Question

Provide the formulas for the clean surplus equation and the net transactions with shareholders computation. Explain why clean surplus accounting is important.

Answer 1

1. Clean Surplus Accounting means the change in Shareholder Equity which gives price as a function of change in book value, earning and expected returns. Its offers one of the element of a forecasting model. The clean surplus is calculated by not including transaction with shareholder while calculating earning.

In other words, method designed to provide predictability for the investor and allows us to compare the operating efficiency of each and every company in the exact same manner.

2. The main use of the clear surplus accounting method is to make an estimate of the value of shares of the company. Alternatively use is to estimate cost of capital as we can calculate it through CAPM model.

3. This accounting relatively quick method to calculate market value of the firm which will be the same as a valuation based on discounted dividend or cash flows.

4. Traditionally accounting calculate the ROE by using "Earning from the Income Statement" divided by book value i.e. Owner's Equity from the balance sheet i.e Earning Less Dividend = Retained Earning which is divided by Owner;s Equity.

Net Transaction with shareholder means dividend, share repurchase or share offering etc.

Clean Surplus instead uses "Net Income from Operation" as a return portion divided by book value i.e. Owners equity from the balance sheet. I.e. Net Income Less Dividend = Retained Earning which is divided by Owner's Equity.

For better understanding :- Difference in Net Income, Earning and retained Earning - as appeared in the income Statement/ balance Sheet statement.

Revenue -Expenses - Interest - Taxes - Non recurring items = Earning

Whereas Revenue -Expenses - Interest - Taxes = Net Income

Earning /Net Income - Dividend = Retained Earning

5. This model is applicable when abnormal earning do not persist ( i.e. no goodwill).