Exercise NO: 21

The following example was provided to encourage the use of the LIFO method. In a nutshell, LIFO subtracts inflation from inventory costs, deducts it f

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

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LIFO reserve account on the books. The LIFO benefit grows as inflation widens the gap between currentyear and past-year (minus inflation) inventory costs. This gap is: With LIFO Without LIFO

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Revenues $3,200,000 $3,200,000

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Cost of goods sold 2,800,000 2,800,000

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Operating expenses 150,000 150,000

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Operating income 250,000 250,000

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LIFO adjustment 40,000 0

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Taxable income $ 210,000 $ 250,000

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Income taxes @ 36% $ 75,600 $ 90,000

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Cash fl ow $ 174,400 $ 160,000

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Extra cash $ 14,400 0

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Increased cash fl ow 9% 0%

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Instructions

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(a) Explain what is meant by the LIFO reserve account.

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(b) How does LIFO subtract inflation from inventory costs?

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(c) Explain how the cash flow of $174,400 in this example was computed. Explain why this amount may not be correct.

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(d) Why does a company that uses LIFO have extra cash? Explain whether this situation will always exist.

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