Question

In an article that appeared in the Wall Street Journal, the phrases “phantom (paper) profits” and “high LIFO profits” through involuntary liquidation were used. Explain the sephrases.

Short answer

Phantom profit is a result of FIFO inventory in an inflationary period. Involuntary liquidation is the result of layer reduction of base year reduction.

Step-by-step solution

Phantom (paper) profits

Phantom (paper) profit is the result of using the FIFO method during an inflationary period. In the FIFO method, ending inventory is valued at recent prices, and COGS is valued at historical prices. So during the inflation period, COGS seems to be very low. As a result, the profits are overvalued, and it is reflected only as a paper profit and not a real profit.

 Step 2: High inventory profits through involuntary liquidation

This is the problem that happens when the LIFO base year or layer is forcibly reduced. The LIFO base or layer is reduced due to the reduction in ending inventory at base cost in the subsequent year. Thus, as a result, irrelevant and old costs are matched with the current revenues leading to the problem of net income distortion.