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Chapter 8: Q18E (page 428)

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

Expert verified

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

01

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.

02

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.

03

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.

04

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.

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Most popular questions from this chapter

Question:Presented below is a list of items that may or may not be reported as inventory in a company鈥檚 December 31 balance sheet.

1. Goods out on consignment at another company鈥檚 store.

2. Goods sold on an installment basis (bad debts can be reasonably estimated).

3. Goods purchased f.o.b. shipping point that are in transit at December 31.

4. Goods purchased f.o.b. destination that are in transit at December 31.

5. Goods sold to another company, for which our company has signed an agreement to repurchase at a set price that coversall costs related to the inventory.

6. Goods sold where large returns are predictable.

7. Goods sold f.o.b. shipping point that are in transit at December 31.

8. Freight charges on goods purchased.

9. Interest costs incurred for inventories that are routinely manufactured.

10. Costs incurred to advertise goods held for resale.

11. Materials on hand not yet placed into production by a manufacturing firm.

12. Office supplies.

13. Raw materials on which a manufacturing firm has started production but which are not completely processed.

14. Factory supplies.

15. Goods held on consignment from another company.

16. Costs identified with units completed by a manufacturing firm but not yet sold.

17. Goods sold f.o.b. destination that are in transit at December 31.

18. Short-term investments in stocks and bonds that will be resold in the near future.

Instructions

Indicate which of these items would typically be reported as inventory in the financial statements. If an item should not bereported as inventory, indicate how it should be reported in the financial statements.

The management of Tritt Company has asked its accounting department to describe the effect upon the company鈥檚 financial position and its income statements of accounting for inventorieson the LIFO rather than the FIFO basis during 2017 and 2018. The accounting department is to assume that the change to LIFO wouldhave been effective on January 1, 2017, and that the initial LIFO base would have been the inventory value on December 31, 2016. Thefollowing are the company鈥檚 financial statements and other data for the years 2017 and 2018 when the FIFO method was employed.

Financial Position as of

12/31/16 12/31/17 12/31/18

Cash \( 90,000 \)130,000 \(154,000

Accounts receivable 80,000 100,000 120,000

Inventory 120,000 140,000 176,000

Other assets 160,000 170,000 200,000

Total assets \)450,000 \(540,000 \)650,000

Accounts payable \( 40,000 \) 60,000 \( 80,000

Other liabilities 70,000 80,000 110,000

Common stock 200,000 200,000 200,000

Retained earnings 140,000 200,000 260,000

Total liabilities and equity \)450,000 \(540,000 \)650,000

Income for Years Ended

12/31/17 12/31/18

Sales revenue \(900,000 \)1,350,000

Less: Cost of goods sold 505,000 756,000

Other expenses 205,000 304,000

710,000 1,060,000

Income before income taxes 190,000 290,000

Income taxes (40%) 76,000 116,000

Net income \(114,000 \) 174,000

Other data:

1. Inventory on hand at December 31, 2016, consisted of 40,000 units valued at \(3.00 each.

2. Sales (all units sold at the same price in a given year):

2017鈥�150,000 units @ \)6.00 each 2018鈥�180,000 units @ \(7.50 each

3. Purchases (all units purchased at the same price in given year):

2017鈥�150,000 units @ \)3.50 each 2018鈥�180,000 units @ $4.40 each

4. Income taxes at the effective rate of 40% are paid on December 31 each year.

Instructions

Name the account(s) presented in the financial statements that would have different amounts for 2018 if LIFO rather than FIFOhad been used, and state the new amount for each account that is named. Show computations.

In what ways are the inventory accounts of a retailing company different from those of a manufacturing company?

Question:Where, if at all, should the following items be classified on a balance sheet?

(a) Goods out on approval to customers.

(b) Goods in transit that were recently purchased f.o.b. destination.

(c) Land held by a realty firm for sale.

(d) Raw materials.

(e) Goods received on consignment.

(f) Manufacturing supplies.

The net income per books of Linda Patrick Company was determined without knowledge of the errors indicated.

Net Income Error in Ending

Year per Books Inventory

2012 \(50,000 Overstated \) 3,000

2013 52,000 Overstated 9,000

2014 54,000 Understated 11,000

2015 56,000 No error

2016 58,000 Understated 2,000

2017 60,000 Overstated 8,000

Instructions

Prepare a worksheet to show the adjusted net income figure for each of the 6 years after taking into account the inventoryerrors.
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