Explain how does lifo subtract inflation from inventory cost

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Reference no: EM131221955

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.

Reference no: EM131221955

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