Table Of Contents
What Is Clean Surplus Accounting?
Clean surplus accounting refers to an accounting method that involves showing the alterations in shareholder equity not resulting from transactions with shareholders, like share offerings and share purchases, in the company’s income statement. The main purpose of it is to estimate the value of a company’s shares.
With this accounting method, businesses do not record equity-related losses/gains on their income statements. Instead, a company’s earnings report shows the changes in the fair value of its liabilities and assets. One can utilize this method as an alternative to the DCF or discounted cash flow approach to determine the overall value of a company’s shares.
Table of contents
- Clean surplus accounting refers to an accounting method that excludes equity-related losses and gains recorded by a company from its income statement. Businesses can consider this process as an alternative to the DCF approach.
- In this process, a company’s earnings include the fluctuations in its assets and liabilities fair value.
- A key importance of clean surplus accounting is that it enables a firm to estimate its market value quickly and even faster than multiple methods, like the DCF approach.
- Dirty surplus accounting includes equity-related losses/gains in an income statement, unlike clean surplus accounting.
Clean Surplus Accounting Explained
Clean surplus accounting refers to an accounting process enabling companies to deal with fluctuations concerning equity-related income for the calculation of the total earnings. Companies can use this method to estimate the overall value of their shares. Additionally, they can utilize it to estimate their cost of capital instead of using the capital asset pricing model or CAPM.
As noted above, various kinds of shareholder transactions, for example, share repurchase, an offer for sale, etc., might involve a company. Typically, corporations include such transactions while computing returns. That said, companies do not include these transactions. Separating such information provides a ‘clean’ estimation of a company’s share value when using the clean surplus concept.
Nevertheless, one must remember that since this method does not include any shareholder transactions, it functions more like a forecasting model than an accurate record. This model shows the price as an increase or decrease in the book value, returns, and earnings without the transactions’ added details.
Individuals must remember to assume that market conditions are ideal under this model, which means abnormalities and fluctuations will not work. The market value of a company is the same as the net value of its net assets plus the abnormal future earnings’ present value. If one writes it as a formula, it will be as follows:
Market Value = Present Value Of The Future Abnormal Earnings + Net Value Of The Net Assets
Examples
Let us look at a few clean surplus accounting examples to understand the concept better.
Example #1
Suppose Company ABC sold its existing equity shares worth $2 million via an offer for sale. It uses the clean surplus accounting process. Hence, it did not include the transaction in its income statement when computing returns. As a result, it obtained a clean estimate of its share value. Moreover, the company was able to determine its market valuation quickly by using this accounting method.
Example #2
Suppose Company XYZ repurchased its shareholders during a financial year. Since the company used clean surplus accounting, it did not include the information in its income statement. This helped it get a clear estimate of the total value of its shares. Keeping the shareholder transaction separate allowed it to prevent muddying the waters and compute a fair value of the company for its investors. Moreover, this accounting process was vital in keeping its financial statements accurate.
Violation
Accountants cannot manipulate abnormal earnings or any other issue for this accounting concept to work. Sometimes, companies charge unusual losses or gains to equity instead of recording them on their income statement. A few examples include adjustments made to pensions or country translations and an increase or decrease in the fair value of the financial instruments. If this happens, the violation of clean surplus accounting occurs. Companies must adjust their net income to factor in such abnormal losses or gains.
Benefits
One can understand the importance of clean surplus accounting by going through the following points:
- It offers a way to compute a company’s market value quickly.
- This method enables individuals to compute the fair value of a company for investors.
- It cleans the dirt of a company’s income statement. Since this method does not include the unrealized losses or gains on financial instruments held for sale, the estimated income is like the real income.
- Since this accounting method does not involve including foreign translation losses and gains, the benefit is that the company can determine a more normal estimated income.
Clean Surplus Accounting vs Dirty Surplus Accounting
Understanding clean and dirty surplus accounting can be challenging, especially for individuals new to accounting. That said, knowing the differences between the two concepts can certainly help avoid confusion. Hence, let us look at this table showing how they differ.
| Clean Surplus Accounting | Dirty Surplus Accounting |
|---|---|
| In this accounting process, a company does not include the unrealized losses or gains on securities or treasury stocks held for sale. | Dirty surplus accounting includes unrealized gains or losses on securities or treasury stocks held for sale. |
| This process does not include foreign translation gains and losses. | The dirty surplus accounting method involves the inclusion of foreign translation losses and gains. |
| When a company uses this accounting method, its net income does not include unusual items or comprehensive income. | If a company utilizes the dirty surplus accounting process, it includes comprehensive income and unusual items in its net income, which flows into its retained earnings statement. |
Frequently Asked Questions (FAQs)
The clean surplus concept in accounting does not include transactions with shareholders, such as share offerings or share repurchases, when computing returns. That said, the standard accounting procedure for a company’s financial statements requires the increase or decrease in book value to be equal to the result obtained by subtracting dividends earnings.
The key components of the equation are the expected earnings from the business and the expected present value of the future abnormal earnings.
This process does not include non-recurring losses or gains and extraordinary items when computing the net income of a business.
The payment of dividends by a company is a transaction with its shareholders, and according to the concept of clean surplus accounting, such transactions should not be included in an organization’s income statement.
Recommended Articles
This has been a guide to what is Clean Surplus Accounting. We explain its examples, violation, benefits, and comparison with dirty surplus accounting. You can learn more about it from the following articles –
