Clean Surplus Solution?

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CFAdummy

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My mind is going numb. Can someone explain to me what it is? I know it affects Residual valuation.
 
The addition to retained earnings = ni-dividends
in other words, there are no adjustments to equity from currency translation, pension obligations, or secruities
 
I think I remember Adjustments to the Comprehensive Income are not made to the Income Statement.
 
ROE cant be forecasted properly and hence RI can go for a toss. also if CTA,MLA,Available securities adjustments are expected to reverse sooner than later,one can still trust the avg ROE
 
Definition from BNET ->
“the idea that a company’s income statement should show the totality of gains and losses, without any of them being taken directly to equity”
 
jpm351 Wrote:
——————————————————-
> The addition to retained earnings = ni-dividends
>
> in other words, there are no adjustments to equity
> from currency translation, pension obligations, or
> secruities
This is where I’m not very clear. I understand it is a violation if transactions bypass income statement and affect equity directly. But are those transactions such as currency translation and pension obligations have already been reflected in equity? Please explain why there are no adjustment to equity in more detail.
 
cding Wrote:
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> This is where I’m not very clear. I understand it
> is a violation if transactions bypass income
> statement and affect equity directly.
Just stop there: This is right. Pension obligations bypass income statement. Foreign currency translation (using All-current method) bypasses i/s. Available for sale unrealised gains/losses bypass the income statement. This is a violation of the clean surplus relationship.
> But are
> those transactions such as currency translation
> and pension obligations have already been
> reflected in equity? Please explain why there are
> no adjustment to equity in more detail.
This doesn’t make sense.
 
The clean surplus basically tells you that the book value of a company can only increase by the amount earned through the income statement minus the dividends.
you have to remember that Residual income usese ROE and book to compute the future residual income. if Roe does not reflect an item but book value does then there is a violation- the clean surpulus violation. therefore all the companies that have other comprehensive income - that is income that goes directly into the balance sheet can’t use the residual income method.
 
I admit I’m dumb, pleasehelp me understand this topic.
Is the term “other comprehensive income” in book or equity? Aren’t book and equity the same thing?
 
other comprehensive income does not go through income statement, goes directly in the equity - and therefore reflected in book value
 
I think one could think of it as ROE has NI in it (i.e. NI/BV of equity) which doesn’t have the direct equity charges (i.e. Available for sale, CTA etc) and so its not correct whereas Book value has the direct equity charges. So, everything that bypasses the I/S is going to violate the clean surplus relation.
Hope that helps,
-Amit
 
Florinpop and adb258, thanks for your explenations.
My last question: How do we make adjustment? Increase NI by the amount of other comprehensive income or decrease equity/book by that amount?
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Quote from jpm351
The addition to retained earnings = ni-dividends
in other words, there are no adjustments to equity from currency translation, pension obligations, or secruities
—————————————–
I don’t quite understand the no adjustment to equity part he mentioned, anyone care to clarify?
 
The equity part already has direct equity charges to it due to AFS, CTA etc so you wouldn’t need to adjust it. You would have to use comprehensive income derived from NI i.e. subtract losses and add gains due to direct equity charges (see calculation of comprehensive income in SS7).
 
Your welcome. Its through all these questions only that our knowledge also improves and solidifies, so it helps us too.
 
Might be a silly question, but you are able to use the RI method after you make adjustments for comprehensive income by capitalizing leases, pension adjustments, FIFO accounting, etc. right?
 
That would be the extended version of comprehensive income that Schweser mentions (which is in SS7). But I would think for an RI problem, I would just do the basic ones: CTA, AFS, Hedging derivates, Min. Liab Adj and Funded status. All others that you mentioned, I wouldn’t do unless its a FSA problem. In any event, I don’t think it will be that complicated, atleast I hope not.
 
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