What are Phantom Profits?

Phantom profits are earnings generated when there is a difference between historical costs and replacement costs. If there is a difference between this historical cost and the current cost at which it can be replaced, then the difference is said to be a phantom profit. Managers need to be aware of phantom profits, especially when there is a substantial difference between the old cost layers and replacement costs. Once the old cost layers have been eliminated, managers may find that their reported profit levels suddenly decline.

Characteristics of Phantom Profits

Most types of phantom profits share certain characteristics, which are noted below:

Non-cash in nature. Phantom profits do not correspond to actual cash inflows. They are "paper profits" created by accounting methods rather than real increases in wealth.
Influenced by accounting policies. Phantom profits are triggered by accounting policies, such as the types of depreciation methods or inventory valuation methods used.
Caused by inflation. Inflation can cause the reported value of inventory or assets to rise, which may lead to higher profits on paper, particularly when older, cheaper inventory is replaced with newer, costlier goods.
Temporary in nature. Phantom profits are often temporary. Over time, the accounting or economic conditions that created them may reverse, eliminating the unreal profits.

FIFO Phantom Profits

The phantom profits issue most commonly arises when the first in, first out (FIFO) cost layering system is used, so that the cost of the oldest inventory is charged to expense when a product is sold. This can trigger the recognition of a significant phantom profit when the cost of the oldest inventory items are much lower than the cost of this inventory if it were to be purchased today.

LIFO Phantom Profits

When a business uses the last in, first out (LIFO) cost layering system, the most recent historical costs are charged to expense first, so there should be little difference between these costs and current replacement costs. Thus, phantom profits tend to be reduced in a LIFO environment. The one exception is when the newest cost layers are used up and earlier cost layers are accessed, in which case phantom profits are more likely.

Related AccountingTools Courses

Accounting for Inventory

How to Audit Inventory

Example of Phantom Profits

A company sells a green widget. The firm uses the FIFO cost layering system, and the oldest cost layer for the green widget states that the widget costs $10. The widget sells for $14, so the profit appears to be $4. However, the replacement cost of the widget is $13, so if the widget had been sold at replacement cost, the profit would instead have been $1. Thus, the $4 profit using FIFO is comprised of a $3 phantom profit and a $1 actual profit.