Question

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.

Short answer

LIFO reverse account is the adjustment account for LIFO from any other method. This LIFO reverse creates the inflation effect in the inventory cost and extra cash flows are generated.

Step-by-step solution

LIFO Reverse Account

LIFO reverse is the difference between the inventory value through LIFO method and inventory value through any other method. The account that records these differences is called LIFO reverse account. LIFO reverse account is maintained to get the LIFO effect (Difference in LIFO reverse account between two periods).

In the given case, the LIFO adjustment or LIFO reverse is $40,000. This shows that without LIFO, the inventory was valued at a lower cost than the LIFO method. So under LIFO reporting, the inventory is adjusted by $40,000 with a LIFO adjustment account or LIFO reverse account.

LIFO subtract inflation

Under LIFO method, the cost of goods sold is valued at the current prices. Thus the Cost of goods sold would be higher under LIFO than any other method. This higher cost is due to the inflationary effect. Because of this inflationary effect in cost, net profit would be lower and ultimately tax would be calculated on the lower income.

In the given example, LIFO adjustment has been made in the operating income under LIFO method. This has reduced taxable income by $40,000, and so the tax has been saved by $14,400.

Computation of cash flow and accuracy

In the given example, the cash flow without LIFO method is $160,000. But there is a tax saving of $14,400 under the LIFO method. This tax-saving has been adjusted in the $160,000 amount to get the cash flow of the LIFO method.

Ideally, this amount may not be correct. Because the cash flow under LIFO has been computed based on adjustment, the actual cash flow may be lower if computed from the LIFO perspective.

Extra cash under LIFO

The company that uses LIFO has tax savings due to the higher cost of the inventory or LIFO adjustment. This tax-saving drives extra cash flow for LIFO than any other method of inventory valuation.