Residual Income (RI) measures performance by subtracting a capital charge (investment base × cost of capital) from controllable profit. This can lead to dysfunctional behaviours.

1. Short-termism (B): Since RI is a single-period measure, managers may reject profitable long-term projects (with positive NPV) if those projects reduce RI in the short term, for instance, due to high initial investment increasing the capital charge before significant profits are generated.

2. Transfer Pricing Disputes (C): The transfer price directly impacts the revenues of the selling subsidiary and the costs of the buying subsidiary. This affects the controllable profit of each, and consequently their RI. Managers may therefore engage in lengthy disputes to set a price that benefits their own division's RI, potentially at the expense of optimal decisions for the group.

3. Hedging Translation Risk (A): In a multinational company, a subsidiary's assets and profits are subject to translation risk when converted to the parent's currency. A manager may hedge this risk to protect their reported RI from adverse exchange rate movements, even if this is costly and not aligned with the group's overall risk management strategy.

D. Subsidiary boards may waste time and incur unnecessary fees in order to recognise gains on the revaluation of property.

This is incorrect because revaluing property upwards increases the investment base, which in turn increases the capital charge and reduces residual income.

E. Subsidiary boards may be motivated to spend heavily on capital expenditure in order to ensure that budget allocations are maintained and even increased.

This is incorrect because heavy capital expenditure increases the investment base, which lowers residual income. Managers evaluated on RI are incentivised to be prudent with capital investment.

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1. Drury, C. (2018). Management and Cost Accounting (10th ed.). Cengage.

For B (Short-termism): On p. 528, it is noted that a major criticism of both ROI and RI is that "they encourage managers to take a short-term view and concentrate on short-term performance at the expense of long-term profitability."

For C (Transfer Pricing): Chapter 18, Section 18.2 (p. 546), explains how transfer prices directly impact the reported profits of the divisions involved in a transaction, which is the primary cause for disputes when divisional profit (a component of RI) is used for performance evaluation.

2. Kaplan, R. S., & Atkinson, A. A. (1998). Advanced Management Accounting (3rd ed.). Prentice Hall.

For D & E (Incorrect Logic): The formula for residual income is presented as RI = Income - (Cost of Capital × Capital Invested) (p. 579). This formulation demonstrates that an increase in the 'Capital Invested' base, either through asset revaluation (D) or new capital expenditure (E), will, all else being equal, decrease the calculated RI, thus acting as a disincentive for such actions.

3. Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2016). Multinational Business Finance (14th ed.). Pearson Education.

For A (Hedging Translation Risk): Chapter 10, "Translation Exposure," discusses how subsidiary managers whose performance is evaluated in the parent's currency (which is necessary for calculating RI for the group) may be motivated to hedge translation exposure. This is done to reduce the volatility of their reported results and protect their performance metrics from currency fluctuations, which may not be in the best economic interest of the consolidated group.