Key takeaways
- Phantom profit is profit in the financial statements with no real economic profit behind it. It arises when cost of sales is understated or revenue is recognised too early.
- The problem is embedded during construction but hits cash in the transfer year, when corporate income tax (CIT) must be paid.
- Every THB 1 of phantom profit is taxed at 20%, or THB 0.20, if there is no brought-forward tax loss to offset it.
- Land held for development and sale is inventory under TAS 2, not TAS 16, and must be expensed to COGS on transfer.
What is phantom profit
Phantom profit is profit that appears in the income statement (P&L) but is not backed by cash or by real economic profit. The figures on paper reflect full revenue recognition while cost of sales (COGS) is recorded below the true cost. Gross profit and net profit in the accounts are therefore overstated, which leads to a corporate income tax burden higher than necessary.
Real estate projects run for 3–5 years, require heavy investment and involve complex cost items, including land, construction costs, interest during construction and design fees. The risk of phantom profit is therefore especially high. This article explains the five main causes, with numerical examples and the effect on cash flow. All figures are illustrative and are used only to explain the principles.
The five main causes of phantom profit
Case 1: WIP recorded incorrectly, with construction costs expensed before the transfer day
Work in progress (WIP) is the asset that accumulates project costs on the balance sheet until ownership is transferred to the customer. The costs are then recognised as COGS in proportion to the units transferred. If a company expenses some construction costs in the period incurred instead of capitalising them into WIP, WIP is understated, and COGS on the transfer day is understated accordingly.
Example: Actual construction cost is THB 3,500 million, but only THB 3,000 million is recorded in WIP. The other THB 500 million is wrongly expensed during construction. Assuming 91% of the saleable area has been transferred, COGS is understated by 500 × 91% = THB 455 million. Gross profit in the transfer year is overstated by the same amount, and CIT at 20% on this amount is THB 91 million.
Wrongly expensed costs also create a loss in the construction years. If that loss can still be offset in the transfer year, part of the tax effect is only a matter of timing. But if the loss expires before there is any profit to offset, or the Revenue Department disallows it, that tax becomes a real cost. The schedule of brought-forward losses must therefore always be reviewed alongside.
Case 2: COGS per unit calculated wrongly, with incorrect cost allocation
Projects with many units or several phases must allocate total cost to each unit on a reasonable basis. The base commonly used is net saleable area (NSA), not gross floor area (GFA), which includes common areas, corridors, car parks and service areas that are not sold.
If GFA is used instead of NSA, cost per square metre is immediately understated, and the difference in cost stays in WIP with no units to absorb it.
| Item (example) | GFA basis (wrong) | NSA basis (correct) |
|---|---|---|
| Construction cost (THB) | 3,500,000,000 | 3,500,000,000 |
| Area (sq m) | 35,000 | 22,400 |
| COGS per sq m (THB) | 100,000 | 156,250 |
The difference is THB 56,250 per square metre. For a unit with an NSA of 160 sq m, COGS per unit would be off by THB 9 million. If 68 units are transferred in a single year, phantom profit would be THB 612 million, and the related CIT would be about THB 122.4 million.
Another common cause is failing to include in WIP the interest during construction (IDC) that qualifies under TAS 23, and omitting indirect costs (soft costs) such as design fees, consultancy fees and permit fees, which are part of project cost.
Case 3: Forgetting to include land cost in COGS
Land held for development and sale is inventory under TAS 2. It is recorded at cost and measured at the lower of cost and net realisable value. A rise in market price during development does not change cost. This land is not an asset under TAS 16, because it is not held for use.
The problem found in practice is that some companies classify the land as a fixed asset separate from WIP, and then fail to expense the land cost relating to the units sold to COGS on the transfer day.
Example: Land cost is THB 350 million and the whole project is transferred. If none of it is included in COGS, phantom profit arises in the full amount of THB 350 million, and the related CIT is about THB 70 million.
Case 4: Revenue recognised too early (timing mismatch)
TFRS 15 requires revenue to be recognised when control transfers to the buyer. For outright residential sales in Thailand, this is generally the ownership transfer day at the Land Department, not the date the sale and purchase agreement (SPA) is signed, and not according to the percentage of construction progress.
If revenue is recognised on signing the contract or by progress, an imbalance arises immediately, because revenue is recorded while COGS is still zero. For example, if THB 2,200 million of revenue is recognised in the wrong period, phantom profit arises in full in that year, and the related CIT is as high as THB 440 million. Besides cash leaving too early, this is also an issue on which the auditor will require the financial statements to be adjusted (restatement).
Case 5: Failing to write down when the selling price is below cost
TAS 2 requires WIP to be measured at the lower of cost and net realisable value (NRV). When market prices fall, or there are signs that units will sell below cost, the company must write down the value in the period in which this is identified, not wait until the transfer day.
If no write-down is made, WIP in the financial statements is overstated, and losses that should have been recognised earlier are hidden until the transfer day. Conversely, if an allowance is set up in excess of what is needed and without evidence, a false loss arises in the period it is set up, and phantom profit may arise in the period it is reversed.
When phantom profit arises in the project cycle
The distinctive feature of phantom profit is that it is embedded in the financial statements from the construction stage but shows its real tax effect at the transfer stage. Executives who do not monitor closely therefore often do not notice until cash has already left as tax.
- Construction stage (years 1–4): If costs are expensed instead of capitalised, cumulative losses look abnormally high, and management may wrongly conclude that the project is making a loss, when part of it is a false loss.
- Ownership transfer stage (years 4–5): COGS released from WIP is understated, so gross profit and net profit in the accounts are overstated, CIT is correspondingly higher, and cash actually leaves the business.
- After full transfer: The auditor or the Revenue Department may identify the errors retrospectively, leading to restatement of the financial statements. The tax refund process takes time and costs money, and it damages credibility with shareholders and financial institutions.
Summary of causes and effects
| Cause | When it arises | Impact |
|---|---|---|
| WIP understated (wrongly expensed) | Accumulates throughout the construction stage | COGS understated on transfer day and CIT overstated |
| COGS per unit wrong (GFA used instead of NSA) | Transfer day | Large CIT overpayment |
| Revenue recognised before the transfer day | The period in which it is wrongly recorded | CIT paid early or in excess, and problems with the auditor |
| Land cost or IDC not included in COGS | Transfer day | CIT overstated by the amount omitted |
| No write-down to NRV | End of the accounting period | Financial statements do not reflect reality |
The iron rules of phantom profit
Every THB 1 of phantom profit means THB 0.20 of cash that may leave as CIT with no real profit behind it. Prevention is therefore not about dressing up the accounts but about directly protecting the company's cash flow. Executives should hold to five rules.
- Capitalise all qualifying costs into WIP in full, in accordance with TAS 2 and TAS 23
- Allocate cost per unit by NSA, not GFA
- Recognise revenue strictly on the date control transfers, in accordance with TFRS 15
- Test NRV regularly whenever market conditions change
- Have a WIP capitalisation checklist and an internal control system that can be verified in every accounting period