Question

One reason accounting earnings may not be a realistic measure ofeconomic income is the incentive and ability of business managersto manipulate reported profits for their own benefit. This may beparticularly true when their company has an incentive compensationplan that is linked to reported net income. The manipulation ofearnings known as earnings management frequently involvesincome smoothing. Income smoothing has been defined as thedampening of fluctuations about some level of earnings that isconsidered normal for the company. Research has indicated thatincome smoothing occurs because investors prefer a stable ratherthan a volatile earnings trend.

Discuss why investors prefer stable and consistent earningstrends. Identify ways and methods that business managers might useto smooth earnings