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%
(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.
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.
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.
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.
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.
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.
The following information relates to the Jimmy Johnson Company.
Ending Inventory Price
Date (End-of-Year Prices) Index
December 31, 2013 $ 70,000 100
December 31, 2014 90,300 105
December 31, 2015 95,120 116
December 31, 2016 105,600 120
December 31, 2017 100,000 125
Use the dollar-value LIFO method to compute the ending inventory for Johnson Company for 2013 through 2017.
Question: Shania Twain Company was formed on December 1, 2016. The following information is available from Twain’s inventory records for Product BAP.
Units Unit Cost
January 1, 2017 (beginning inventory) 600 $ 8.00
January 5, 2017 1,200 9.00
January 25, 2017 1,300 10.00
February 16, 2017 800 11.00
March 26, 2017 600 12.00
A physical inventory on March 31, 2017, shows 1,600 units on hand.
Prepare schedules to compute the ending inventory at March 31, 2017, under each of the following inventory methods.
(a) FIFO (b) LIFO. (c) Weighted-average (round unit costs to two decimal places).
Ehlo Company is a multiproduct firm. Presented below is information concerning one of its products, the Hawkeye.
Date Transaction Quantity Price/Cost
1/1 Beginning inventory 1,000 $12
2/4 Purchase 2,000 18
2/20 Sale 2,500 30
4/2 Purchase 3,000 23
11/4 Sale 2,200 33
Compute cost of goods sold, assuming Ehlo uses:
(a) Periodic system, FIFO cost flow. (d) Perpetual system, LIFO cost flow.
(b) Perpetual system, FIFO cost flow. (e) Periodic system, weighted-average
(c) Periodic system, LIFO cost flow. (f) Perpetual system, moving-average
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