This is from Schweser Live Mock (afternoon session) # 55. I think their answer explanation has an error. If a company switched rmo LIFO to FIFO in a deflationary environment, what is the effect on return on assets? I thought: NI decreases (due to higher COGS), and Avg. Assets decreases (due to lower inventory). The net effect is likely an increase in ROA since NI change is a greater % in most instances than assets % change.
Schweser states: The return on assets (net profit divided by average assets) will be lower (not higher) under FIFO because net profit (numerator) is lower and the average assets (denominator) are higher. So I agree with their answer, and disagree with their explanation. Thoughts?
LIFO Reserve was $3183 in 20X0 and $2603 in 2011. I think where you’re going with this is: Despite the declining LIFO reserve, as long as it is still positive, FIFO inv. will still be higher than LIFO inv? FIFO inv = LIFO inv. + LIFO Reserve. But Schweser says in the answer explanation, “As noted above, during a deflationary environment, the LIFO method has higher ending inventory and lower cost of goods sold (cost of sales) than FIFO”. I must be missing something.
But this isn’t an analyst’s change; this is the company changing from LIFO to FIFO; you said so. In that case the entire LIFO reserve has to go through the income statement. This will be done through prior years, increasing assets and equity. There will also be an income tax effect (increased income taxes) this year, further reducing net income. (You may actually adjust the income tax expense in the previous years; you’ll have higher taxes payable this year, and a reduction in cash when you pay them.)
I believe that you’ll have lower net income, and higher assets (beginning assets much higher, ending assets (possibly) somewhat lower, average assets higher), so ROA will decrease.
The explanation they offer has no reference to anything you’ve said above (hence my confusion). But is what you’re saying: 1) FIFO would give lower ending inventory for 2011, but 2) FIFO would give higher inventory in the previous years (if LIFO reserve is positive), thus 3) The beginning assets are signifcantly higher than the lower ending assets, so average assets is higher?
How much higher beginning assets will be depends, obviously, on how big the LIFO reserve is, but CFA Institute usually has companies that have been around for several years, so if this shows up on an exam you should imagine that the LIFO reserve will be sizable.