Illusory profits are generated when there is a difference between historical and current costs. These profits are largest when two circumstances are present:
- Costs are rising; and
- A business 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.
For example, 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.
Illusory profits are also known as phantom profits.