Phantom Profits

Phantom profits, sometimes called inventory profits or illusory profits, are the portion of a company's reported profit that results from rising prices rather than from genuine improvement in its business. They arise because accounting measures many costs at historical cost. When prices are rising, goods sold are charged at what they cost months earlier, and long-lived assets are depreciated on what they cost years earlier, while sales are made at today's prices. The difference inflates profit, but the business has to spend more cash to replace the stock and equipment it has used.

The idea is closely linked to inflation and to the choice of inventory method. It is most pronounced under first-in, first-out (FIFO), which matches the oldest, cheapest costs against current revenue. Under last-in, first-out (LIFO), more recent costs are charged to cost of goods sold, which reduces phantom profits on inventory.

• Inventory: under FIFO, cost of goods sold reflects older purchase prices. The gain between the historical cost and the current replacement cost of goods sold is a holding gain included in gross profit.
• Depreciation: charges based on the historical cost of buildings and machinery understate the current cost of using them, so operating profit is overstated in real terms.
• Taxes and dividends: because tax is charged on reported profit, a company can pay real tax on phantom profits, and paying them out as dividends can leave it short of cash to replace assets.

A hardware distributor buys 1,000 units of a product at $10 each. By the time it sells them for $18 each, the supplier has raised the price to $13. Under FIFO, gross profit is:

Here $\text{Units sold}$ is the quantity sold, $\text{Replacement cost}$ is the current cost to buy the same goods, and $\text{Historical cost}$ is what the goods actually cost. Reported gross profit is 1,000 times ($18 minus $10), or $8,000. On a replacement cost basis, gross profit is 1,000 times ($18 minus $13), or $5,000. The phantom profit is 1,000 times ($13 minus $10), or $3,000. If the company pays 25 percent tax on the $8,000 and distributes the rest, it will be left with $18,000 of sales receipts minus $2,000 of tax and $6,000 of dividends, or $10,000 of cash, which is not enough to buy 1,000 replacement units at $13, a total of $13,000. To maintain the same volume, it must borrow or raise $3,000.

Phantom profits can mislead investors, managers and policymakers about how well a business is really doing. In the high-inflation years of the 1970s in the United States and the United Kingdom, many companies reported record profits while struggling to fund the replacement of inventory and plant, and some economists estimated that a large share of reported corporate earnings was inventory profit. The national accounts address this through an inventory valuation adjustment, which removes holding gains from measured corporate profits.

The problem led to experiments with inflation accounting, including the FASB's requirement from 1979 to 1986 that large US companies disclose supplementary information on current cost and constant dollar bases, and the UK's current cost accounting standard of 1980. In countries with hyperinflation, IFRS requires financial statements to be restated using a general price index under IAS 29.

Companies in the United States can reduce phantom profits for tax purposes by electing LIFO, but must then also use LIFO in their financial reports under the inventory conformity rule. Analysts adjust for phantom profits by comparing FIFO and LIFO results, using the LIFO reserve disclosed by LIFO users, and by comparing depreciation with current capital spending. A business that pays dividends equal to its reported profits during a period of high inflation may be distributing capital rather than income, a point emphasized by the capital maintenance approach to net income.