Question

Just wondering if someone can clarify why the ROA ratio will be higher under the LIFO inventory accounting method in comparison with the FIFO inventory accounting method. I understand that under LIFO (in the case of rising prices) COGS will be higher which will reduce net income, but the ending inventory and thus total assets will also be lower. I am assuming that the reduced affect on net income from using LIFO as opposed to FIFO will be less than the reduced affect on the ending inventory (total assets). If this is the case, could you elaborate?

Answer 1

I guess the first remark that we have made here i.e. LIFO leads to higher ROA is not true. In true sense, LIFO will lead to less ROA as the same will lead to higher COGS (Assuming inflationary period - as suggested), which will lead to lower Net Income i.e. Numerator. However, you have rightly observed that the same will lead to lower Inventory and thus leading to lower assets.

However, the portion of net income affected by increased COGS is larger than the positive benefit of reduced inventory on the total assets. In other words, the numerator falls by larger amount/ percentage than the denominator decreases thus leading to lower ROA than the FIFO method.

Therefore, the explanation and the thought process that you followed was perfectly fine but the conclusion that LIFO leads to higher ROA is not true.

I hope the answer was able to clear your doubt :)