Here are the data. I am using semi-colons to indicate different years. There is no way of posting a pretty Excel sheet.
Years: 2002; 2001; 2000 Net Income (LIFO) : 3557; 3541; 3537 Inventory: 8781; 7204; 6351 LIFO Reserve: 3183; 2617; 2403 Tax rate: 20%; 30%; 30%
Question: What is the total tax savings that above company has generated through 2002 by using LIFO instead of FIFO Method?
My solution: Under FIFO, COGS would go down, so net income should go up.
Let’s first calculate net income under FIFO method.
Change in LIFO Reserve = (3183-2617=566); 2617-2403=214; for 2002 and 2001 respectively. New Net Income under FIFO = 3557 + .8*566 = 4009.8; 3541 + 0.7*214 = 3690.8 for 2002 and 2001 respectively after factoring the taxes on change in LIFO Reserve (i.e. COGS savings).
Therefore, tax savings would be additional tax paid under FIFO scheme (= the tax saved by using LIFO scheme) = (0.2 * 566) + (0.3 * 214) = 113.2 + 64.2 = 177.4
However, the answer is 898.3. Official answer says that tax savings = 566*0.2 + 0.3*2671. I have no clue why the official answer uses 2671 (i.e. the entire LIFO reserve for 2001) to calculate tax savings. Wouldn’t we use 0.3*214? Moreover, the total tax paid under FIFO scheme would have been 177.4, so I am not sure whether tax savings of 898.3 even make any sense.
I’d appreciate thoughts. I am really lost. I have spent about 1.5 hours on trying to solve this, but ended up nowhere.