Fundamentals of Financial Instruments. Sunil K. Parameswaran
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the shares cannot be traded on a stock exchange. However, the shareholders continue to enjoy limited liability and hence the name. The disclosure norms for public limited companies are generally more stringent than those for private limited companies.
During a given financial year, every economic unit, irrespective of which sector it may belong to, will get some form of income from its operations, and will also incur expenditure in some form. Depending on the relationship between the income earned and the expenditure incurred, an economic unit may be classified into one of the following three categories:
A balanced budget unit
A surplus budget unit
A deficit budget unit
A balanced budget unit (BBU) is one whose income in a period is exactly equal to its expenditure. It must be reiterated that a balanced budget unit is impossible to observe in practice and consequently exists only in the realm of textbooks. For it is virtually impossible for a business or government to ensure that its scheduled income during a period is perfectly matched with its scheduled expenditure during the same period. In practice an economic unit may be a surplus budget unit (SBU) or a deficit budget unit (DBU). A surplus budget unit is one whose income exceeds its expenditure while a deficit unit is one whose expenses exceed its income. Usually, in most countries, governments and businesses invariably tend to be deficit budget units, whereas households consisting of individuals and families generally tend to be savers, that is they tend to have budget surpluses. By this we do not mean that all households and individuals are savers or that all governments and businesses have a budget deficit. What we mean is that while it is not impossible for a government or a business to have a surplus in a financial period, taken as a group, the government sector and the business sector generally tend to be net borrowers. By the same logic, it is not necessary that all households should save, although the category generally has a budget surplus in most periods. Finally, a country may have a budget surplus or a budget deficit.
AN ECONOMY'S RELATIONSHIP WITH THE EXTERNAL WORLD
The record of all economic transactions between a country and the rest of the world is known as the Balance of Payments (BOP). It is a record of a country's trade in goods, services, and financial assets with the rest of the world or, in other words, a record of all economic transactions between a country and the outside world. The transaction may be a requited transfer of economic value or an unrequited transfer of economic value. The term requited, in this context, connotes that the transferor receives a compensation of economic value from the transferee. On the other hand, an unrequited transfer represents a unilateral gift made by the transferor.
For instance, if Microsoft exports software to Germany in return for a payment in euros, it is a requited transaction of economic value. On the other hand, if the Gates Foundation were to donate $10 million to a charity in Zimbabwe, it is an unrequited or unilateral transfer.
Economic transactions can be classified into the following five basic categories. First is the import and export of goods and services in return for a payment in financial terms. For instance, a company in Houston imports crude oil from Saudi Arabia and pays in US dollars. The second category may be illustrated as follows. Sometimes an import or export of a product may be paid for by an equivalent export or import of another. A party in India imports crude oil from Nigeria by paying in the form of wheat. This is nothing but a barter transaction in simple English. The third type of transaction entails the exchange of one financial asset for another. For instance, a party in London buys US Treasury Bonds as an investment and pays the equivalent amount in dollars. The last two categories pertain to unilateral transfers, inward and outward, respectively.
The BOP is typically broken up into three major categories of accounts, each of which is further subdivided into various components. The major categories are:
The Current Account: This accounting head includes imports and exports of goods and services, factor incomes and payments, and unrequited transfers in both directions.
The Capital Account: Under this head we have the transactions that lead to changes in the foreign assets and liabilities of a country.
The Reserve Account: The reserve account is similar to the capital account, in the sense that it also deals with financial assets and liabilities. This account, however, deals only with reserve assets, which are assets used to settle the deficits and surpluses that arise on account of the other two categories taken together.
A reserve asset is one that is acceptable as a means of payment in international transactions, and which is held by and exchanged between the monetary authorities of various countries. It consists of monetary gold, assets denominated in foreign currencies, Special Drawing Rights (SDRs), and reserve positions at the International Monetary Fund (IMF). If there is a deficit in the current and capital accounts taken together, then there will be a depletion of reserves. However, if the two accounts show a surplus when taken together, there will be an increase in the level of reserves.
The balance of payments is an accounting system that is based on the double-entry system of bookkeeping. Consequently, every transaction is recorded on both sides, that is as a credit and as a debit. All transactions that have led to or will lead to a flow of payments into the country from the rest of the world will be shown as credits. The payments themselves should be shown as the corresponding debit entries. Similarly, all transactions which have led to or will lead to a flow of payments from the country to the rest of the world should be recorded as debits, and the corresponding payments should be recorded as credits.
The accounting principle can also be stated as follows. Any transaction which leads to an increase in the demand for foreign exchange should be shown as a debit, whereas any transaction which leads to an increase in the supply of foreign exchange should be shown as a credit. Thus, capital outflows will be debited, whereas capital inflows will be credited.
Why would the residents of a country demand foreign exchange? First, they may wish to pay for imports of goods or services. Second, they may want to make a dividend or interest payment to a party abroad. Third, they may want to repay a loan taken from an entity abroad. Unlike a company, a country does not have shareholders. Thus, all liabilities of the latter represent debt. It should also be clarified that a company's debt is what it owes to its banks or bondholders. In the case of a country, however, if a foreign entity were to take an equity stake in a domestic company, it would be treated as a part of the country's external debt.
Now let us analyze the receipts of foreign exchange by residents of a country. First, they may have exported goods or services. Second, they may have received dividend or interest payments from parties abroad. Third, they may have taken a loan from an entity abroad or may have liquidated a foreign financial asset.
A payment received from abroad will increase the country's foreign assets. Thus, an increase in foreign assets or a decrease in foreign liabilities will be shown as a debit. On the other hand, when a payment is made to an external party it will either reduce the country's holding of foreign assets or show up as an increase in its liabilities. This will obviously be shown as a credit.
The equivalence with corporate accounts: An export of goods and services by a country is equivalent to a sale by a company. It will be recorded as a credit, and the corresponding payment received or to be received will be recorded by debiting the cash account or the receivables account, if the sale is made on credit. Similarly, an import of goods and services is like a purchase by a company. It will be recorded as a debit and the payment, if made immediately, will be shown by crediting cash, or by crediting the creditor's account if the counterparty has supplied on credit. Dividends and interest payments made to foreign parties are equivalent to expenses for a company and will be debited. Inward dividends and interest are equivalent to income and will be credited. As we said earlier, a country has only creditors and no shareholders. Consequently, foreign liabilities will go up with credits and down with debits. Unlike a company's reserves, which belong to the shareholders and are consequently a liability for it, a country's reserves are an asset for it. Thus, a country's reserves will increase with debits