Why is ROA and ROE higher for FIFO?

[steve11]

When compared to LIFO, FIFO gives higher value of net income, equity and assets (assuming inflatory environment). So when we use FIFO to calculate ROA and ROE, both the numerators and denominators are higher than when we use LIFO. The result must be inconclusive. Then, why are the ratios higher under FIFO? Can anyone please explain? Thanks1

 

[Flashback]

As you said under inflatory environment (consider low inflatory environment as a normal condition):
First spent inventory in production process is with lower purchasing prices, since COGS are lower thus GP is higher and net earnings are also higher. Thus nominator in ROA/ROE is higher.
Accumulated higher earnings (all else equal) lead to higher equity position.
Ending inventory in TB is those with higher prices (purchased later) so Asset position is also higher under FIFO compared to LIFO in inflation environment. Thus denominator is also tending to be higher.

 

[steve11]

Flashback wrote:
As you said under inflatory environment (consider low inflatory environment as a normal condition):
First spent inventory in production process is with lower purchasing prices, since COGS are lower thus GP is higher and net earnings are also higher. Thus nominator in ROA/ROE is higher.
Accumulated higher earnings (all else equal) lead to higher equity position.
Ending inventory in TB is those with higher prices (purchased later) so Asset position is also higher under FIFO compared to LIFO in inflation environment. Thus denominator is also tending to be higher.

Yes I understand that both numerator and denominator values are higher. But, what I dont get is if both the values are higher, then how can one say that ROA is higher in case of FIFO?

 

[Harrogath]

This is a mathematical issue. Consider a year where sales are 100 and net income is 12 under FIFO, beggining equity is 150 and beggining assets is 300. Assume no dividends are distributed, so ending equity and assets are 162 (150+12) and 312 (300+12) respectively.
Average equity is (150+162)/2 = 156
Average assets is (300+312)/2 = 306
ROE is 12/156 = 7.69%
ROA is 12/306 = 3.92%
What happens under LIFO: net income is just 10. So avg equity is 155 and avg assets is 305
ROE = 10/155 = 6.45%
ROA = 10/305 = 3.28%
ROE & ROA are higher under FIFO. The mathematical explanation is that net income under FIFO is 20% higher than net income under LIFO (12 vs 10), however avg equity and avg assets are only 0.65% and 0.33% higher under FIFO compared to LIFO.
Hope this clarifies the dubt!

 

[Flashback]

steve11 wrote:

Flashback wrote:
As you said under inflatory environment (consider low inflatory environment as a normal condition):
First spent inventory in production process is with lower purchasing prices, since COGS are lower thus GP is higher and net earnings are also higher. Thus nominator in ROA/ROE is higher.
Accumulated higher earnings (all else equal) lead to higher equity position.
Ending inventory in TB is those with higher prices (purchased later) so Asset position is also higher under FIFO compared to LIFO in inflation environment. Thus denominator is also tending to be higher.

Yes I understand that both numerator and denominator values are higher. But, what I dont get is if both the values are higher, then how can one say that ROA is higher in case of FIFO?

This is because net earnings in nominator increased higher than equity or asset position in denominator under FIFO in inflation environment. Harrogath is maybe right considering this as mathematical issue. For me is straightforward as an accounting issue and have never considered this by mathematical approach. You can try if you find this manner more clear to understand.