Unravelling non-linear dynamics between earnings management, governance quality, and bank profitability: Evidence from emerging financial system

The study explores the non-linear relationship between earnings management, governance quality, and profitability in the evolving financial system of Oman. It addresses the issues of endogeneity, persistence, and simultaneity of discretionary provisioning and profitability using a two-step system Generalised Method of Moments (System-GMM) method. It uses a panel dataset of 72 bank-year observations from eight banks listed on the Muscat Stock Exchange over the period 2015–2023. Governance quality is used as a composite indicator of board independence, audit committee activity, and regulatory compliance, while earnings management is represented by discretionary loan loss provisions. The study provides empirical evidence for the inverted U-shaped relationship between discretionary provision and profitability, implying that some income smoothing stabilizes profitability while excessive earnings management reduces profitability. Governance quality has a considerable impact on the relationship between earnings management and profitability, implying that monitoring can help to prevent opportunistic earnings management and reporting. This study provides context-specific insights for the Central Bank of Oman and the Capital Market Authority, highlighting the importance of governance mechanisms in constraining opportunistic earnings management. By focusing on Oman’s dual banking system during the IFRS 9 transition and post-pandemic period, the study contributes to the literature by demonstrating how institutional and regulatory characteristics in a small, concentrated banking system shape the relationship between earnings management and profitability.