6 Conclusion
This study examines the effect of two sources of ethical principles, CSR and membership in a Shariah index, on the quality of financial reporting. We expect that opportunistic behavior or moral obligation drives the firms’ engagement in ethical activities. Our empirical results show that firms engaging in CSR activities are less likely to manipulate earnings. These results are robust when using each main component of CSR as well as alternative earnings quality metrics. In contrast, membership in a Shariah index has the opposite effect on earnings quality. This finding indicates that membership does not play an important role in ensuring managers’ ethical behavior. This result supports the idea that the current Shariah screening process does not fully conform to the underlying Islamic principles and concentrates primarily on negative screening rather than social welfare and transparency.
Furthermore, the inclusion in a Shariah-compliant index plausibly results from firms satisfying the screening criteria rather than from a conscious decision to conduct business in a Shariah-compliant manner. Membership basically implies that the firms do not do anything prohibited under Shariah law. Another plausible explanation for the variance between the two ethical sources could be that CSR rating agencies provide comprehensive details regarding CSR information that is relevant to investors in assessing every aspect of the firms’ CSR performance. The Shariah screening process, in contrast, is less transparent in that the process provides only the final outcome without explaining in detail the aspects that affect the decision to include a firm in, or exclude it from, the index. This in turn limits investors’ ability to track the firm’s Shariah performance and to predict the possibility of its Shariah-compliance in the future.
