Task Force on the Valuation and Measurement of Equity – --Potential SNA93 Stock-Flow Equity Issue
- Note by Canada (document for Agenda item 6)
Introduction
1. The SNA93Balance Sheet Account(BSA) measures the market value of all assets and liabilities, including equity. It is clear that the intent in SNA93 is that all changes in the market valuation of outstanding assets (and corresponding) liabilities are to be clearly articulated in the Revaluation Account (RA) of the Other Changes in Assets Account (OCAA). This implies that changes in the value of equity outstanding should fully take into account changes in the market price of equity issues outstanding on the liability side as well as equity holdings on the asset side. Equally clear in SNA93 is that the SNA93 Financial Account (FA) is to measure financial transactions. This implies that equity flows should include net new issue of equities (corporate shares) on the liability side as well as net acquisitions of equity (corporate shares) shareson the asset side, including both portfolio and inter-company equity. However, there is one smallexception noted in the FA: Tthe inclusion of re-invested earnings (RIE) on foreign direct investment positions. This item is mentioned but not articulated in the FA(11.88), and BSA(13.74) and RAare silent on RIE.
2. This short note questions whether RIE gives rise to a stock-flow inconsistency in SNA93. If so, then this inconsistency should be brought to the attention of the Advisory Expert Group (AEG) for clarification, as part of the TFVME report to the AEG.
SNA93 basic equity stock-flow model
3. In a world excluding direct investment enterprises, the SNA93 stock-flow relationship is relatively straightforward, as in Table 1. In this table, the second and sixth columns are the opening and closing balance sheets, the third column covers the financial account transactions, and the fourth and fifth columns include the revaluations and volume change accounts, respectively.
4. AssumingIf we assume one firm in the economy and several domestic several investors, anthe economy-wide framework for recording equity is shown in Table 1. The domestic firm has a market value of equity in the opening BSA of 200. Share prices increase by 10% over the course or the period, which alone would alter total equity assets and liabilities by +20 in the form of an unrealized holding gain. In addition, the firm issues at period-end +30 of new shares on the liability side, giving rise to a +30 net acquisitions of equity by the investors on the asset side. Therefore, the total change in equity over the period is +50 and the period-end stock of equity assets and liabilities in the economy is 250. This total change in market value equity is comprised of +20 in the RA and +30 in the FA.
Table 1: Equity assets and liabilities in a stock-flow framework
BSA t-1Stocks / FA t
Transactions / OCAA -RAt
Revaluations / OCAA - OCVAt
Volume / BSA t
Stocks
ASSETS
INVESTORS
- Shares / 200 / 30 / 20 / 250
LIABILITIES
ENTERPRISE EQUITY
- Shares / 200 / 30 / 20 / 250
SNA93 equity stock-flow modelwith direct investment enterprises
5. The inclusion of direct investment enterprises complicates the model somewhat, by introducing two classes of investors. A modification to the above example is shown in Table 2. In this case, the domestic firm is a 50%- owned foreign direct investment (FDI) enterprise. The remaining 50% of the firm’s equity is owned widely by domestic portfolio investors.
6. AssumingIf we assume one firm in the economy and one-half owned by a foreign parent firm (in the Rest of the WorldOW sector) and one-half owned by domestic portfolio investors, the economy-wide framework for equity is shown in Table 2. The domestic firm has a market value of equity in the opening BSA of 200. This 200 is equally allocated to direct and portfolio investors on the asset side. Share prices increase by 10% over the course ofr the period, which alters equity assets and liabilities by +20 in the form of an unrealized holding gain. Direct and portfolio investors share equally in this gain (+10 each). In addition, the firm issues at period-end +30 of new shares on the liability side, giving rise to a +30 net acquisitions of equity by the investors on the asset side. Assume that Tthese issues are picked up by investors in the same proportion as their ownership, so that direct investors acquire +15 and portfolio investors acquire +15. Therefore, the total change in equity over the period is +50 and the period-end stock of equity assets and liabilities in the economy is 250. This total change in market value equity is comprised of +20 in the RA and +30 in the FA.
Table 2: Equity assets and liabilities in a stock-flow framework with FDI
BSA t-1Stocks / FA t
Transactions / OCAA - RAt
Revaluations / OCAAt
Volume / BSA t
Stocks
ASSETS
INVESTORS
- Portfolio / 100 / 15 / 10 / 125
- Foreign Ddirect / 100 / 15 / 10 / 125
LIABILITIES
DIRECT INVESTMENT ENTERPRISE EQUITY
- Shares / 200 / 30 / 20 / 250
7. The existence of an FDI relationship implies the existence of RIE – that is,the imputed remittances of the FDI domestic subsidiary to the FDI foreign parent (in the ROW sector). These imputed remittances reflect the foreign parent’s claim on the domestic subsidiaries undistributed earnings in the period, based on the parent’s proportion of equity participation in the direct investment enterprise subsidiary. Therefore, in the example that we are using, the direct investment owner (FDI foreign parent) would have an imputed claim of 50% of the direct investment enterprise subsidiary’s undistributed earnings.
8. The undistributed earnings are reflected in the corporate saving flows in the economy. In our case, we assume that the one firm in the economy records saving of 40, so that the RIE flow would account for 20 (50% of the saving). If domestic sector corporate saving is reduced by 20, in the Capital Account(CA), then the imputation results in the internally-generated sources of funds being reduced by 20. Since total CA and FAuses of funds are unchanged, an additional source of funds must be imputed in order to balance the corporate sector Capital and Financial Account[1]. Failure to make a second imputation would create or expand the sector’s measurement error.
9. The only account in which toallocate an additional source of funds is the FA, and the only financial instrument to allocate an additional imputed source of funds to the domestic direct investment enterprise subsidiary is the equity liability. In our example, the foreign parent’s imputed withdrawal[2] of 20 (50%) of the domestic direct investment enterprise subsidiary saving must be re-injected (or re-invested) in the domestic direct investment enterprise subsidiary as an imputed additional acquisition of equity by the parent[3]. This is equivalent to an additional equity issue/acquisition on the FA. This imputation is an addition to financial transactions on both the asset and liability sides of the economy. This implies the following adjustments to Table 2, as shown below in Table 3.
10. The domestic firm has a market value of equity in the opening BSA of 200. This 200 is equally allocated to direct and portfolio investors on the asset side. Share prices increase by 10% over the course or the period, which should alter equity assets and liabilities by +20 in the form of an unrealized holding gain:–+10 to each of portfolio and direct investors, respectively. In addition, the firm issues at period-end +30 of new shares on the liability side, giving rise to a +30 net acquisitions of equity by the investors on the asset side:–+15 to each of portfolio and direct investors, respectively. However, in addition to the +30 equity issues/acquisitions in the FA, there is an imputed re-investment flow of earnings in the FA of +20 that is allocated to the direct investor assets in the ROW sector.;and, tThe required offset to this is the corresponding matching imputed +20 equity issue liability flow by the domestic direct investment enterprise.
12. The equity flows in the FAare now to +50 and the equity revaluations are +120, – amounting to a total change of +70. However, in this example, the total change in equity positions is constrained to be +50, … a and can only be +50. – It is comprised of actual share issues/acquisitions plus revaluations. In orderto balance the accounts in a stock-flow framework, and adjustment must be made somewhere to the OCAA. The likely candidate is the RA entry for direct investment assets (more on this below). However, making a -20 RARIE adjustment is not in keeping with the SNA93conceptual model, as currently articulated.
Table 3: Equity assets and liabilities in a stock-flow framework with FDI and RIE
BSA t-1Stocks / FAt
Transactions / OCAA - RAt
Revaluations / OCAA – OCVAt
Volume / BSA t
Stocks
ASSETS
INVESTORS
- Portfolio / 100 / 15 / 10 / 125
- Foreign Ddirect / 100 / 15 / 10 / 125
PLUS RIE: 20 / MINUS RIE: 20
EQUALS: 325 / EQUALS: -10
LIABILITIES
DIRECT INVESTMENT ENTERPRISE EQUITY
- Shares / 200 / 30 / 20 / 250
PLUS RIE: 20 / MINUS RIE: 20
EQUALS: 50 / EQUALS: 0
13. Therefore, the inclusion of RIE in the transactions accounts appears to give rise to an SNA93 stock-flow inconsistency with respect to equity.
Accrual of earnings on FDI and changes in the value of SNA93 equity positions
SNA93 is clear and solidly based on market valuation for equity positions. The principal reason why RIE might lead to an inconsistency in the SNA93 model is that it is a book value concept. The flow of RIE has been included for many years as part of the change (increase/decrease) in the value of IIPbook valuedirect investment positions[4][POH1]. This was also true of domestic inter-company investment in certain OECD countries’ BSA, including– the case for Canada’s. It would appear that, when RIEwas added as part of the flows of direct investment in SNA93, that it was not considered within the full sequence of accounts. Evidence to support this contention is that (i) RIE is mentioned briefly in SNA93 chapters 11 and 13, and (ii) there is no mention of RIE in the Other Changes in Assets Account chapter.
In keeping with the SNA93 market value concept for equity, the Revaluation Account (RA) suggests that we should be using the change in market prices to calculate holding gains for all instruments. To the extent that corporate earnings are influential in moving equity prices, RIEaccrues accruesals on market value equity as an implicit part of calculated holding gains/losses. The change in corporate equity at market value as defined in SNA93 has only two components to it -- share issues/acquisitionsin the FAand changes in the value of shares outstandingin the RA.[5]. Therefore, RIE seemingly drives a wedge into the clearly articulated SNA93 stock-flow model with respect to equity.
Very Eearly on in the ongoingSNA93 review process, RIE was considered as a potential review item, and rejected. Given this, if the inclusion of RIE in equity transactions is internally -inconsistent in the SNA93 framework, then some adjustments should be sought to eliminate this problem. There are two possible options: tThat RA holding gains/losses be re-defined and adjustedto accommodateRIE as an imputed transaction; or, that the Other Changes in the Volume of Assets Account (OCVAA)be re-defined and adjusted to accoimodateaccommodate RIE as an imputed transaction. The latter approach (illustrated below) would allow for holding gains to remain as currently defined by allowing for a RIE offset in OCVAA.
TFVME consideration
It is proposed that the TFVME, consistent with its mandate,underline this potential SNA93 stock-flow with respect to RIEas part of its final report to the AEG on the valuation and measurement of equity.
[1] This is a similar treatment in the Balance of Payments (BOP) or ROW sector account where the financial account must also reflect the imputed RIE flows that are included in the current account in order to match sources and uses of funds (and thus avoid adversely impacting on the BOP net errors and omissions or ROW sector discrepancy).
[2] As reflected in the BOP Current Account.
[3] As reflected in the BOP Financial Account (ROW sector in FA).
[4] This is consistent with book value corporate accounting. While there is a tendency to hold financial accounting up as an ideal, there are many instances where it is not progressive enough for the SNA. --Mmarket valuation of assets and liabilities, in particular with respect to valuation of inter-company investment, isbeing a good example.
[5]This claim excludes the possibility of volume changes.
[POH1]