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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
Cost of goods sold
2,800,000
Operating expenses
150,000
Operating income
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
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.
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