Question

why is it illegal to inflate income statements and how does it affect stockholders?

Answer 1

To inflate income statements is an accounting fraud and thus it is illegal. Income statement can be inflated by overstating revenues ore understating expenses. The manipulation of financial statements is done for the self-interest of business. This is mostly done to attract investors for financing. Stockholders mostly derive value of the firm on the basis of revenues. If the exaggerated revenues are reported in the income statement, then the value of firm derived on its basis will be high. If the price/earnings ratio is used for stock valuation then in that case also the stock valuation will have influence of inflated revenues. The stock valuation and value of firm are the important elements on which stockholders keep check on. Due to inflated income statement, stockholders would always perceive these elements to be high, which in actual may not be.