Net income is the bottom line of your income statement. To get there you add up your revenues and subtract your expenses and net income is the result. In practice, some of the income statement entries are estimates. If you overstate or understate them, net income becomes inaccurate. That can give you a distorted idea of how your business is doing. At worst, investors might accuse you of fraud.
Why Net Income Matters
Investors and lenders study financial statements to decide if your business is a good risk. The income statement, which shows how much you earned in a given period, is particularly important to investors. Dividends come out of net income; the amount of dividends divided by the number of shares gives the important earnings-per-share figure. Overstating net income makes your earnings per share better. It also affects performance-based bonuses.
Understating net income makes your company look less profitable, and therefore less desirable. Even so, there have been cases where executives deliberately opted to understate it.
The top of the income statement deals with your revenue for the period. Income includes cash sales and credit sales, which are accounts receivable as credit sales are income you've earned but haven't received yet. Some of that debt may never be paid, for example when customers refuse to pay or go bankrupt. By looking at how many bills went unpaid in the past, an accountant can estimate how many current debts will also go unpaid.
Understating the amount of bad debt makes both your income statement and your balance sheet look stronger and healthier. For every debt you don't write off, your net income gets a little bigger. Likewise, if you understate the number of returns you anticipate, that makes the revenue and net income figures higher.
After you write the revenue on your statement, you subtract the cost of goods sold to determine your gross income. Various other additions and subtractions turn gross income into net income.
The cost of goods sold is based on the difference between your beginning and ending inventory. If you overstate inventory, indicating you've sold fewer items, cost of goods sold shrinks and your net income gets larger. If you understate inventory, your net income becomes smaller than it really is.
It's easy to get inventory figures wrong. The inventory team can miscount items or misclassify them in the files, or inventory in transit isn't entered into the computer properly. In some cases, managers will deliberately overstate inventory to pad net income.
If the big concern is the company's tax bill, the incentives are reversed. Companies want to understate net income to reduce the company's tax. The same kind of errors and frauds exist, but they work in the opposite direction. For example, understating inventory to make net income less makes for a smaller tax bill.