Set out the accounting problems that arise when residual income models are applied

Applying the residual income model means scrutinising the accounting. 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. Book values may need adjusting for items such as inventory valued under LIFO (US GAAP only), off-balance-sheet obligations and intangible assets. Aggressive accounting that delays expenses inflates both earnings and book value. Non-recurring items should be removed when forecasting persistent residual income. International differences in accounting also affect comparisons. The trap is using reported ROE without adjustment when dirty surplus items are large, which misstates future residual income.