Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol 3, No 3, 2012 88 Earnings Management to Avoid Earnings Decreases and Losses: Empirical Evidence from Islamic Banking Industry Faouzi Mohamed Hamdi 1* Mohamed Ali Zarai 2 1. College of Administrative Sciences and Humanities in Majmaah, Al Majmaah University, Saudi Arabia. 2. Faculty of Administrative and Financial Sciences, Al Baha University, Saudi Arabia. * E-mail of the corresponding author: faouzi_hamdi@yahoo.fr Abstract We use earnings distribution approach (EDA) to investigate whether and why Islamic banks manage reported earnings. First findings confirm the assumption that Islamic banks manage earnings to avoid reporting losses (with statistical tests) and earnings decreases (with visual evidence but without statistical tests). However, earning management phenomenon is not as obvious in Islamic banking institutions as in other non-Islamic institutions. That is, Islamic banking institutions practice earnings manipulations but not as well as non-Islamic institutions. Additionally findings show that prospect theory can explain the trade-off between risk and return, i.e., Islamic banks above the earnings threshold are found to be risk averters while banks below the earnings threshold are found to be risk seekers. Therefore, we have accepted the hypothesis that prospect theory explains Islamic banks’ motivation in managing earnings to exceed thresholds. Keywords: Earnings Management, Earnings Distribution Approach (EDA), Prospect Theory, Islamic Banking Institutions. 1. Introduction Banking industry is shown to be of a great importance to national, regional, and global economy. However, banks around the world are found to have managed their earnings (Shen and Chih, 2005). Earnings management 1 restricts investor’s capacity to forecast banks’ future cash flow correctly based on the current financial information. So, it increases information asymmetry problems between banks and investors and reduces banking sector stability. The latest global financial crisis has shown that information dispersal in banking industry is not enough and information asymmetry problems are very severe. One remarkable phenomenon is that Islamic banking institutions were not brutally affected by the financial crises period (Anouar M., 2011). Thus, it is an interesting and important question to examine whether Islamic banks are less likely to manage their earnings. Earnings management has attracted the attention of academic researchers in accounting and finance, especially in recent years after the many accounting scandals in prominent companies such as Enron and WorldCom1 (Ibrahim S. S., 2005; Giroux, 2004). However Islamic banks and other Islamic financial institutions are often neglegted from earnings management research because their characteristics differ fundamentally from other conventional institutions. There have been prior empirical studies investigating earnings management by Islamic banks. These studies have focused on loan loss provisions (LLPs) 2 as a 1 In the context of this study, we refer to earnings management as manipulation of earnings that is designed to serve management’s purposes. Whether it is fraudulent is not a consideration. Also, whether it is harmful to investors and others is not a consideration. 2 In accounting literature, the focus of empirical studies on earnings management in banks is on loan loss provisions (LLPs). Loan loss provisions (LLPs) are a relatively large accrual for commercial banks and therefore have a significant impact on earnings and regulatory capital of banks. The purpose of t hese provisions is to adjust banks’ loan loss reserves to reflect expected future losses on their loan portfolios. However, bank managers also have incentives to