Balance Mechanics 3: Flows that change the balance sheet

We had already defined the different items on a balance sheet that we are interested in here. Now the question is how one can change any of those items. In German standard accounting there are three kinds of flows that change the items on the balance sheet:

  • Incomey \, increases and consumptionc\, decreases an economic unit’s net worth: y-c=\Delta nw \ (Remember, net worth is the difference between assets (both tangible and financial) and liabilities: nw=ta+fa-l \,).
  • Revenues, r \, increase and expendituresr \, decrease net financial assets: r-e=\Delta nfa \ (Remember, net financial assets are the difference between financial assets and liabilities: nfa=fa-l \).
  • Receipts increase and payments decrease a unit’s means of payment (stock of money): , receipts-payments=\Delta m \,

Now, it is very important to keep those items clearly apart. Too often, receipts, income and revenues are mixed up with each other as are consumption, expenditures or payments. While there might sometimes be an overlap between those different flows (a revenue might also be income and come in the form of a receipt), they have to be kept strictly apart.

Here are some examples:

  • Income but no revenue: Here only tangible assets increase and net financial assets do not. The simplest example would be a non-monetary gift.But it also contains all production of tangible assets to which no expenditures correspond (this will be very important when we will talk about profit). Another example is the appreciation of an asset (financial or tangible) you already own. An important note: Although net financial assets can increase through an appreciation because after one they are worth more, this does not count as a revenue since revenues are transactions and a change in an asset’s value is not a transaction.
  • Consumption but no expenditure: Those are all transactions that leave your net financial assets unchanged. Imagine you cook for yourself and eat what you cooked. This is a consumption but not an expenditure. For companies, depreciation of your tangible assets (sometimes also called consumption of fixed assets) is a consumption that is no expenditure.
  • Revenue but no income: This is an increase in net financial assets that leaves your net worth unchanged. This then has to be a transaction in which an increase of your net financial assets is compensated for by a decrease in your tangible assets. This could be the sale of a machine — it increases your net financial assets (more money) and decreases your stock of tangible assets (less machines).
  • Receipt but no revenue: The stock of means of payments increase without an increase in net financial assets. This can be due to two things: a) liabilities increase by the same amount as your means of payment, i.e. you take out a loan. This is a balance sheet lengthening (more on that later). b) somebody pays you back money she owes you. Then your other financial assets decrease (your claim) and your stock of money incrases. This is an asset exchange.

And so on. You can make up other examples but the bottom line is: in order to understand what is going on in the economy, you have to keep those different transactions apart (and as an appetizer: I think much of academic economics does not properly keep those different transactions apart with grave consequences…).

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