Capital Following Profitability: Why the Residual Income Dynamic Is Nonlinear

Abstract

Having introduced the LID approach in Chap. 2, we now take an alternative approach to modeling the residual income dynamic, premised on the notion of “capital following profitability.” As previously explained, the linear approach ignores firms’ active decision-making in the value-generation process and treats decision-making either as absent altogether (Ohlson 1995) or following a mechanical path that does not respond to the changing environment (Feltham and Ohlson 1995, 1996). In this chapter, we recognize the importance of capital investment decisions and assume that the accounting system yields signals which are useful for guiding these decisions. In a world where economic agents (that is, company managers and investors) seek to enhance value and increase wealth, they will rationally allocate capital to investment opportunities that yield high rather than low returns. The notion of capital following profitability accords with economic intuition and is widely reflected in actual business practice. For example, firms commonly adopt the NPV criterion to determine whether investment projects are acceptable, and rely on profitability information (such as return on assets, ROA) in internal resource allocation.