13. The flow-of-funds account and the net financial position

In: A Primer in Monetary Economics

14 Feb 2012

Net income and capital expenditure
The flow-of-funds account as well originates from the double-entry ledger book, and it can be seen as an extension of the income statement. In the latter, “net-income generated” is the balance between revenue (on the credit side) and current expenditure (on the debit side). If positive, net income is a source of funds, which are used for purchasing capital goods, acquiring financial assets (lending), or reducing liabilities.

If negative, net income is a use of funds, which are provided by selling capital goods, selling financial assets, or increasing liabilities (borrowing). As opposed to the income statement, the flow-of-funds account fully tracks all uses and sources of funds for a given economic unit engaged in monetary transactions. Because it includes all entries in the ledger, all recorded debits match all recorded credits.

Consider, for example, an economic unit selling a service: On the ledger, both a debit entry (the payment received) and a credit entry (the service provided) will show. Yet, the income statement shows a positive net income, because the value of the transaction is only recorded as being delivered as part of the current operations of this unit. The flow- of-funds account, however, includes both the value relinquished as well as the value received (e.g., an increase in the balance of a bank account when payment is credited).

The net financial position

In any given accounting period, the net financial position of a single economic unit is the difference between its net income generated and its capital expenditure (i.e., its net acquisition of capital goods). It is also defined as the difference between revenue and total (i.e., current as well as capital) expenditure. In contrast to the definition of profit and saving, the net financial position of a given unit is independent of the classification of output between “output for consumption” and “output for investment.”

Figure 5 illustrates the structure of a flow-of-funds statement that is applicable to a household as well as to a business unit.

The upper section explains the net financial position as the balance between all sources and uses of funds that are related to economic (value-creating) transactions. It thus includes the income statement plus the capital account.
The lower section shows all funding transactions and thus provides information on how the unit has externally funded its operations and how it has used internally generated funds. This includes issuing and repaying debt (IOUs), selling and buying other units’ debt (financial assets), and decreasing or increasing money balances.

Figure 5. The flow-of-funds statement

ITEM DEBITS CREDITS
ECONOMIC TRANSACTIONS:
Revenue (proceeds) Source of funds
Current expenditure (payments) Use of funds
Capital expenditure (payments) Use of funds
Net balance (economic transactions) Net financial position
FUNDING TRANSACTIONS:
Issuing IOUs Source of funds
Repayment of previously issued IOUs Use of funds
Sale of financial assets Source of funds
Purchase of financial assets Use of funds
Decrease in money balances Source of funds
Increase in money balances Use of funds
Net balance (funding transactions) Net financial transactions
Overall net balance 0

Every source (or use) of funds in the upper section is matched by a use (or source) of funds in the lower section. It is a logical requirement that the funds a sector receives must necessarily be disposed of in some way. For example, a salary earned by a household and credited on a bank account is counted both as revenue (source) and an increase in money balances (use). This entails that the overall balance is zero, and thus the balance of net financial transactions in the lower section must be equal (with opposite sign) to the net financial position.

Because the revenue of any unit must match the expenditure of some other unit, the sum of the revenue of all units engaged in transactions must equal the sum of their expenditures. Thus, the net financial position of all units is zero.

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