Clean surplus relation
The link between earnings and book value: ending book value equals opening book value plus net income minus dividends. Gains and losses taken to other comprehensive income break it.
Where you will meet it
Clean surplus relation appears in 2 learning outcomes on the CFA syllabus. A few of them:
- Explain where residual income models are strong and weak and argue for using one to value a firm's common stock
“Their weaknesses are that they depend on accounting data that may be distorted or managed, they assume a clean surplus relation in which book value changes only through earnings and dividends, and they may need adjustments for items taken directly to equity.”
- Set out the accounting problems that arise when residual income models are applied
“The clean surplus relation requires all gains and losses to pass through net income, but items reported in other comprehensive income, such as currency translation differences or certain pension remeasurements, bypass it, so forecast earnings may need adjusting.”
See also
Practise it
Practise clean surplus relation until it is automatic: questions that explain every wrong option.
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