THEORETICAL FRAMEWORK AND HYPOTHESIS DEVELOPMENT Agency Theory

2. THEORETICAL FRAMEWORK AND HYPOTHESIS DEVELOPMENT Agency Theory

This theory is a model developed in 1976 proposed by Jensen and Meckling, which discusses the contractual relationship among the members of the company that originated from the form of corporates that separates clearly between business owners with management. Management considered as an agent and owner of the company is considered as the principal. Principal normally delegated their authority to the management (agent) of the company.

The imbalance of information between agent and principal will lead the management (agent) tend to act in accordance with their interests to maximize its utility. And sometimes cause a specific policies are only known to the management (agent) without consent of the owner of the company (principal).

International Conference on Business, Economics, Socio-Culture & Tourism 2016 (ICBEST2016)

Positive Accounting Theory Positive Accounting Theory explained process, by using ability, understanding, and accounting knowledge

and also appropriate accounting policy to face certain conditions in the future. Three hypotheses positive accounting theory, which can be used as a basis for understanding income smoothing practice was formulated by Watts and Zimmerman (1986), are as follows:

1. The bonus plan hypothesis ―Ceteris paribus, managers of firms with bonus plans are more likely to choose accounting procedures that shifts reported earnings from future periods to the current period‖.

The management of the company that has a bonus plan, tend to choose accounting procedures to shifting income from future periods to the current period. This is accordance with the principle Time Value of money.

2. Debt Convenant Hypothesis ―Ceteris Paribus, the larger a firm‘s debt/equity ratio, the more likely the firm‘s manager is to select accounting procedures that shifts reported earnings from future periods to the current periods‖.

In companies that have high level of Debt to Equity Ratio, the management at these companies tends to use accounting methods that can increase revenue and profits.

3. Political Cost Hypothesis. ―Ceteris paribus the larger firms, the more likely the manager is to choose accounting procedure that defer reported earnings from current period to future periods‖.

This hypothesis is based on the assumption that large companies are more sensitive to political interest. Big companies have a large amount of tax, so, they try to avoid paying the higher taxes by transferring income in the current period to the next period.

Profit Accounting Principal Board (APB) statement defines net income (loss) as an excess (deficit) of revenue over

expenses during the accounting period. While, based on Financial Accounting Standard Board (FASB) defines accounting income as the change in equity (net assets) of an entity during a given period, resulting from transactions and events or events that derived not from the owners (Syafriont, 2008).

Income Smoothing Income Smoothing can be seen as an intentionally efforts to normalize income to achieve the desired income

level. Ratnasari (2012) stated that income smoothing practice intentionally did by management have purpose to give good perception to investor related to the success of the company to make the income stable.

Research Model This research will analyze the effect of profitability, leverage, and company size to income smoothing

practice on manufactures companies listed in LQ 45 Index in the period of 2010 – 2015. The independent variables in this research are profitability, leverage, and company size. While, the dependent variable in this research is income smoothing practice.

Profitability toward Income Smoothing According to Weston and Copeland (1995) Profitability was defined as a ratio in measuring the effectiveness

of management based on reported earnings. Profitability is a component of company financial statement that aim to assess management performance, estimate representative earning capacity in the long term and assess risks in investment (Dwiatmini and Nurkholis, 2001).

Based on Bonus Plan Hypothesis, manager in a company that has bonus plan will be motivated to perform income smoothing practice, manager will seek to achieve results between bogey (minimum income level for bonuses) and cap (maximum level for bonuses). Company that has bonus plan, is a company that has a good level of profitability. Managers at company that have a good level of profitability will be more flexible to

2016 International Conference on Business, Economics, Socio-culture and Tourism

perform income smoothing, because management knows the company‘s ability to generate income in the future.

Thus hypothesis can be formulated: H1 : Profitability has a positive effect to income smoothing practice. Leverage toward Income Smoothing According to Riyanto (1995) stated that leverage is the use of funds with a fixed expense. Based on Debt

Convenant Hypothesis, Company that have high level of leverage indicated perform income smoothing practice because company threatened default. Debt Convenant Hypothesis just stated the condition when the company have high level of leverage. In this research, the researcher have own perspective when the company have low level of leverage. When the company have low level of leverage, means that the company using less debt compared to equity, then fixed expense of the company will be low and will increase company‘s income.

Thus hypothesis can be formulated: H2 : Leverage has a negative effect to income smoothing practice Company Size toward Income Smoothing According to Moses (1987) larger companies have a greater encouragement to perform income smoothing

practice than smaller companies because the larger companies became the object of inspection. This is similar to Madura (2007) which stated that the larger company has a more encouragement to perform income smoothing practices rather than smaller company. Based on Political Cost Hypothesis, managers at large company will try to choose accounting procedures or accounting method that can be shift profit from current period to future period, in order to avoid pay more taxes.

Thus hypothesis can be formulated: H3 : Company size has a positive effect to income smoothing practice.