Financial Accounting: Income Concepts and Working Capital

One reason accounting earnings may not be a realistic measure of economic income is the incentive and ability of business managers to manipulate reported profits for their own benefit. This may be particularly true when their company has an incentive compensation plan that is linked to reported net income. The manipulation of earnings known as earnings management frequently involves income smoothing. Income smoothing has been defined as the dampening of fluctuations about some level of earnings that is considered normal for the company. Research has indicated that income smoothing occurs because investors prefer a stable rather than a volatile earnings trend.

Discuss why investors prefer stable and consistent earnings trends. Identify ways and methods that business managers might use to smooth earnings.

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