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Earnings quality and clean surplus principles

Mahmood, J 2019 , 'Earnings quality and clean surplus principles', PhD thesis, University of Tasmania.

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Earnings quality has a range of measures, including persistence, smoothness and accruals. There is no unique definition of earnings quality. Proposals to move to a notion of Hicksian income to underpin earnings quality are appealing. This thesis explores two concepts of surplus: clean and dirty. Clean surplus (CS) earnings require that all items that affect the book value of equity be included in earnings and flow in the income statement however, flows of dirty surplus (DS) arise if certain variations in shareholders’ equity bypass the income statement and are directly reported in retained earnings.
Clean surplus earnings provide the underlying earnings strength of a firm in value creation and provide transparent information. However, dirty surplus reduces the informativeness and predictive power of accounting earnings, impairs the quality of earnings as a significant input for contracting and valuation, captures all sources of value creation, and reduces ‘transparency’ and ‘visibility. This appeal to use clean surplus as a theoretical understanding of income. This theoretical (calculated) income is then compared to other comprehensive income (OCI). Contradictory opinions regarding the recycling timing, location of OCI items and reporting of large losses in OCI after 2011 increased the importance of FASB update (ASU) 2011-05.
This study addresses the question of quality of earnings with respect to the clean surplus assumption after 2011. Its purpose is to assess the quality of reported earnings of Compustat firms, major industries and individual firms, by analysing the patterns of the relationship between earnings disclosed in the income statement and earnings disclosed in the other comprehensive income (OCI) statement. For this purpose, this study analyses the patterns of net income (NI), OCI, accumulated other comprehensive income (AOCI), clean surplus book value and reported book value, using SPSS 16 to analyse data for the period 1995–2014. Clean surplus book value is based on changes in assets and labilities unrelated to dividends that pass through the income statement.
This study finds that, for Compustat firms and most industry groupings, OCI is unusually negative and the accumulated sum of other losses is very high after 2011, which caused divergence of reported book value from clean surplus book value. The net reported book value of Compustat firms and the assets of most of the industry groupings are noticeably lower than the net asset values that would be expected from earnings reported in the income statement (i.e., assuming clean surplus principles in accounting measurement). The impact of this is that reported earnings generally provide an overoptimistic picture of net assets throughout the period.
This study also finds evidence in three case studies that the movement of OCI losses attributed to discontinuous operation goes through retained earnings and gains on the statement of operation, indicating that these transactions are affecting earnings quality and not reversing over time. However, evidence is also found from two other case studies that regular reversal of OCI gains and losses shows less possibility of poor earnings quality.
This study finds some evidence from two case studies against the clean surplus principle that movement of repurchase and retirement of treasury stock through retained earnings affect the pattern of OCI and influence the divergence of reported book value and clean surplus book value. Based on the assumptions adopted in this study, earnings quality is judged to be lower in these firms.
This study contributes to the theoretical framework for earnings quality in several ways. The argument is proposed that clean surplus is a baseline against which reported earnings can be evaluated. Clean surplus income is considered the summary performance measure in firm valuation. This position takes the literature on comprehensive income back to firm performance, where the axiomatic principles of clean surplus impart properties to time series analysis. This study also contributes to the literature by examining why AOCI losses increase over time and may reverse in more than two years.
Cases are noted where the writing down of discontinuous operations through retained earnings remains a problem for standard setters since FASB update (ASU) 2011-05. This examination indicates that large losses are sometimes reported through OCI and, in some cases, directly through an adjustment to retained earnings without appearing in the comprehensive statement of income. This indicates that large loss transactions are affecting earnings quality by neither passing through the income statement nor reversing in short period.
There are several implications from the findings of this study. First, there are implications for the FASB update (ASU) 2011-05. A large unrealised loss is recognised through the equity section rather than the statement of comprehensive income. The omission of such very large write downs from comprehensive income has a very significant effect on a firm’s patterns of income over time and gives a greatly unrealistic picture to stakeholders of the firm’s long-term performance. Second, the reported book value of the sample companies is deviating from the clean surplus book value, which indicates that the reporting of a firm’s performance is overstated. Third, the accumulative sum of OCI indicates that reversal of unrealised gains or losses is taking more time. Fourth, this study has implications for securities exchanges and investment analysts who evaluate the earnings quality of firms over time.

Item Type: Thesis - PhD
Authors/Creators:Mahmood, J
Keywords: Clean surplus book value, reported book value, other comprehensive income, earnings quality
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