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:

(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 alwaysexist.

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