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What Is Clean Surplus Accounting?

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Last editedDec 20222 min read

If your business activity involves a high volume of shareholder transactions, you might be wondering how to account for this on the income statement. The clean surplus concept offers a way to deal with equity-related income fluctuations to calculate overall earnings. We’ll explore the pros and cons of clean surplus accounting below.

What is clean surplus concept in accounting?

The clean surplus concept is used to determine the total value of a corporation’s shares. With clean surplus accounting, a business doesn’t record any equity-related losses or gains on its income statement. Instead, the earnings report shows any changes to the fair value of assets and liabilities. This provides an alternative to the discounted cash flow accounting method, among others.

There are many different types of shareholder transactions that a company might be involved in. A few examples include paying out dividends, repurchasing shares, or offering shares for sale, and all of these are typically included on the income statement when calculating returns. However, in the case of clean surplus accounting, these transactions are not included. Keeping this information separate gives a “clean” estimate of the company share value without the added transactions to muddy the waters. If you want a quick valuation, it’s a convenient option.

How does clean surplus accounting work?

Because it doesn’t include common shareholder transactions, clean surplus accounting functions more as a forecasting model than accurate record. Price is shown purely as the change in book value, earnings and returns without the added details of these transactions. With current accounting of financial statements, change in book value is calculated by subtracting dividends from earnings. Under this model, you must assume ideal market conditions – any fluctuations or abnormalities won’t work. The company’s market value is equal to the net assets’ net value plus the present value of abnormal future earnings. Written as a formula, it looks like this:

Market Value = Asset Net Value + Present Value of Future Abnormal Earnings

The goal of this theory is to give a clear, scannable value right from the balance sheet.

What is a clean surplus relation violation?

For clean surplus accounting to work, the accountant also can’t manipulate any abnormal earnings or other issues. Sometimes unusual gains and losses are charged to equity rather than recorded on the income statement. Examples include things like adjustments to foreign currency translations or pensions as well as changes to the fair value of financial instruments. When this happens, the clean surplus relation is considered “violated” in accounting terms. You’ll need to adjust net income to account for these abnormal gains and losses.

What are the benefits of clean surplus accounting?

The main benefits of clean surplus accounting include its use to provide a quick calculation of a firm’s market value. When calculated correctly, this should be equal to the cash flow model and discounted dividend. However, you can arrive at the value faster than with these other methods with the value visible on the balance sheet. As a forecasting model, it’s generally accurate provided there are no clean surplus relation violations like those mentioned above.

The clean surplus accounting concept offers one way to calculate a firm’s fair value for investors. There are numerous methods to choose from when it comes to equity valuations, but what’s important in any case is the accuracy of your financial statements.

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