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«Abstract: This research aims to analyze the relationship between financial leverage, debt covenant, and dividend payout ratio to income smoothing ...»

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THE RELATIONSHIP BETWEEN FINANCIAL LEVERAGE,

DEBT COVENANT AND DIVIDEND PAYOUT RATIO

TO INCOME SMOOTHING PRACTICES

(Empirical Study On Companies Listed In Indonesia Stock Exchange

On 2006-2011)

By:

; Mukhtaruddin, Emilia Nurhuda and Abukosim

Economics Faculty, Sriwijaya University, Palembang, Indonesia Abstract: This research aims to analyze the relationship between financial leverage, debt covenant, and dividend payout ratio to income smoothing practices on companies listed on Indonesia Stock Exchange (IDX) on 2006-2011 periods. The amount of samples for the observation as the results of Eckel Index is 18 companies. Hypothesis tested by t-test to test regression partially and F-test to test regression simultaneously. The regression model used is multiple regression. The results of research show that financial leverage, debt covenant and dividend payout ratio do not significantly influence income smoothing practices partially and simultaneously. This caused by many limitation of this research such as the amount of variables are few and the amount of samples are only 18 samples because the delimitation of companies observed which excludes manufacturing and banking companies and lists on IDX.

Background Financial statement provides information for the owner and the stakeholder in order to making decision. For example, investors examine whether the company is trustworthy in making high profit or not from the financial statement. Meanwhile, the owner can use financial statement to evaluate the management’s work and the company’s financial performance. One of the parameter used in evaluating company’s performances is earnings. Management uses many ways in making the company could face the globalization such as expanding the business with short and long term business strategy. In this day, there are a strategy trends to expand the company by joining the stock exchange (go public). Based on Indonesia Stock Exchange, in early 2000, there were 259 companies listed go public (Wangi, 2010). It gradually increases until in 2012, there are 453 companies (www.idx.co.id).

This study focuses on the practice of opportunistic earnings management, one of the ways that can be used in the practice of earnings management is to use income smoothing technique (income smoothing). Belkaoui (2000, in Amanza 2012) suggests that income smoothing understanding by management is a deliberate effort in order to minimize fluctuations in the rate of profit according to the company are considered normal. Because the investors prefer the stable profit. The stable the profit, the stable dividend and wealth will be gained. For the management, the stable profit shows good signal to the creditor that the management performance is on stable state.

There are many factors that affect management practice income smoothing. But for this study, there are financial leverage, debt covenant and dividend payout ratio. When the earnings manipulated, the financial ratios in the financial statements will also be manipulated.

Finally, when a user of financial statements is using the information that has been manipulated for the purpose of decision making, the decision is manipulated indirectly. On the other hand, the financial statements are used by investors in making economic decisions.

According to Sartono (2001 in Budiasih 2009) financial leverage shows proportion of debt to finance its investment. Another leverage ratio is debt equity ratio or debt covenant. It illustrates company’s capability to guarantee the debt with its own equity and the proportion of company’s expenditure which is financed by shareholders (equity) and loans. High Leverage 1 Company has big risk to suffer losses because the higher leverage causes the higher financing proportion of a company from debt or loans. So it tends to break loan’s agreement because company cannot pay the debt on due date. The larger the firm's debt, the greater the risk faced by investors so that investors will ask for higher profits. Due to these conditions companies tend to practice income smoothing.

Joining the Indonesia Stock Exchange means companies sell the shares or obligations to public. Instead, the companies have to pay dividend to shareholders. The Dividend Policy set dividend distribution to investors or shareholders. The amount of the dividend depends on the amount of profits. From the dividend ratio, investors probably interest to invest. One of dividend policy is constant dividend payout ratio. The DPR imply the amount of dividend may be changed according to the earnings with constant dividend ratio. Investor typically assume the stable profit will effect to the stable dividend (Hepworth (1953, cited Rachmawati 2002). So companies tend to do income smoothing practices in order to make the fluctuation of earnings is stable.

Theoritical Views and Hypothesis Development

1. Agency Theory This theory assumes that the respective individuals motivated solely by self-interest that is a conflict of interest between principal and agent. Shareholders as the principal want high profitability every year to increase the wealth. Managers as agents are motivated to maximize economic needs by doing disfunctional behaviors. Because each individual has a tendency to maximize its own interests, information asymmetry comes out. It is possible for the management (agent) to hide information from the principals primarily related to management performance within the company even though it does not show the real condition of the company. One of the way used by managers is income smoothing. So this theory supports the income smoothing practices.





2. Signalling Theory The signaling theory explains why the company has encouragement to provide information on external financial reports so there is asymmetry of information between company and external parties. Signalling theory describes how companies give signal to the investor that the companies have good future by disclosure the information in financial statement. So the financial statement that published in Indonesia Stock Exchange must give relevant, complete and accurate information in order to persuade the investors. Giving good signal to investors by disclose the ratio of financial statement in order to pull investors attention.

For example, the leverage ratio consists of financial leverage and debt covenant or debt to equity ratio. In order to show a good ratio probably manager practices income smoothing.

Income Smoothing Income smoothing can be defined as an effort to minimize the number of reported earnings if actual income is greater than normal profits, and efforts to increase the number of reported earnings if actual earnings are smaller than normal profits (Amanza, 2012). Belkaoui (2000) defines as income smoothing is a deliberate attempt made to try to reduce the management of abnormal variations in the company's profits in order to achieve a normal level for the company. So it means income smoothing is one of earnings management efforts by reduce the fluctuation in the company’s profit.

According to Eckel research (1981, in Dewi 2011) income smoothing can be

caused by two types, namely:

2

1. Natural Smoothing Stating that income smoothing process is inherently generate a stream of flat income. It means the income will be smooth by itself without the intervention of other parties.

2. Intentional Smoothing/Designed Smoothing Stating income process is influenced by other parties’ actions, such as management.

Designed smoothing is divided into two, there are artificial smoothing and real smoothing.

Artificial smoothing is income smoothing process from doing such manipulating the accounting. Real smoothing is the process how management’s actions to control the economy activities.

Some Reasons Management Conduct Income Smoothing There are some reasons management conduct income smoothing. Hepworth (1953, cited Rachmawati 2002) states motivation that pushing for income smoothing is to improve relations with creditors, investors, and employees as well as smoothing the business cycle through a psychological process. Hepworth (1953, cited Rachmawati 2002) said income

smoothing is used to:

1. Reduce the tax

2. Enhance investor confidence, as investors typically assume that stability of income will affect the stability of the dividend.

3. Maintain good relations between managers and workers. If the company reported a sharp increase profits, they (workers) will demand higher wages and salaries.

Factors Influence Income Smoothing Financial leverage is defined by debt to total assets. It is calculated by dividing total debt to total assets. The indications of income smoothing practices could exist because the companies avoid debt infringement that implied from the capability of paying debts with the assets. A high leverage company is expected doing income smoothing due to the default possibility. So, management makes strategy in order to increase the profit.

H1: The financial leverage significantly influences the income smoothing practices Debt Covenant or debt equity ratio implies the capability of company in paying debt with the equity. The higher the DER, the higher proportion of company finance from debt.

It dispose company breaks the loan’s agreement due to cannot pay debt on due date. So company practices income smoothing to showing that the company has stable and good profit.

According to Rahmawati (2002), debt equity ratio has a positive relation with income smoothing.

H2 : The debt covenant significantly influences the income smoothing practices Investors choose the company to invest by considering the dividend. Company decides the amount of dividend (dividend per share) that will be given to shareholder by making dividend policy. To enhance investors’s confidence, company should show a stable profit that results stable dividend. Because of that, managers could do strategy such income smoothing in stabilizing income.

H3 : The dividend payout ratio significantly influences the income smoothing practices Population And Sample The population of study is all public companies listed on the Indonesia Stock Exchange excluding manufacturing and banking companies. The companies will be observed are agriculture, forestry and fishing, mining and mining services, constructions, securities, insurance, real estate and property, transportation services, telecommunication, whole sale and 3 retail trade, hotel and travel services, holding and other investment companies, and also others sectors. The total of the companies are 143 of 453 companies.

Variables And Measurements Variable Dependent Dependent variable in this study is income smoothing. Author classify if there are income smoothing practices or not in a company using Eckel index (1981).

Eckel index is chosen as the most effective to measure income smoothing because most of the previous research also use it. Eckel used Coefficient Variation (CV) of income variables and net income variables.

Income smoothing is calculated as follows (Eckel, 1981):

IS = and where

Where:

IS : Income Smoothing △I : Change in net income in a period △S : Change in sales/revenue in a period CV : Coefficient Variation of variables, i.e. the standard deviation divided by the average change in earnings(I) or sales/revenue (S).

CV△I : Coefficient Variation of change in net income CV△S : Coefficient Variation of change in sales/revenue

CV△I/ CV△S is calculated as follow:

CV△I or CV△S =

–  –  –

CV△I or CV△S = : change in net income or sales/revenue : the average change in net income or sales/revenue n : the number of years observed Variables Independent Financial Leverage Financial leverage is proxied by debt to total assets acquire by total debt divided by total assets (Budiasih, 2009).

Debt to assets ratio = Debt Covenant Debt Covenant (Rahmawati, 2002) is measured by debt to equity ratio, by the

formula:

–  –  –

Data Collection Methods The data used in this study is secondary data. The source of data in this study is annual financial statement for 2006-2011 periods on Indonesia Stock Exchange. The data is obtained from ICMD and website link www.idx.co.id. It also uses information taken from some literatures, book, and websites accordance the topic research.

Techniques Analysis The method of analysis used in this study is the method of quantitative data analysis using SPSS 17 as a tool for test data. There are several tests for analyzing, there are normality tests, multicollinearity tests, heterocedacity tests, autocorrelation tests, determinant coefficient tests, and some descriptive statistics tests. In analyzing the hypothesis, this study uses t-test for tests regression partially and F-test for test regression

simultaneously. The model regression of this research is multiple regressions, as follows:

IS = α+ β1 DARit + β2DERit + β3DPR +εit.....

Where :

ISit : Income Smoothing Ranks based Eckel index on firm i in year t β1 DARit : Financial Leverage Ratio on firm i in year t β2DERit : Debt Covenant (Debt to Equity Ratio) on firm i in year t β3 DPRit : Dividend PayOut Ratio on firm i in year t εit : error term Description of Research Samples This research observed all companies listed in Indonesia Stock Exchange but manufacturing and banking companies. According to Indonesia Stock Exchange, there are 453 companies joining IDX. The total of companies observed are 145 companies. So the companies observed are agriculture, forestry and fishing, mining and mining services, constructions, securities, insurance, real estate and property, transportation services, telecommunication, whole sale and retail trade, hotel and travel services, holding and other investment companies, and also others sectors. To classify the samples, this research uses Eckel Index. As results, the table below shows the list of companies as the samples that do income smoothing.

Table 1 Eckel Index Results

–  –  –



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