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 $880,000 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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Revenues Cost of goods sold Operating expenses Operating income LIFO adjustment Taxable income Income taxes @ 40% Cash floW Extra cash Increased cash flow With LIFO $6,500,000 4,800,000 300,000 1,400,000 100,000 $1.300,000 Without LIFO $6,500,000 4,800,000 300,000 1,400,000 0 $1,400,000 $560,000 $520,000 $880,000 $840,000 $40,000 0 5% 0%