In a nutshell, LIFO subtracts inflation from inventory costs, deducts
accounting teacherE8-21 (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.
10 years ago
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