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:
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With LIFO
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Without LIFO
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Revenues
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$3,200,000
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$3,200,000
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Cost of goods sold
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2,800,000
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2,800,000
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Operating expenses
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150,000
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150,000
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Operating income
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250,000
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250,000
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LIFO adjustment
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40,000
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0
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Taxable income
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$ 210,000
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$ 250,000
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Income taxes @ 36%
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$ 75,600
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$ 90,000
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Cash flow
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$ 174,400
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$ 160,000
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Extra cash
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$ 14,400
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0
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Increased cash flow
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9%
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0%
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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.