Clean surplus accounting
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The clean surplus accounting method provides elements of a forecasting model that yields price as a function of earnings, expected returns, and change in
book value In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. T ...
. Ohlson, J. A. (1995)
"Earnings, Book Values and Dividends in Equity Valuation"
Contemporary Accounting Research ''Contemporary Accounting Research'' is a peer-reviewed academic journal covering research on all aspects of accounting's role within organizations, markets, or society. The journal publishes articles in all areas of accounting, (including audit, ...
, 11 (Spring), 1995.
Ohlson and Feltham, (1995
"Valuation and Clean Surplus Accounting for Operating and Financial Activities"
''Contemporary accounting research''
Frankel, R., & Lee, C. M. (1998)

Journal of Accounting and economics, 25(3), 283-319.
The theory's primary use is to estimate the value of a company’s shares (instead of discounted dividend/cash flow approaches). The secondary use is to estimate the cost of capital, as an alternative to e.g. the CAPM. The "clean surplus" is calculated by not including transactions with shareholders (such as
dividend A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-i ...
s, share repurchases or share offerings) when calculating returns; whereas standard accounting for financial statements requires that the change in book value equal earnings minus dividends (net of capital changes).


Theory

The market value (MV) of the firm -- and hence security returns -- can be expressed in terms of
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a Partnersh ...
and
income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''stateme ...
components, as below. This allows reading the firm's value directly from the balance sheet. The theory assumes ideal conditions. Here: :The market value of a firm = net
book value In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. T ...
of the firm’s net assets +
present value In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has inte ...
of future abnormal earnings ( goodwill). :Logic: # Goodwill is calculated as the difference between actual earnings and expected earnings ("abnormal earnings"). #* Actual earnings are the “clean surplus” - this ensures that all gains or losses go through the income statement. The impact of fair values is recognized in earnings. #* Expected earnings = opening
shareholders' equity In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth $2 ...
X the firm’s cost of capital (similar to accretion of discount.) # Finally, convert book value to market value as above: firm value = net worth of the firm + calculated estimate of firm’s goodwill.


Applicability

This approach provides a relatively "quick and dirty" method to calculate the market value of a firm - which should be (approximately) the same as a valuation based on discounted dividends or cash flows. The model provides one estimate of the firm’s shares, useful for comparison to their market value. Research by Frankel & Lee shows that this ratio provides a good predictor of share returns for 2–3 years into the future. The model is applicable when abnormal earnings do not "persist" (i.e. no goodwill); in this case all gains and losses go through the income statement, and the firm's fair value appears on the balance sheet. The investor can then calculate expected earnings directly from the balance sheet, as above. However, if persistence is assumed, the income statement will have emerging "information content": this increases the impact of the income statement on firm value, and the method is less applicable. (Greater persistence similarly translates to a greater
Earnings response coefficient In financial economics, finance, and accounting, the earnings response coefficient, or ERC, is the estimated relationship between equity returns and the unexpected portion of (i.e., new information in) companies' earnings announcements. Developme ...
.)


See also

* Valuation (finance) #Net asset value method *
Residual income valuation Residual income valuation (RIV; also, residual income ''model'' and residual income ''method'', RIM) is an approach to equity valuation that formally accounts for the cost of equity capital. Here, "residual" means in excess of any opportunity cos ...
* T-model


References

{{reflist


External links


Accounting for dirty surplus


Financial statements Accounting terminology Valuation (finance) Fundamental analysis