Answer
Phantom inventory profits occur when the inventory costs matched against sales are less than the replacement cost of the inventory. The costs of goods sold therefore is understated and profit is considered overstated. Phantom profits are said to occur when FIFO is used during periods of rising prices.
Work Step by Step
High inventory profits through involuntary liquidation occur if a company is forced to reduce its LIFO base or layers. If the base or layers of old costs are eliminated, strange results can occur because old, irrelevant costs can be matched against current revenues. A distortion in reported income for a given period may result, as well as consequences that are detrimental from an income tax point of view.
