Reference no: EM131139629

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 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.