Violations of the Clean Surplus Relationship

Say you walk into a store to haggle with a salesperson over the latest expensive tech gadget. In your mind, there's one set price and that's the amount you'll pay. In the salesperson's mind, there's the negotiated price and then all the added fees and necessary accessories that you must have to operate the device. It's never just one price. And unfortunately, that's also typically the case when it comes to residual income.

Recall that residual income requires clean surplus accounting, so that one final amount of income can be established. That number is called __comprehensive income__, which is the amount of all changes in equity other than contributions by and distributions to owners. Why do you think that total value matters so much?

That's right! In fact, it's both! Comprehensive income is important for residual income because it can impact the ROE calculation and obscure an accurate book value. And that matters because ROE and book value are the two primary drivers of residual earnings.

Under both IFRS and US GAAP, dirty surplus accounting is allowed, which means that items can bypass the income statement and be recorded directly in shareholders' equity. So net income isn't affected—and that's a problem. But that's not the only "dirty" issue when it comes to net income. What might be another problem?

No, that's not it. Employee compensation is recorded on the income statement.

Actually, no. LIFO cost of goods sold would still be recorded on the income statement.

You got it! Items recorded in other comprehensive income, like available-for-sale securities, aren't calculated in net income, so those items need to be included too. Other issues that require adjustments are foreign currency translation adjustments, certain pension adjustments, and some gains and losses on hedging instruments. IFRS even adds two more adjustments: the revaluation surplus related to property, plant, and equipment and the change in fair value attributable to changes in the liabilities credit risk.

So there are lots of potential adjustments that can be caused by the lack of recording income through the income statement. But how would that impact the book value?

No, not quite. Book value wouldn't be overstated by the lack of recording income through the income statement.

Actually, no. Book value isn't understated when income is recorded through other comprehensive income or shareholders' equity.

Bingo! Book value is still correct, even though income isn't recorded on the income statement and passed through retained earnings. That's because shareholders' equity includes net income (retained earnings), other comprehensive income, and the gains or loss booked directly to shareholders' equity. So while book value isn't affected, ROE definitely is. It's a good idea to check out how items are recorded through dirty surplus accounting, because historical income recognition could change over time and gains/losses could offset in different periods.

Historical assumptions based upon ROE and the price-to-book ratio need to be evaluated closely, especially if future other comprehensive income is expected to be significant relative to net income. In that case, you should attempt to include those adjustments in the residual income forecast so that an accurate clean surplus accounting total income figure can be used.

To summarize: [[summary]]

It impacts the calculation of ROE

It can obscure an accurate book value

Income recorded for employee compensation

Income recorded in other comprehensive income

Income recorded for LIFO inventory cost of goods sold

It's overstated

It's understated

It's correct as is

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