Capital structure and earnings management: evidence from Saudi Arabia

Abstract

Purpose

This study aims to examine how capital structure influences earnings management for firms in the Saudi market, which is influenced by an Islamic environment that discourages excessive borrowing.

Design/methodology/approach

This study uses a data set that covers the period from 2013 to 2020 for firms listed on the Saudi Stock Exchange (Tadawul) and uses panel data regression models to test the impact of capital structure on earnings management.

Findings

The empirical results reveal that earnings manipulation is less common among firms that have less debt, which implies that firms in the Saudi market face high scrutiny to maintain lower leverage to meet the investment requirements of stakeholders based on religious status, which in turn reduces information asymmetry and constrains opportunistic behaviour in managing earnings.

Practical implications

This study provides insights for regulators, investors, and managers on the role of religion in shaping capital structure and monitoring financial reporting practices. This study recognises that firms’ decision-making can be explained by non-economic motives, such as religion, which can serve as a less costly external mechanism to alleviate agency costs compared to other economic motives.

Originality/value

This study contributes to the literature by exploring how capital structure and earnings management relate to a distinctive and unique Islamic context that remains largely unexamined. This context allows us to investigate this issue by examining how the Islamic environment, which is not driven by economic or legal reasons, affects managers’ choices of capital structure and earnings management. This study reveals how a strong religious setting can shape firms’ choices regarding capital structure and financial reporting practices.