Review of Accounting Studies, 7, 229–245, 2002
2002 Kluwer Academic Publishers. Manufactured in The Netherlands.
Residual Income and Value-Creation:
The Missing Link
AND KEN PEASNELL
Management School, Lancaster University, Lancaster LA1 4YX, U.K.
Abstract. This paper extends the residual income literature to provide a framework for the use of residual income
in performance measurement, applicable in value-based management. It shows that, under a simple initializing
assumption, an accounting-free measure of ‘excess value created’ over a multi-period interval can be written
entirely in terms of (i) within-interval realized residual incomes and (ii) end-of-interval expected future residual
incomes, both appropriately adjusted for the time value of money. It also shows that, when the simple initializing
assumption is relaxed, excess value created can be expressed in terms of ‘excess residual incomes,’ measured by
comparison with expectations as at the beginning of the multiperiod interval.
Keywords: residual income, EVA, value-based management, performance measurement
JEL Classiﬁcation: D8, G3, J33, M4
Residual income is a measure of accounting income in excess of a normal (required) return
on capital employed. It has a long history as a performance measure, and was the object of
extensive academic debate in the management accounting literature in the 1960s and 1970s.
It played no prominent role in ﬁnancial accounting research until Ohlson’s (1989, 1995)
seminal work introduced to a new generation the old idea that the economic value of
an entity equals its accounting book value plus the present value of all of its expected
future residual incomes. This residual income-based valuation relationship (RIVR) has
now become a familiar feature of recent research into the role of accounting numbers in
RIVR is a forward-looking relationship that speciﬁes how economic
value, book value and expected future residual incomes articulate with one another. It does
not encompass a backward-looking articulation between past accounting numbers and the
value created during a multi-period interval, but there appears to be some demand for such an
articulation. For example, the consulting ﬁrm Stern Stewart & Co. propose their economic
value added (EVA
) version of residual income as a periodic performance measure, to be
used in conjunction with another measure they call market value added (MVA), which is the
excess of market value over the (adjusted) book value of capital employed. Stern Stewart
cite RIVR in support of their advocacy of EVA and MVA as measures of management’s
success in value-creation (Stewart, 1991, pp. 153–154). However, the articulation given by
RIVR provides no formal support for the use of residual income or MVA as measures of
In this paper, we ﬁll this gap by extending RIVR to provide an articulation between
residual incomes and a measure of the excess return in dollar terms during a multi-period
interval. We show that, if the initial accounting book value of shareholders’ funds is equal
Address correspondence to: Management School, Lancaster University, Lancaster LA1 4YX, U.K.