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 is known as earnings management and 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 business managers prefer a stable rather than a volatile earnings trend.

Required:

a. Why do business managers prefer stable earnings trends?

b. Discuss several methods business managers might use to smooth earnings.