Clean Surplus Research Articles

Dirty surplus accounting flows: international evidence

It has been suggested that dirty surplus accounting (violation of the clean surplus relationship (CSR)) may result in mismeasurement of performance and value, and that cross-country variation in dirty surplus accounting may cause particular problems for international comparisons. Using articulated data that are largely hand-collected, we evaluate the potential impact of dirty surplus accounting in France, Germany, the UK and the US for the period 1993-2001. First, we report summary statistics on dirty surplus accounting flows. These indicate that distributions of dirty surplus flows are often not centred on zero, and that there is significant cross-country variation in such flows. Then, we use a measure of multi-period abnormal performance to document the bias and inaccuracy, and cross-country variation therein, that would have arisen from omitting dirty surplus flows in measuring performance. Where significant bias and cross-country variation therein arise, they are largely caused by omission of goodwill-related flows, which regulators are eliminating as a dirty surplus item. In contrast, all classes of dirty surplus flow contribute to significant cross-country variation in inaccuracy. Finally, we address the issue of dirty surplus flows from the valuation perspective. We use the residual income valuation model, which relies partly on CSR, to test whether perfect-foresight forecasts of dirty surplus accounting flows explain beginning-of-interval market-to-book ratios after controlling for other inputs to the valuation model. We find little evidence to suggest that omission of dirty surplus flows from residual income value estimates would have caused systematic valuation errors in the period and countries examined.

Do Accruals Drive Firm‐Level Stock Returns? A Variance Decomposition Analysis

This paper extends the variance decomposition framework of Campbell [1991], Campbell and Ammer [1993], and Vuolteenaho [2002] to address the relative value relevance of accrual news, cash flow news, and expected‐return news in driving firm‐level equity returns. The extension is based on the Feltham‐Ohlson [1995, 1996] clean surplus relations. Using three models, this study shows that all three factors, accruals, cash flows, and expected future discount rates are value relevant. Moreover, accrual news is found to significantly dominate expected‐return news in driving firm‐level stock returns. Operating income news is also found to significantly dominate both expected‐return news and free cash flow news in driving firm‐level stock returns. Furthermore, after splitting net income into cash flow and accrual earnings components in the Vuolteenaho model, accrual earnings news and cash flow earnings news are found to equally drive firm‐level stock returns and to dominate expected‐return news. Further disaggregation of the data yields some evidence that accrual earnings news is a more important factor than cash flow earnings news in driving current stock returns. Overall, the three models indicate that changes in expected future accruals are a primary driver, if not the primary driver, of current stock returns.

An Equivalent Form of the Residual Income Valuation Model

The purpose of this note is to show that if clean surplus is assumed, Easton's model (2004) can be viewed as an equivalent form of the residual income valuation model (RIVM). While Easton's model does not require clean surplus and there are problems with the clean surplus assumption (Ohlson, 2003), the fact that his model can be derived directly from the RIVM is of interest.

Accounting research and researchers of the nineteenth century and the beginning of the twentieth century: an international survey of authors, ideas and publications

At the beginning of the nineteenth century the former glory of Italian accounting was overshadowed by its decline during the eighteenth century, and literature from France, England, Germany, America and other countries took centre-stage. ‘Theories of accounts’ (rather than ‘accounting theories’) dominated not merely the early but also the later part of this century when Italian accounting had regained a prominent position beside other countries. The relation of those theories to the ‘charts of accounts’-which later became so prominent in Continental Europe is historically important. The controversies over personalistic versus materialistic accounts and that between entity versus proprietary theories, as well as the emergence of other theories are discussed with reference to individual authors. Diverse topics from railroad accounting and auditing to various aspects of cost accounting are investigated. Particularly important are the pioneering efforts of this period that anticipated further developments. These manifested themselves in the following ideas: entity theory, flow of funds statement, matrix accounting, different aspects of valuation, allocation and depreciation, price-level adjustments and indexation, current values, exit values, residual income valuation, managerial control, the emergence of competing accounting (and Bilanz) theories, the separation of fixed from variable costs, fixed and flexible budgeting, zero-based budgeting, PERT, transfer prices, break-even charts, variance analysis, job-order costing, labour and machine hour rates, standard costing, price determination, integrating financial and cost accounting, clean surplus theory, agricultural accounting, holding gains, and other topics. Appendix A offers an overview of Nineteenth century scholars concerned with accounting history (together with one representative work of each), and Appendix B lists the nationally (and often internationally) prominent names of accounting authors born in the nineteenth century but also or exclusively active during the twentieth century. The paper integrates approximately 400 publications of which less than half are of the English tongue.

Do Accruals Drive Stock Returns? A Variance Decomposition Analysis

This paper extends the variance decomposition framework of Campbell (1991), Campbell and Ammer (1993) and Vuolteenhao (2002) to address the relative value relevance of accruals news, cash flow news and expected return news in driving firm-level equity returns. The extension is based on the Feltham-Ohlson (1995, 1996) clean surplus relations. Accruals news is found to significantly dominate expected-return news in driving firm-level stock returns. Operating income news is also found to significantly dominate both expected-return news and free cash flow news in driving firm-level stock returns. Furthermore, after splitting net income into cash flow and accrual earnings components in the Vuolteenhao (2000) model, accrual earnings news is found to significantly dominate both expected-return news and cash flow earnings news in driving firm-level stock returns. Overall, these three results indicate that changes in expected future accruals are the primary driver of current stock returns rather than changes in expected future cash flows or future discount rates.

Accounting For Stock-Based Compensation: An Extended Clean Surplus Relation

Residual income valuation is based on the assumption that the clean surplus relation holds. As pointed out by Ohlson (2000), among others, the standard clean surplus relation is frequently violated. Moreover, standard residual income valuation models rest on the implicit assumption that future stated earnings belong to current shareholders only. This is clearly invalid for companies granting employee options. In order to overcome these deficiencies, this paper establishes an extension of the clean surplus relation and derives simple analytical solutions for the value of outstanding stocks in terms of already known accounting information.

Earning Management in Two-Period Principal-Agent Models

Theory suggests that in a multiperiod principal-agent setting optimal cash flow based contracts should exhibit memory of wages (Lambert, Bell Journal of Economics, p. 447); that is, wages should depend on both present and past outcomes. There is only weak empirical evidence such as raises/pay cuts and promotions/demotions for this theoretical result. Thus the conclusion can be made that real management compensation is in fact rather memoryless. In addition, these memoryless contracts are usually based on reported earnings, not on cash flows. This paper offers an explanation for this phenomenon. Although cash flow based contracts with memory c. p. strictly Pareto-dominate memoryless ones, the welfare improvement may be outweighed by an increment of transaction costs, i. e., costs of writing and specifying the memory contract. This paper focuses on the second question: Why does practice prefer earnings-based to cash flow-based memoryless contracts even if the agent has discretion to manage earnings to maximize her own utility? It will be proven that at least in a setting without the agent's access to capital markets, the former contracts strictly Paretodominate the latter. To present a strictly formal proof, a model modifying Lambert's (1983) scenario is introduced in which the agent is allowed to manage earnings in period 1; in period 2 there is the reverse effect resulting from the 'clean surplus' or 'tidiness' property of accrual accounting. The interpretation for the result is that earnings management enables the agent to smooth consumption over time. Thus the (risk-neutral) principal can lower the expected wage payment to implement the optimal action pair without violating the agent's reservation utility. Consequently the agency is strictly better off. A brief analysis of earnings management in a dynamic principal-agent setting with free access to capital markets concludes the paper.

An Empirical Investigation of the Traditional and the Clean Surplus Valuation Models

Early theoretical work on equity valuation suggests that equity prices are determined by variables such as dividends and growth in dividends. However, these 'traditional' views have been challenged by recent studies that seem to indicate that equity prices are determined by book value and discounted future abnormal earnings. This paper employs panel data methodology and equity prices from Athens Stock Exchange empirically to compare the performance of the traditional and the more recent models of equity valuation. The results show that the performance of the Ohlosn (1995) model is quite similar to that of the traditional models even though in some cases Ohlson's model performance appears to be superior.

An empirical investigation of the traditional and the clean surplus valuation models

Early theoretical work on equity valuation suggests that equity prices are determined by variables such as dividends and growth in dividends. However, these “traditional” views have been challenged by recent studies that seem to indicate that equity prices are determined by book value and discounted future abnormal earnings. This paper employs panel data methodology and equity prices from Athens Stock Exchange empirically to compare the performance of the traditional and the more recent models of equity valuation. The results show that the performance of the Ohlosn (1995) model is quite similar to that of the traditional models even though in some cases Ohlson’s model performance appears to be superior.

Accounting representation and the onion model of reality: a comparison with Baudrillard's orders of simulacra and his hyperreality

Baudrillard's “order of simulacra” and his notion of “hyperreality” are attempts of a postmodern author to deal with (or possibly reject) the problems of representation and ontology. These attempts were applied to accounting by Macintosh et al. [ Accounting, Organizations and Society 25 (2000) 13–50] with the conclusion that our present notions of income, capital, etc. no longer refer to real objects or events, and that “accounting no longer functions according to the logic of transparent representation, stewardship or information economics”. The current paper presents the author's own ontological and epistemological theory in reference to accounting representation (particularly to such notions as income and capital). These results are then juxtaposed to and compared with Baudrillard's view and its application to accounting by the Macintosh team. The conclusions are: (1) Baudrillard's approach is not suitable to accounting research or any scientific analysis; (2) the notions of income and capital still have referents in reality; (3) for accounting valuation a purpose-oriented representation is required; (4) the “clean surplus model” harbours some hope for future improvement of accounting. While Macintosh et al. (2000) and I disagree on the first two points, the last two items seem to be the major points of agreement between us.

Horsing Around with Clean Surplus Relations

Researchers continue to horse race the Residual Income (RI) model and the Cash Flow (CF) model, with no regard for the underlying assumptions. Recently, Lundholm and O'Keefe (2000) asserted that they have identified an important reason for the discrepancy between the results obtained from the two models, the so-called incorrect discount rate error. In their paper, it is unclear whether this error with the calculation of the weighted average cost of capital (WACC) can occur in a M & M world because the assumption about a M & M world is not explicitly stated. In other words, they are agnostic about the correspondence between the M & M world and reality. In this note, I illustrate the use of the WACC in a M & M world and show that the error that has been identified by Lundholm and O'Keefe cannot occur in a M & M world. Thus, it is reasonable to conclude that perhaps the error with the calculation of the WACC only occurs in a non-M & M world, whatever that may be. In addition, I show the estimation of the residual income and CF models with variable returns to levered equity.

What Affects the Implied Cost of Equity Capital?

We estimate implied cost of equity capital for a sample of firms from 1984 to 1998 using the Ohlson and Juettner (2000) model that does not make restrictive assumptions about clean surplus and payout policies. We find that cost of equity capital is strongly positively associated with conventional risk factors such as earnings variability, systematic and unsystematic return volatility, and leverage, and is negatively associated with analyst following. These associations are robust to controls for industry membership and to running the regression in changes instead of levels. Our results support the Ohlson-Juettner metric as a robust and appealing measure of cost of equity capital.

Accounting For Stock-Based Compensation: An Extended Clean Surplus Relation

Residual income valuation is based on the assumption that the clean surplus relation holds. As pointed out by Ohlson (2000), among others, the standard clean surplus relation is frequently violated. Moreover, standard residual income valuation models rest on the implicit assumption that future stated earnings belong to current shareholders only. This is clearly invalid for companies granting employee options. In order to overcome these deficiencies, this paper establishes an extension of the clean surplus relation and derives simple analytical solutions for the value of outstanding stocks in terms of already known accounting information.

Models of the reporting entity and accounting for equity-based consideration

Conventional accounting practice for equity-based consideration (EBC) and, in particular for employee share schemes (ESS), recognises an expense for cash-based settlement but not for settlement by the issue of new shares. In principle, expense recognition based on a choice of method of settlement is inconsistent and, in the case of ESS, undermines managerial accountability by understating pay, overstating profit and weakening the link between reported profit and the change in the wealth of existing shareholders. The choice of a model of the reporting entity (MRE) provides the conceptual basis to address issues in accounting for EBC. In the light of the controversy over the FASB's recommendation for partial expense recognition based on the date of grant fair value of EBC, and the recent decisions of the ASB and G4+1 to consider how to account for EBC. this paper reviews the role of MRE in expense recognition for EBC. To provide a consistent, reliable and relevant measure of expense for resources acquired by EBC, the application of fair value and clean surplus accounting is recommended. A method of presentation is proposed to separate the expense based on the date of grant fair value from the cost of subsequent changes in the value of EBC. This allows income measured according to different MREs to be reported in a single set of financial statements, and allows users to choose the information best suited to their purposes.

Accounting Practices and the Market Valuation of Accounting Numbers: Evidence from Indonesia, Korea, Malaysia, the Philippines, Taiwan, and Thailand

This study examines the relation between stock prices and accounting earnings and book values in six Asian countries: Indonesia, South Korea, Malaysia, the Philippines, Taiwan, and Thailand. The analysis is based on a residual earnings model that expresses the value of the firm in terms of book value and residual income. The model holds for any clean surplus accounting system. However, for finite time horizons, biased accounting may affect model estimates. The six countries examined in this study differ in faithfulness to clean surplus accounting as well as bias (conservatism). The study addresses two questions. First, are there systematic differences across countries in the value relevance of accounting, and are these differences related to accounting differences? Second, are there systematic differences in the incremental and relative information content of book value per share (BVPS) and abnormal (residual) earnings per share (REPS) across the countries, and are such differences related to accounting differences? We find differences across the six countries in the explanatory power of BVPS and REPS for firm values. Explanatory power for Taiwan and Malaysia is relatively low while that for Korea and the Philippines is relatively high. These differences are generally consistent with differences in accounting practice; however, since Korean accounting practice is strongly influenced by tax law, we did not expect the high association for Korea. Second, with respect to the incremental and relative explanatory power of BVPS and REPS, we find BVPS to have high explanatory power in the Philippines and Korea but little in Taiwan. In all six countries REPS has less explanatory power than BVPS in most years. Again, the evidence may be interpreted as suggesting accounting practice affects valuation (with Korea again as the exception). Finally, we provide evidence on the sensitivity of the timing of comparisons of stock prices and accounting values. We find that comparing prices at year-end (even though annual accounting information has not been released at that time), in general, provides the highest correlation between market and accounting numbers.

Residual Income Valuation: The Problems

This paper identifies problems related to RIV in an equity valuation context. Three problems are discussed. First, on a per share basis clean surplus will not generally hold if there are expected changes in shares outstanding; this aspect eliminates a necessary condition for the RIV-formula to be valid. Second, an all equity approach does not work if the firm plans to bring in new shareholders who derive a net benefit from their capital contributions. Third, GAAP violates clean surplus because some capital contributions are not accounted for in market value terms. As an alternative to RIV, the paper shows that it makes more economic/accounting sense to focus on expected eps, adjusted for dps, as a valuation attribute instead of current book value and expected residual earnings.

Accounting Information, Capital Investment Decisions, and Equity Valuation: Theory and Empirical Implications

This paper develops a theoretical model to reexamine the roles of earnings and book value for equity valuation and to explore cross-sectional differences in the properties of the valuation function. Ohlson [1995] and Feltham and Ohlson [1995; 1996] show that, assuming the clean surplus relation and a specific linear information dynamic, equity value can be represented as a linear function of earnings and book value. However, recent empirical evidence indicates linear valuation functions do not fully capture the effects of earnings and book value on equity value. For instance, Burgstahler and Dichev [1997] find the valuation impact of either earnings or book value depends on the levels of these two variables, and the valuation function is convex, not linear; similarly, Hayn [1995] and Collins, Pincus, and Xie [1999] report that the valuation effect of earnings is asymmetric between positive and negative earnings. Also, as Collins, Pincus, and Xie [1999] show, the relative and the incremental importance of earnings versus book value in explaining equity

Accounting as simulacrum and hyperreality: perspectives on income and capital

This paper draws on two independent strands of literature — Baudrillard's orders-of-simulacra theoretic and financial accounting theory — to investigate the ontological status of information in accounting reports. It draws on Baudrillard's concepts of simulacra, hyperreality and implosion to trace the historical transformations of the accounting signs of income and capital from Sumerian times to the present. It posits that accounting today no longer refers to any objective reality but instead circulates in a “hyperreality” of self-referential models. The paper then examines this conclusion from the viewpoint of recent clean surplus model research and argues that the distinction between income and capital is arbitrary and irrelevant provided the measurement process satisfies the clean surplus relation. Although accounting is arbitrary and hyperreal, it does impart a sense of exogeniety and predictability, particularly through the income calculation. Therefore, it can be relied on for decisions that do have real, material and social consequences. The paper ends with some implications of Baudrillard's theoretic for accounting, reflections on accounting's implications for Baudrillard's theoretic and suggestions for future research.

Residual Earnings Valuation With Risk and Stochastic Interest Rates

This paper provides a general version of the accounting-based valuation model that equates the market value of a firm's equity to book value plus the present value of expected abnormal earnings. Prior theoretical work (e.g., Ohlson 1995; Feltham and Ohlson 1995, 1996) assumes investors are risk neutral and interest rates are nonstochastic and flat. Our more general analysis rests on only two assumptions: no arbitrage in financial markets and clean surplus accounting. These assumptions imply a risk-adjusted formula for the present value of expected abnormal earnings. The risk adjustments consist of certainty-equivalent reductions of expected abnormal earnings. A key issue deals with the capital charge component of abnormal earnings. It is measured by applying the (uncertain) riskless spot interest rate to start-of-period book value. Risks do not affect the rate used in the capital charge, and accounting policies do not affect the formula's constructs. An application of the general formula shows how the classic risk-adjusted expected cash flows model derives as a special case.

The Relation of Firm Market Values with Book Values and Residual Accounting Earnings in Six Asian Countries

We examine the relation between stock prices and accounting numbers across six Asian countries: Indonesia, South Korea, Malaysia, the Philippines, Taiwan, and Thailand. Accounting practice in the six countries differs in faithfulness to clean surplus accounting and in bias (conservatism). We address two questions. First, are there systematic differences across the countries in the value relevance of accounting? Second, are there systematic differences in the incremental and relative information content of book values and abnormal (residual) earnings per share (REPS) across the countries? We also examine whether differences are related to accounting differences. We find differences across the six countries in the value relevance of accounting numbers. Explanatory power for Taiwan and Malaysia is relatively low while that for Korea and the Philippines is relatively high. Second, we find book value to have high explanatory power in the Philippines and Korea but little in Taiwan. REPS had less explanatory power than book value (and less than EPS) in all six countries.