Clean surplus accounting

Clean surplus accounting method provides elements of a forecasting model that gives price as a function of earnings, expected returns, and change in book value.^[1][2]

Clean surplus accounting is calculated by not including transactions with shareholders (such as dividends, share repurchases or share offerings) in calculating the return of an organization. Current accounting for financial statements requires that the bottom-line items in the balance sheet and income statement—(book value and earnings)—and its format requires the change in book value to equal earnings minus dividends (net of capital contributions).^[3]

The key use of the clean surplus theory is to estimate the value of a company’s shares (instead of the more lengthy discounted dividend/cash flow approaches. Secondary use would be an alternative to CAPM to estimate the cost of capital.

Ohlson’s clean surplus theory provides a framework consistent with the measurement perspective. MV (market value) of the firm (hence security returns) can be expressed in terms of B/S and I/S components. Theory assumes ideal conditions.

Market value of firm = NBV of firm’s net assets + expected PV of future abnormal earnings (goodwill)

.’. can read firm value directly from B/S.

Key Points: 1) Actual earnings are based on “clean surplus” -> ensures that all gains or losses go through the I/S. Means that the gain/loss impact of fair values is recognized in earnings.

2) Goodwill is calculated as the difference b/w actual and expected earnings (same concept as abnormal earnings)

3) Expected earnings -> opening shareholders’ equity X firm’s cost of capital (similar to accretion of discount.)

4) Net worth of the firm + calculated estimate of firm’s goodwill = firm value. (Basically takes book value (accounting approach) and converts it to market value)

Benefit of this approach is that it is a relatively quick method to calculate the “market value” of a firm -> should be the same as valuation from discounted dividend and cash flow model. So can use the F&O model to estimate the value of a firm’s shares and then compare to actual market value of shares. Research (Frankel & Lee 1998) shows that the ratio of this calculation compared to actual market value was a good predictor of share returns for 2–3 years into the future.

Unbiased accounting – when accounting is unbiased (i.e. not manipulated, not overly conservative) and abnormal earnings do not persist (i.e. no goodwill), all of firm value appears on B/S. Note: all gains & losses go through I/S, fair values are used in I/S then should be no abnormal earnings –> thus B/S shows fair values by default)

Since state realizations typically come into subsequent years then the effect of persistence comes into play. • Persistence of earnings means that there now is info content in the I/S • More persistence means more impact of I/S on firm value (also remember that greater persistence means greater ERC)

Note that Lesson 1 says a B/S prepared with PV’s will have all of the info on the B/S and none in NI (since investor can calculate expected earnings directly from B./S). Ditto here with Clean Surplus Theory unless there is persistence of earnings (key difference from Lesson 1)

Once persistence is factored in, all the action is no longer in the B/S (even with ideal conditions).

(Info: doesn’t matter what accounting policies are used.)

Advice: Read through text to understand the process and the various uses to which the Clean Surplus Theory can be applied

References

1. ^ Ohlson, Contemporary accounting research, 1995, Earnings, Book Values, and Dividends in Equity Valuation.
2. ^ Ohlson and Feltham, Contemporary accounting research, 1995, Valuation and Clean Surplus Accounting for Operating and Financial Activities.
3. ^ Ohlson, Contemporary accounting research, 1995, Earnings, Book Values, and Dividends in Equity Valuation.

Further reading

• Ohlson, (1995) "Earnings, Book Values, and Dividends in Equity Valuation", Contemporary accounting research
• Ohlson and Feltham, (1995) "Valuation and Clean Surplus Accounting for Operating and Financial Activities", Contemporary accounting research

External links

• Accounting for dirty surplus
• What is clean surplus