Clean Surplus Relationship
The clean surplus relationship is a very important assumption that is used in the context of residual income models. The clean surplus relationship formula implies that ending book value equals
Thus, the book value of the company increases by the amount of retained earnings. If this is not the case, we have a clean surplus violation. On this page, we discuss what may cause a clean surplus violation.
Clean surplus relationship violations
The clean surplus assumption may not hold when items are charged to shareholders’ equity directly and do not go through the income statement. In that case, we have to adjust net income such that these items are accounted for. Importantly, we should only account for them if we do not expect them to reverse in the future. If they are expected to reverse, we can ignore them.
Examples of items that bypass the income statement are:
- foreign currency translations gains and losses
- certain pension adjustments
- gains/losses on hedging instruments
- changes in revaluation surplus for long-lived assets
- changes in liabilities due to changes in liabilities’ credit risk
- changes in the market value of securities classified as available for sale
Clean surplus violations consequences
The consequence of cleans surplus violations is that net income is not correct, but book value is. If we apply a residual income model when the relationship does not hold, then ROE forecasts will not be accurate. For example, imagine the clean surplus relationship does not hold. If this is due to an item that is expected not to reverse, then the ROE cannot be forecasted accurately.
We discussed the clean surplus assumption in accounting. It is an important assumption that must hold if one wants to use a residual income model. If this relationship is violated, net income should be adjusted before we can continue.