(LIFO Effect) The following example was provided to encourage the use of the LIFO method. In a nutshell, LIFO subtracts inflation from inventory costs, deducts it from taxable income, and records it in a LIFO reserve account on the books. The LIFO benefit grows as inflation widens the gap between current year and past year (minus inflation) inventory costs. This gap is:
|
With LIFO |
Without LIFO |
|
|
Revenues |
$3,200,000 |
$3,200,000 |
|
Cost of goods sold |
2,800,000 |
2,800,000 |
|
Operating expenses |
150,000 |
150,000 |
|
Operating income |
250,000 |
250,000 |
|
LIFO adjustment |
40,000 |
0 |
|
Taxable income |
$ 210,000 |
$ 250,000 |
|
Income taxes @ 36% |
$ 75,600 |
$ 90,000 |
|
Cash fl ow |
$ 174,400 |
$ 160,000 |
|
Extra cash |
$ 14,400 |
0 |
|
Increased cash fl ow |
9% |
0% |
Instructions
(a) Explain what is meant by the LIFO reserve account.
(b) How does LIFO subtract inflation from inventory costs?
(c) Explain how the cash flow of $174,400 in this example was computed. Explain why this amount may not be correct.
(d) Why does a company that uses LIFO have extra cash? Explain whether this situation will always exist.