Accounting and International Considerations

There are two main drivers of residual income; ROE and book value. In applying the residual income model, the following accounting issues must be considered:

• Violations of the clean surplus relationship.
• Balance sheet adjustments for fair value.
• Intangible assets.
• Nonrecurring items.
• Aggressive accounting practices.
• International considerations.

Violations of Clean Surplus Relationship

Clean surplus accounting must hold for an analyst to use the residual income model. i.e.,

$$\text{Ending book value}=\text{Beginning book value}+\text{Net income}-\text{Dividends}$$

The clean surplus relationship is violated if gains or losses, like unrealized changes in the fair value of some financial instruments, foreign currency translation adjustments, certain pension adjustments, bypass the income statement and are charged directly to equity. When clean surplus relation does not hold, net income must be adjusted to account for these items.

Balance Sheet Adjustments for Fair Value

Off-balance sheet assets and liabilities need to be adjusted for an analyst to have an appropriate measure of book value. In addition, reported assets and liabilities should be adjusted to fair value when possible. Other items requiring adjustments include inventory, deferred tax assets, liabilities, and intangible assets.

Financial statements and footnotes must be examined for items unique to the company.

Intangible Assets

It is appropriate to include identifiable intangibles that can be separated from the entity and sold in the computation of book value. If these assets have a finite useful life, they will be amortized over time. Intangible assets, however, require particular consideration because they are often not recognized as an asset unless they are obtained in an acquisition.

Research and development (R&D) expenditure is a type of intangible asset that should be considered. If a firm involves itself in unproductive R&D expenditures, residual income will be lower. If a company involves itself in productive R&D expenditures, revenues will be higher to offset the expenditures over time. For a mature firm, ROE should reflect the productivity of R&D expenditures without requiring an adjustment.

Nonrecurring Items

Residual income should be forecasted based on recurring items. Without any adjustments of earnings, future residual income may be overstated or understated. Items that may require adjustments include extraordinary items, restructuring charges, discontinued operations, and accounting changes. An analyst should consider whether these items are likely to continue and contribute to residual income. If not, they should be removed from operating earnings when forecasting residual income.

Aggressive Accounting Practices

Firms may employ accounting practices that result in the overstatement of assets or earnings, like accelerating revenues or deferring expenses. For example, a company could capitalize rather than expense a cash payment, resulting in lower expenses and increased assets.

An analyst must carefully evaluate a company’s accounting policies and consider the integrity of management when evaluating the inputs in a residual income model.

International Considerations

Accounting standards are different globally, which results in different measures of book value and earnings. There are three key considerations in applying a residual income model internationally:

• The availability of reliable earnings forecasts.
• Systematic violations of the clean surplus assumption.
• Accounting rules that result in delayed identification of value changes.

Question

Which of the following would least likely be considered an accounting issue when using the residual income model?

1. International considerations.
2. Intangible assets.
3. Recurring items.

Solution

The correct answer is C. 

Recurring items are not considered an issue when using the residual income approach. It is only a problem when a company has nonrecurring items in its financial reports that would need to be deducted from its earnings to arrive at recurring earnings.

A in incorrect. International considerations are items to consider when using the residual income approach. This includes accounting rules and the availability of data.

B is incorrect. Intangible assets are an issue to consider when using the residual income approach. Identifiable intangibles that can be split from the entity and sold should be included in the computation of book value.

Reading 26: Residual Income Valuation

LOS 26 (k) Describe accounting issues in applying residual income models.