Clean Surplus Accounting

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Definition

Clean surplus accounting means the changes in the shareholder equity which is not the consequence of transaction with shareholders such as share repurchase, dividends, etc are shown in the income statement. The clean surplus accounting method offers elements of a forecasting model which gives price as a function of change in book value, earnings and expected returns.

Overview

While calculating returns in clean surplus accounting, transactions with shareholders are not included. For current accounting of financial statements, it is required that the book value change equals earnings less dividends.

The main use of the theory is to make an estimate of the value of the shares of a company. Its other use is to estimate the cost of capital as an alternative to CAPM.

This theory is consistent with the perspective of measurement. The market value of a firm can be expressed as I/S and B/S components. The assumption of the theory is that there is ideal condition. A firm’s market value is equal to the net value of the net assets of the firm plus present value of abnormal earnings of future. This helps in reading the value of the firm easily from the balance sheet.

Benefits

Under this approach, the market value of a firm can be calculated relatively more quickly. It will be the same as the valuation from cash flow model and discounted dividend. One estimate of the shares of the firm and their comparison to the market value is provided by the F&O model. According to research, it is seen that this calculation’s ratio was good at predicting the share returns for 2 to 3 years in the future.

When there is no manipulation of the accounting and persistence of abnormal earnings, all the values of the firm is seen on the balance sheet. Abnormal earnings should not be produced by the fair values that are used in income statement. Thus, fair values are shown by the balance sheet.

A balance sheet which is made with present values contains all information on it and nothing in net investment. In case of clean surplus theory where persistence of earnings does not exist, the same principle is applied. 

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