Question

2. The theoretical development of the residual income model relies on the “clean surplus relation,” or that all changes in book value are caused by either current earnings that are retained in the firm or dividends that are paid out. What transactions cause a violation to this relationship under U.S. GAAP? Should U.S. GAAP alter accounting standards to move closer to this clean surplus relationship? Why or why not?

Answer 1

Residual Income (RI) is the dollar amount minus the imputed cost of the Investment.

Clean surplus concept states equity related gains and losses are not to be included in the Income statement.Under this approach changes in the fair value of assets and liabilities are included in the earnings.

if we include fair value of assets and liabilities, Estimated residual income will be plus or minus, that mean it will not be accurate. The import thing is we should account in the books that we do not expect reverse in the future.

Transaction of Revaluation of Assets, changes in the market value or fair value of debt securities like bonds or Equity securities like stock, FOREX rate difference loss or Gain - these transaction may or may not be cause violations to this relationship.

The consequence of clean surplus violation is that net income is not correct, only book value will be correctly involved in books of accounts. So that US GAAP can alter accounting standards.