hold

different kinds of loans and other asset portfolio structures; thus, they

could have different incentives to increase/reduce certain accounting

behaviors. We also control for country effects and year effects that

are likely to affect accounting conservatism.

Based on a sample of 3,772 bank-year observations from 82 IBs

and 82 CBs in 15 countries between 1993 and 2015, we find IBs are

more conservative in their accounting practices compared to CBs. In

fact, we show IBs are about 95% more likely to be more conservative

in accounting practices than their counterparts, depending on

different model specifications. This result holds after adjusting for

country and year effects and is robust to the inclusion of various con-

trol variables (microlevel and macrolevel). In addition, the average loss

avoidance for IBs is 26% compared to 30% for CBs. The abnormal loss

loan provision for IBs is 0.1% compared to 0.3% for CBs. Neverthe-

less, the mean C-score for IBs is 9%, and the mean C-score for CBs is

5%. These results indicate IBs have greater ethical standards, which

leads to higher accounting conservatism. They also indicate Shari'ah

effectively constrains unethical behaviors among IB managers.

We also report several board characteristics such as size, indepen-

dence, reputation, tenure, and diversity are important determinants of

accounting conservatism in IBs. For example, the relationship

between loss avoidance and abnormal LLPs (C-score), and board char-

acteristics is negative (positive). This relationship indicates certain

board traits lead to greater monitoring roles, consequently reducing

unethical behavior and increasing the degree of conservatism in

accounting practices.

The remainder of the article is organized as follows. Section 2

reviews the extant literature and develops the research hypotheses.

Section 3 describes data collection, sample selection procedures, and

empirical models. Empirical main and robustness results are presented

in Section 4. Summary and major conclusions are presented in

Section 5.

2|LITERATURE AND HYPOTHESES

DEVELOPMENT

2.1 |Features of banks

The banking industry is the most regulated industry in the world, and

it is unlike other industries. For instance, its governance structures

have numerous unique features that could magnify agency problems.

Banks are less visible than nonfinancial firms, which also aggravates

agency problems (Caprio Jr. & Levine, 2002) because greater informa-

tion asymmetry exists among investors.

Adverse selection happens in banks when deposit insurance pro-

grams intended to protect small depositors' interests actually lead to

moral hazards. These programs may incentivize managers to engage in

unethical practices or risky projects. Unlike creditors who have exper-

tise and skills to evaluate bank products and services, and therefore

are better at monitoring bank managers, small depositors lack such

advantages. In fact, deposit insurance schemes may motivate man-

agers to rely less on borrowing. Thus, managers may be more likely to

monitor insured depositors than uninsured creditors, which could

expose their banks to litigation risks. Creditors can sue bank directors

for mismanagement and misconduct (Petrin, 2012).

In addition, banks are highly leveraged with a significant portion of

their debts consisting of cash deposits. On the other side, banks' illiq-

uid assets may fail to meet claims of creditors, creating substantial

risks to debt holders (Heremans, 2007). Furthermore, the reputation

and credibility of the banking industry are far more critical than in

other industries. This is because banks provide a large number of

intangible services and run financial operations primarily based on

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