INCOME SMOOTHING

FROM ISLAMIC PERSPECTIVE

Arranged by:
Soraya Laili Jabin 17312108
Syahirah Rossya 17312149

ACCOUNTING INTERNATIONAL PROGRAM

FACULTY OF ECONOMICS
UNIVERSITAS ISLAM INDONESIA
YOGYAKARTA
2018/2019
 ABSTRACT

This paper offers an explanation about income smoothing. Income smoothing

is a form of income management that reflects the results or economic results, not
because of those results, but because management produces lower quality of profits
or profits because income does not describe the economic performance of a
business for a certain period. This paper provides the factors that influence the
example of income smoothing and also how the financial statement can cause
income smoothing. This paper specifies income smoothing in Islamic perspective.
This study aims to find out the ethics of income smoothing seen from the perspective
of Islamic religion because the action of income smoothing (smoothing earnings) is
an action that can mislead the users of financial statements by presenting
information that is not accurate, and sometimes even the cause of illegal acts,
accountants educators, managers, and Ustadz believes it is an act that is prohibited
by religion because the nature of the work it does is a mandate, whether it is worldly
from its superior or business owner, or worldly from Allah SWT who will be held
accountable for the work he does.

Keywords: Income Smoothing, Islamic Perspective, Financial Statement, Shari’ah

 INTRODUCTION

Economic activity is an effort made by humans to achieve a level of prosperity

or prosperity in life. While economics in Islam is a study in which it discusses a rule of
the economy in Islam, everything is based on the values of Islam in a good and right
manner in accordance with Islamic rules. Economics in Islam must also lead to
positive things and activities carried out can be beneficial. In Islam, we as Muslims
are strictly prohibited from committing corruption, usury, monopoly, and so on. We
must be fair in doing anything, one of which is in activities related to the economy. In
the Qur'an, it is said that we must be fair because we will account for everything we
have done. If we obey and follow the teachings of Islam, God willing, we will get
merit and become worship for us. In this essay, we will discuss an economic activity
in accounting related to profit, namely income smoothing in an Islamic perspective.
Income smoothing is an action taken by management intentionally to reduce
fluctuations in profits with the aim of reducing earnings fluctuations that are too
large and make the company's reported profits look stable. Financial statements can
affect the capital market means to show how important financial statements. The
importance of financial statements can invite management to do things that change
the income statement for personal interests such as maintaining a position or getting
a high bonus. A good company is a company that has a stable profit and not many
fluctuations in each period. In accounting there are two methods of recording
transactions related to cash inflows and outflows, namely cash basis and accrual
basis.
 EXPLANATION

A. Ethics of Income Smoothing From Islamic Perspective

Income smoothing is an action taken by management intentionally to
reduce fluctuations in profits with the aim of reducing earnings fluctuations that
are too large and make the company's reported profits look stable. Fahmi ( as
cited in Ramadhona, p. 47) asserted income smoothing is an action that is done
by changing information on company income not as it should, and it is done with
a specific purpose and purpose. According to Subekti (as cited in Ibrahim, 2010,
p. 2) asserted the initial definition of income smoothing is a rational behavior
based on assumptions in positive accounting theory, where the management of
a company carries out certain policies to maximize its interests. Fuddenberg &
Tirole argues that income smoothing is a process of manipulating the time of
profit or earnings report so that reported earnings look stable.
In accounting there are two methods of recording transactions related to
cash inflows and outflows, namely cash basis and accrual basis. Islamic
accounting experts have conflicting opinions about recording accrual-based
accounting transactions. The statement of QS Luqman verse 34:

“Indeed, Allah [alone] has knowledge of the Hour and sends down the rain and
knows what is in the wombs. And no soul perceives what it will earn tomorrow,
and no soul perceives in what land it will die. Indeed, Allah is Knowing and
Acquainted. “
 It means that what will happen in tomorrow and future is ghoib. So that
uncertain income should not be recorded as income. According to Rais (as cited
in Suwandi, p. 65) asserted if QS Al-Baqarah verse 282 we associated with QS Al-
Luqman verse 34, it explains that accrual basis is not allowed. Because in Surah
Al-Baqarah verse 282 only recognizes the acquisition when the funds (cash) have
been received.

B. Specifies Income Smoothing in Islamic Perspective

As explained earlier, income smoothing can also be concluded as a
calculation of income that have been done through accounting procedures
applied to reduce costs or income from one period to another period,
specifically with changing accounting policies. Income smoothing has two types
of income smoothing it self, that are real income smoothing and artificial income
smoothing. Real income smoothing specifically described as income smoothing
that has been manipulated through real transactions with those that are
supported and can be changed with transactions. Real leveling uses financial
derivatives that tend to increase the real value of the company. In real income
smoothing, companies use strategies to increase productivity. While in artificial
income smoothing, is not directly related to company value. Artificial income
smoothing occurs when numbers are manipulated by the time of accounting
entries to produce a smooth flow of income.
In Islamic finance theory, the use of income for Investment Account
Holders (IAH) is well recognized. The Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI) and the Financial Accounting Standard
(FAS) 11 require the Profit Equalization of Reserves (PER) and the Investment
Risk Reserves (IRR). These reserves reduce returns for Islamic banking
institutions and the risk of moderate withdrawals. However, empirical studies
related to the practice of smoothing returns are inadequate and report mixed
results.
There are several basic views according from the informants regarding to
the ethics of income smoothing. from the Islamic perspective ethics, the ethics
are based on the provisions of the rules that have been made by Allah SWT
contained in the verses of the Qur'an. One of a view in Islamic perspective, is
that the income smoothing mechanism said to be unethical because the
practice is an attempt by managers in order to smooth out profits, which does
not reflect the condition of the actual financial statements.
Islam, preaches the Muslims to comply what Allah SWT has commanded
and leave what is His prohibition. Sometimes each individual has different
intentions in carrying out an action, in essence every action and action must be
based on intention and good intentions.
In the ethical perspective of Islam, the relationship between humans and
social believers is based on justice, kindness, not doing tyranny and arrogance.
Income smoothing can be described as one of the effort to manipulate financial
statements to make the financial statements look more stable and attractive
from year to year which is presented to external parties. income smoothing can
be done by manipulating accounting variables or by conducting real transactions,
or it can also be done by choosing an accounting method that is in accordance
with the wishes of management.
In the view of Islam, income smoothing should be part of fraudulent
information and attitudes to waste trust. such actions will receive threats and
warnings from the Prophet Muhammad, from Ma'qil bin Yasar al Muzani r.a, he
said,
"I heard the Prophet sallallaahu„ alaihi wa sallam said:

"There is not a servant whom Allah gives leadership over others, then he
dies in a state of cheating on those he leads, but Allah will forbid it upon
heaven."

However, income smoothing is the exploitation of income against

predetermined goals set by management. Currently income smoothing is very
commonly used for a company. According to some Sharia scholars, income
smoothing is unethical because of high income manipulation. In other words,
the Islamic view of income smoothing demands to work based on knowledge,
logical considerations and values set by Allah SWT.
 The client must know the actual income and company account before
investing. If the company does not show actual annual accounts to their
investors, then it is unethical. Sharia companies also may not follow the practice
of artificial income smoothing because of halal factors, because investors who
invest in companies registered in Sharia believe in "fair transactions”. Therefore,
such corporate sharia advisory boards must prevent practice income smoothing.

C. Factors that Influence Income Smoothing Practices

Prasetio (as cited in Fernanda, D., & Ath Thahirah, K., p. 231) asserted the
practice of income smoothing would not occur if the expected profit were not
too different from the actual profit. The first factor that influences the practice of
income smoothing is profitability. Profitability is a factor that is thought to
influence earnings because the level of profit is directly related to the object of
income smoothing. Fajar & Alit (as cited in Ramadhona, p. 14) asserted the
greater the change in ROA shows the greater the fluctuation of management's
ability to generate profits. The level of profitability itself describes the ability of a
company to produce profits and can be used to assess the extent to which a
company is able to generate profits.
The second factor that influences the practice of income smoothing is the
size of the company. The size of the company is considered very sensitive to the
practice of income smoothing because companies with a larger size are expected
to have a greater tendency to do income smoothing.
The third factor that influences the practice of income smoothing is
Financial Leverage. Financial Leverage is one of the factors that influence the
practice of income smoothing. Sartono (as cited in Ramadhona, p. 15) asserted
financial leverage shows the proportion of debt usage to finance a company's
investment. The greater the company's debt, the greater the risk faced by
investors, so investors will ask for a higher level of profit in the company. As a
result of conditions like this, it can force management to carry out income
smoothing practices.
The fourth factor that influences the practice of income smoothing is
public ownership. Public ownership is the level of ownership of the company by
the public or the general public outside the company environment.
Widhianningrum (as cited in Ramadhona, p. 16) asserted found that public
 ownership has a partial effect on income smoothing practices carried out by
company management. This is because the higher level of ownership by the
public will require management to better present the company's earnings
information. The structure of public ownership with a large proportion can
pressure management to present company information in a timely manner.
Because the timeliness of financial reporting can influence economic decision
making (Istiqomah, 2010). Nuraeni (as cited in Ramadhona, p. 16) asserted High
public ownership will improve profit management by the company management.
The higher the proportion of ownership of the company owned by the public
indicates that the level of investor confidence in the company is high, therefore
management tends to do income smoothing to show the level of profit and good
company performance.

D. Example of Income Smoothing

In Indonesia, the phenomenon of income smoothing practices has
occurred among others at PT. Waskita Karya. At the end of 2009, PT. Waskita
Karya was in the spotlight because of cases of financial report manipulation.
Where there was an excess of recording in the 2004-2007 financial statements.
At that time PT. Waskita Karya should have recorded a loss, but in the report it
actually looked profitable. This is because directors carry out financial
engineering since the 2004-2007 financial year by including future multi-year
projections as certain revenues. The company's financial forgery was detected
since August 2009 and caused PT. Waskita Karya to have a capital deficit of
Rp.475 billion. The engineering of the financial statements of BUMN in
construction services is only administrative (accounting). Individual directors
who are involved, are admitted to not intentionally falsifying financial reports for
personal gain. This is only a violation of the accounting side standards. The
difficult condition of the company caused them to find a way to falsify reports.
The example of income smoothing in Islamic Bank can be Mrs. Nurul is a
customer of a Shari’ah Bank. Because she had many businesses everywhere and
was successful, she decided to save 75% of her profits to Islamic banks. The
reason for Mrs. Nurul doing such things is external factors such as economic
fluctuations. 75% of all profits, namely Rp. 75,000,000 deposited in Shari’ah.
 Mrs. Nurul prefers mudharabah contracts to her contract. It was agreed that the
share would be 60% for Mrs. Nurul and 40% for the Bank. This concept will
collide with the notion of Income Smoothing. In Mudharabah the profit sharing
system that must be given to Mrs. Nurul is as much as agreed and given at that
time. However, the concept of Income Smoothing is not the case. For example,
in sharing the results, it turns out Mrs. Nurul gets 60% of it (Rp1,000,000).
Because banks experience problems in procuring capital in the short and long
term, the Bank does not give full rights that should have been received by Mrs.
Nurul. Mrs. Nurul only received half of the share. The other half was given the
following year.

CONCLUSION

In Islam, this income smoothing seems to contradict the rules of muamalah

fiqh, which contain elements of fraud (tadlis) and obscurity (gharar) because there
are parties who hide information from other parties (unknown to one party) in order
to deceive others who do not know about that information. In addition, if this action
is proven, then this is prohibited in Islam, because it violates the principle of "an
taraaddin minkum" (mutual pleasure).
 However, income smoothing is not totally wrong. This is the exploitation of
income against predetermined goals set by management. Income smoothing is very
commonly used for a company nowadays.

RECOMMENDATION

The client must know the actual income and company account before
investing. If the company does not show actual annual accounts to their investors,
then it is unethical.
Shari’ah companies shall not follow the practice of artificial income
smoothing because of halal factors, because investors who invest in companies
registered in Shari’ah believe in "fair transactions." Therefore, such corporate
sharia’ah advisory boards must prevent practice income smoothing.

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