E8-21 (LIFO Effect) The following example was provided to encourage the use of t
ID: 2464856 • Letter: E
Question
E8-21 (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 $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.
Explanation / Answer
Answer:a)
LIFO effect- Reserve Account
The difference between the inventory used for internal reporting purposes and LIFO is referred to as the Allowance to Reduced Inventory to LIFO or the LIFO reserve. The change in the allowance balance from one period to next is called the LIFO effect ( or as shown in example, the LIFO adjustment).
Answer b)
LIFO effetcct - Inflation and inventory costs
LIFO subtracts inflation from inventory costs by charging the items purchased recently to cost of goods sold. As a result, ending inventory (assuming increasing prices) will be lower than FIFO or average costs.
Answer: c)
LIFO effect- Cash flow
Cash Flow was computed as follows:
Revenue ..................3200000
COGS......................(2800000)
Operating expenses...(150000)
Income Taxes............(75600)
Cash flow..................174400
If the company has any sales on account or payables, then the cash flow number is incorrect. It is assumed here that cash basis of accounting is used.
Answer: d)
LIFO effect- Tax impact and cash impact
the company has extra cash because its taxes are less. Taxes are lower because COGS is higher under LIFO than FIFO. As a result, net income is lower which leads to lower income taxes. If prices are decreasing, the opposite effect results.
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