Relationship Between Economic Profit & Clean Surplus Theory

by Will Gish

Clean surplus constitutes an accounting method based on a theory of the same name. According to the clean surplus theory, accountants can determine the value of a company based solely on information found on balance sheets and income statements. A handful of factors, including net income, go into determining the value of a firm under clean surplus theory. Accountants use two factors to determine the net income of a company; one of them is the company's profit.

Clean Surplus Theory

Developed by economist James Ohlson, clean surplus theory provides a method for determining the value of a company based on information found on balance sheets and income statements. This allows accountants to calculate value with readily available information. The theory suggests that all changes in the value of stock, other than those derived from transactions with shareholders, such as the payment of dividends, exist as implicit values in the information available on balance sheets and income statements. Values used in clean surplus equations include net income, dividends and earnings.

Economic Profit

Basically defined, economic profit constitutes money earned from a venture of some kind. In terms of business accounting and investment, economic profit may refer to profit generated from a specific process, by a company during a period of time, on an investment opportunity or even the potential profitability of a present or future investment. Clean surplus theory maintains two relationships with economic profit, both of them related to calculations used in determining value through clean surplus accounting. These two relationships concern actual profits and future profitability.

Profit in Clean Surplus Equations

Economic profit figures prominently in two of the three components of a clean surplus accounting equation. This equation holds that the value of a company = previous company value + earnings -- dividends paid. Earnings equal money generated by a company, while the previous company value constitutes the net income at a previous date. Accountants determine net value by subtracting the total expenditures of a company from its total profits, thus determining the actual profit, and value of, a company. For instance, if a company earns a profit of $500,000, but spends $400,000 to earn that profit, its net income, or actual economic profit, equals $100,000.

Clean Surplus Theory and Future Profitability

Ultimately, clean surplus accounting is a way to determine the present or future value of a firm based on previous financial information. Investors use this method of accounting to predict the future profitability of companies and thereby the value of investing in those companies. According to investment strategist and finance professor Dr. J.B. Farwell, clean surplus accounting gives very accurate values when used to calculate future equity profitability. In this respect, clean surplus theory constitutes a method of analyzing the economic profitability of a company as a means of determining its investment value.

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