Abstract
This paper reviews the theoretical foundations of residual income as a tool for evaluating a firm's interim performance for purposes of assigning incentive compensation. Although residual income can be easily linked to the discounted cash flow model of firm valuation, it bears no necessary relation to wealth creation during any particular time period. Consequently, paying for performance using residual income to measure wealth creation can have incentive effects that are inconsistent with wealth creation. We show that recent attempts to address the shortcomings of residual income can effectively address the wealth measurement issue; however, they give rise to serious implementation problems related to the necessity for forecasting future firm performance. Furthermore, if internal forecasts of future firm performance are used, this is a source of a potentially serious moral hazard problem as the same managers whose performance is being evaluated provide the forecasts.
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