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

E8-21B (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                               $6,500,000                          $6,500,000

Cost of goods sold                   4,800,000                            4,800,000

Operating expenses                    300,000                              300,000

Operating income                      1,400,000                           1,400,000

LIFO adjustment                           100,000                                         0

Taxable income                      $1,300,000                          $1,400,000

Income taxes @ 40%               $ 520,000                            $ 560,000

Cash flow                                  $880,000                            $840,000

Extra cash                                   $40,000                                          0

Increased cash flow                        5%                                           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 $880,000 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.