What is illusory profit?

Illusory profit, also called phantom profit, is the difference between 1) the profit reported using historical costs required by US GAAP, and 2) the profit computed using replacement costs. Illusory profit is greatest during periods of rising costs at companies with significant amounts of inventory and plant assets.

For example, when inventory is measured by using the first-in, first-out cost flow assumption under US GAAP, the actual historical cost of inventory that is charged to the cost of goods sold during periods of rising costs is smaller than the amount computed using replacement costs. This smaller amount of costs charged to the income statement means reporting greater profit. The difference in the profit is said to be illusory.

In the case of plant assets used during periods of rising costs, the depreciation expense reported on the income statement based on historical costs (required by US GAAP) will be less than the depreciation computed by using the higher replacement cost of the plant assets. The additional profit from this difference in depreciation is considered to be illusory profit.