E8-18 (L04) (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:

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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Revenues Cost of goods sold Operating expenses Operating income LIFO adjustment With LIFO $3,200,000 2,800,000 150,000 250,000 40,000 Without LIFO $3,200,000 2,800,000 150,000 250,000 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%