Whether granted up front or over a period of years, the phantom stock units may either be immediately vested or subject to any vesting schedule determined by the company. For example, vesting may be cliff or graded, time-based, or based on the achievement of specified financial performance goals. At the end of the vesting period, the company’s stock has risen to $40 per share. Appreciation on any asset, e.g. stock, is considered phantom profit unless or until the asset is sold, thereby generating cash flow. This is a simplified example, but it shows how accounting methods can sometimes create the appearance of profit where there isn’t one. It’s important for anyone reading a company’s financial statements to understand these nuances.

This is the value today of the benefits you would have received over the course of your working life. They can be moved into and out of the plan with relative ease, while ownership remains with those committed to the business. For employees, there’s no need to purchase phantoms stock shares as regular stockholders must do on the open market. Instead, phantom shares are given to employees with no money changing hands. That’s a big benefit to employees, who share in the stock’s profits without having to pay for it.

Under GAAP the amount of depreciation expense reported in the financial statements is based on the historical cost of the asset and is not based on the asset’s replacement cost. For example, an electric utility is depreciating (and usually charging its customers) the original cost of a power plant until the plant is fully depreciated. However, the utility is using up the economic capacity of that plant and the economic capacity might have a replacement cost that is three times as much as the plant’s original cost. The utility (or any manufacturer depreciating productive assets) will be reporting higher profits using depreciation expense based on old low cost instead of current replacement cost.

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In inflation, the distinction between nominal and real profit is crucial. Phantom profits arise because depreciation is based on historical procurement values. These phantom profits are taxable, leaving a financing gap for new investments in fixed assets. The profit situation of companies varies widely across countries and industries reflecting differences in risk and cost of capital. This margin provides a rather thin buffer against the effects of inflation. Defending real profit becomes very difficult at inflation rates of 8 percent or more.

• Whether granted up front or over a period of years, the phantom stock units may either be immediately vested or subject to any vesting schedule determined by the company.
• The firm uses the FIFO cost layering system, and the oldest cost layer for the green widget states that the widget costs $10.
• Phantom stocks are a form of employee compensation that gives employees access to stock ownership without actually owning the stock.
• Illusory profit is greatest during periods of rising costs at companies with significant amounts of inventory and plant assets.
• Phantom income is also sometimes referred to as «phantom revenue.» While phantom income is not necessarily a common occurrence, it can complicate the process of tax planning when it does occur.
• However, it depends on the agreement made between the company and the employees.
• Had the replacement cost of the product been used, the cost of goods sold might have been $145.

AUD CPA Practice Questions: Applying Professional Skepticism and Judgment

Also, companies can include provisions in a phantom stock agreement that “forfeits” any phantom stock benefits if the employee in question departs the company before the agreed vesting completion date. Phantom stocks are a form of employee compensation that gives employees access to stock ownership without actually owning the stock. Like any genuine stock, phantom stocks rise and fall in value in line with the underlying company stock, and staffers are compensated with profits incurred from any company stock appreciation on specific dates. If payments are to be made in installments, the phantom stock unit plan or grant agreement should also specify whether interest will accrue on the unpaid installments.

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. Problems and complications for employees otherwise not looking for ownership. Specifically, this quiz covers the theories proposed by James MacGregor Burns and Bernard Bass.

When phantom stocks are awarded, a “delay mechanism” kicks in, where the phantom profit formula actual financial payout is made after a long period. However, it depends on the agreement made between the company and the employees. According to their LIFO accounting, they will record a profit of $5 ($20 selling price – $15 COGS). But in reality, if they sold a widget that was manufactured in January, their actual profit is $10 ($20 selling price – $10 COGS). The difference of $5 is phantom profit—it appears on their financial statements, but it’s not money that they’ve actually earned. Phantom profits refer to apparent gains that a company seems to have made but which are not actual or realized profits.

Products

Your choice can result in drastic variations in the cost of goods sold, web income and ending inventory. Therefore, many corporations in the United States use LIFO even when the method doesn’t precisely mirror the actual move of merchandise through the corporate. This is known as «phantom profit.» The consequences of phantom profit can be extremely detrimental to a company, its shareholders, and the economy as a whole. Once you’ve looked at the income statement and the balance sheet, you should have a good understanding of whether or not a company is actually making a profit. If you see that the company is, in fact, making a profit, then you can move on to calculating the phantom profit.

Competing theories, such as behavioral finance, argue that other factors, including irrational investor behavior, impact the price of financial assets. We argue, however, that an analysis of market institutions can help explain when and why the EMH works. Although not widely examined, we argue it is significant that until very recently the New York Stock Exchange (NYSE), whose listed companies’ price behavior inspired the EMH, was a nonprofit organization.

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This can trigger the recognition of a significant phantom profit when the cost of the oldest inventory items are much lower than the cost of this inventory if it were to be purchased today. Since zero-coupon bonds pay no interest until they mature, their prices tend to fluctuate more than normal bonds in the secondary market. And even though zero-coupon bonds make no payments until maturity, their holders may be liable for local, state, and federal taxes on to the amount of their imputed interest. This type of phantom income can be offset by purchasing tax-free zero-coupon bonds or tax-advantaged municipal zero-coupon bonds, in addition to zero-coupon bonds.

The resulting higher profits (the difference between the depreciation under GAAp versus the depreciation based on replacement cost) are phantom or illusory profits. During periods of inflation the amount of phantom or illusory profits will be reduced if the last-in, first-out (LIFO) cost flow assumption is used. The reason is that the last or more recent cost is closer to the replacement cost.

AUD CPA Practice Questions: Preconditions for Accepting an Engagement

• If you see that the company is, in fact, making a profit, then you can move on to calculating the phantom profit.
• Students familiar with transformational leadership should easily be able to answer the questions detailed below.
• GAAP doesn’t allow the use of replacement cost since that violates the (historical) cost principle.
• For employees, the company calls all the shots in a phantom equity deal, giving them little control or maneuverability if the share price goes south.
• Economists prefer that the replacement cost of the inventory be matched with sales.
• This can trigger the recognition of a significant phantom profit when the cost of the oldest inventory items are much lower than the cost of this inventory if it were to be purchased today.

This calls for the random selection of a number of shares to be used for the plan, such as 1,000,000 or 10,000,000. The additional profit from this difference in depreciation is considered to be illusory profit. The historical cost using the first-in, first-out (FIFO) cost flow might have resulted in $100 per unit appearing as the cost of goods sold on the recent income statement. Had the replacement cost of the product been used, the cost of goods sold might have been $145. Assuming the product was sold for $165, the financial statements will report a gross profit of $65 ($165 minus $100). If replacement cost would have been allowed and used, the gross profit would be $20 (selling price of $165 minus the replacement cost of $145).