If firms’ investing decisions are rational, then the purpose of increasing net operating assets is certainly to enhance firm performance. Accordingly, we should exptect a better outlook for firms’ returns on asset (ROA). However, Fairfield et al. (2003) (FWY, hereafter) found that an increase in net operating assets would result in a decrease in firms’ ROA. They argue that diminishing marginal returns on investments arise when firms exploit their most profitable investment opportunities before undertaking less profitable investments. Alternatively, increasing marginal returns in divestment arise when firm divest their least profitable investments. In addition, they also show that a conservative bias in accounting procedure results in investments that appear relatively less profitable in early years and more profitable in later years, biasing accounting rates of return on new investments downward relative to the returns in existing investments. Thus, they conclude that when firms invest more in long-term net operating assets, both conservative accounting bias and diminishing marginal returns to operating assets would, on average, reduce near-term profitability.
In this paper, we argue that diminishing return on assets does not fully describe firms’ investing behavior. Rational firms should invest in long-term net operating assets when the internal rates of returns of the new projects are higher than the required rate of returns. For firms with current lower than the required rate of returns, the future should be, on average, increasing if they increase investments. For firms with current higher than the required rate of returns, the future could be increasing or decreasing, since the result depends on the relative levels of the current and the internal rate of returns of the new projects. That is, if the internal rate of returns of the new projects is higher than the current , then the future could be increasing. In contrast, if the internal rate of returns of the new projects is less than the current , the future could be decreasing.
FWY contend that their evidence is also consistent with the conservative accounting bias. Nonetheless, conservative accounting bias only states that costs with uncertain future economic benefit and some indirect costs related to the acquisition of long-term assets tend to be expensed when incurred. Expenditures which are expensed when incurred could result in a higher one-year-ahead unless these expenditures persist into the next year. This seems to contradict FWY’s argument. For the accounting treatment of the capitalized direct costs, it would be equally conservative for the first year and the second year of the asset life if straight-line method is used for recording the depreciation expenses. The accounting treatment of the first year of the asset life is actually more conservative then that of second year of the asset life when accelerated methods are implemented. Therefore, we believe that, under possible conservative accounting, the accounting treatment for the second year of the asset life would be less conservative than that of the first year. So, the second year ROA will be, on average, increasing as compared to the first year.
Market participants’ reaction to certain financial information is of interest to not only the market regulators but also the market participants themselves. Our results show that the stock market is potentially inefficient when reacting to the change in net operating assets.