What are Illusory Profits?

Illusory profits are generated when there is a difference between historical costs and current costs. These profits are largest when costs are rising or when a firm has a large asset base. Under these circumstances, an organization may charge to expense older costs that have been on the books for some time, and which can only be replaced at higher current costs. Thus, the profits reported have only occurred because the firm had a large store of assets that were acquired at a lower cost. Once these assets are depleted, the illusory profits will vanish. This means that illusory profits should only last for a relatively short period of time.

Example of Illusory Profits

A business has a cost layering system that requires it to retain in its records the costs of the earliest inventory items acquired, until these items are used. When these inventory items are eventually sold, their earlier (and lower) costs are charged to expense. If the company had not retained these extra units of inventory, the company would instead have been forced to acquire or produce goods at current costs and then charge these costs to expense, which would have resulted in a lower reported profit.

How to Create Illusory Profits

There are several ways to create illusory profits. One is to extend the presumed useful life over which assets are being depreciated, so that the depreciation expense in any given period is lower than the actual decline in value of these assets. Another option is increase the presumed salvage value of fixed assets, which also reduces their periodic depreciation expense. Yet another possibility is to switch to the first-in, first-out cost layering method when compiling the cost of inventory, since this method charges the cost of earlier (and presumably cheaper) inventory to expense when goods are sold.