In a nutshell, lifo subtracts inflation from inventory costs, deducts

 E8-21 (LIFO Effect) The following example was provided to encourage the use of the LIFO method.

 

E8-21 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 flow

$  174,400

$  160,000

Extra cash

$  14,400

         0

Increased cash flow

        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.