A User Guide to the Canadian System of National Accounts

Note to readers

This document is a guide to the various components of the Canadian System of National Economic Accounts, describing frameworks, major concepts, definitions and the purpose of each component. It was published in 1989. Most of the information does not change. However, the Canadian System of National Economic Accounts is constantly making important improvements. For more information see Latest developments in the Canadian economic accounts.

Chapter 5

Financial Flows and Balance Sheets

I - Financial flows

General

The financial flow accounts stem from development work done for the Royal Commission on Canadian Economic Prospects in 1959, and published in W.C.Hood's 'Financing Economic Activity in Canada'. The years covered by the prototype financial flows were 1946-1954 and they were known as the national transactions accounts. Statistics Canada first published financial flows in their present form in 1969, commencing with the year 1962. Since their inception the accounts have been available on a quarterly basis. In addition, year-end levels of outstanding financial assets and liabilities are available for the year 1961 forward. In 1985 these partial balance sheets, which excluded non-financial assets and net worth estimates, were superseded by national balance sheet accounts which are described in the latter half of this chapter.

The financial accounts provide a framework within which financial transactions of institutional sectors of the economy may be examined and related to the nonfinancial set of accounts, particularly the capital finance account and saving and investment. The flow accounts record transactions in financial assets and liabilities, an increase in the financial assets of one economic unit being offset by a decrease in the assets or an increase in the liabilities of another.

The value of transactions in financial assets and liabilities for a single sector are unlikely to be in balance. An increase in financial assets in excess of liabilities indicates the sector has been a net lender, whereas a more rapid increase in liabilities reflects net borrowing. Lending and borrowing between resident sectors is offsetting, so that to the extent that the financial assets of all resident sectors exceed their liabilities Canadians are lending to non-residents. To the extent that liabilities are greater than financial assets Canadian residents are borrowing from non-residents. It follows that in the financial accounts financial assets and liabilities for domestic sectors plus non-residents are equal and offsetting. The financial flows are frequently described as a direct extension of the income and expenditure accounts. Both sets of accounts independently derive estimates of sector lending and borrowing, but for the income and expenditure system it is the closing point of the system, while for the financial flows it is the opening statement. It is true that the financial accounts can be viewed principally as a statement of how funds are transmitted from those sectors having surpluses or saving to those whose capital programmes exceed their saving. However, this limited perception of the accounts is likely to encourage the mistaken notion that the recorded financial activity is solely associated with borrowing funds to finance new capital formation. The net result of financial transactions by sectors does indeed provide this perspective; however, the accounts record much more. It is the additional information that complicates the analysis of the accounts and makes difficult a link with existing economic theory. The combination of transactions related to financing current production, transfers of past production and the redistribution of existing financial claims, all within a single framework, presents a formidable analytical challenge touching as it does on a number of different economic theories. Compilers of the accounts have had to face the dilemma of constructing a system which is sufficiently condensed for easy use within the framework of the System of National Accounts, but at the same time is detailed enough to reveal the broader role of financing in the Canadian economy.

Before setting out the framework of the Canadian system, it may be helpful to indicate the underlying motivations for many of the transactions recorded in the financial accounts. Not only will it alert readers to the complex nature of the accounts but it will also be obvious that some transactions would take place even if the flows system were uncoupled from productive activity and no net lending or borrowing activity between sectors was taking place. The transactions recorded in the accounts reflect a combination of the following factors:

1. financing new capital formation,
2. financing transactions in existing non-financial assets
3. financing current production
4. financing current consumption
5. portfolio adjustments

The extent of these activities is a function of the level of development of financial markets in a country; the more sophisticated the financial markets of a country, the greater the scale of financial intermediation.

Of the five factors noted above, three are related to the production process, whilst two record the financing of transfers of existing assets. Examples of the production oriented transactions include trade credit, consumer automobile financing and new residential mortgage financing, while redistributional-type financing includes bond issues to support a corporate merger or take-over or bank lending to support investment in existing shares. It will be apparent to the reader that two of the difficulties confronting the user of the flows is that different types of motivational behaviour may be present in a single category of financial transaction, for example, a mortgage may finance new housing or refinance existing dwellings.

Secondly, the purpose of a transaction is different when viewed from the perspective of the lender and the borrower.

The financial flow accounts' aggregates are also heavily dependent on the degree of netting adopted in the compilation of the numbers. It is possible to present the data on three bases: in their most net form, with individual categories of liabilities netted against assets; with assets on a net basis (increases less decreases) and liabilities on a net basis; and in the greatest detail with increases and decreases in both assets and liabilities shown separately. The ability to interpret the numbers depends considerably on the choice of presentation, which in turn hinges to a large extent on data availability.

The Canadian accounts are presented on the second basis but the most net form can easily be derived.

A final point concerns the extent to which transactions for any sector are presented on the basis of consolidated or combined accounting methods. Transactions between units within a sector are netted out on a consolidated basis, whereas on a combined basis the transactions of each unit are summed regardless of whether the transaction is intra- or intersectoral. The absolute measure of activity will vary depending on the choice of presentation.

The above general observations on the nature of the financial flow accounts are intended to alert the reader to the facts that they do not fit a theoretical model in the fashion of the income and expenditure accounts, that although the system has built-in constraints and balances, there is no single conventionally accepted aggregate towards which it builds, such as the gross domestic product, and that choices concerning the degree of netting, sectoring and consolidation determine the shape of the accounts and the amount of analysis that can be supported. The next section deals specifically with the Canadian framework.

Extending the statistical analysis of the economy

i) General

The financial flow accounts in the Canadian system are designed to bring into a comprehensive framework the transactions in financial assets and liabilities both as they relate to each other and as they relate to the non-financial activities portrayed in the income and expenditure accounts.

For any period of account the transactions are brought together in a matrix form. The rows show saving, non-financial capital acquisition, net lending or borrowing, details of changes in holdings of financial instruments and net financial investment. (Net financial investment is conceptually identical to net lending or borrowing but is derived from the flows system by subtracting net increases in liabilities from net increases in assets.) The columns represent each of the main institutional sectors of the economy, for example, persons and unincorporated business and government.

The matrix in its most condensed form is a capital account for the economy and corresponds to the capital finance accounts of the income and expenditure system, with four basic sectors - persons and unincorporated business, government, corporate and government business enterprises, and non-residentsand three underlying types of transactions - saving, non-financial investment and net financial investment.

The real contribution of the flow accounts is in disaggregating net financial investment to show transactions in the various forms of financial instruments (assets and liabilities) which give rise to the net position, and in systematically presenting information concerning the role of financial institutions in the economy. The schematic presentation of the Canadian System of National Accounts shows the financial flows matrix at a highly condensed level.

ii) Extension of sector detail

The extension of sector detail in the financial flow accounts mainly affects the corporate and government business enterprise sector, which is subdivided into non-financial and financial components; the financial sector is further subdivided to provide detailed information about the role and market share of specific types of financial institutions. Most of the funds moving through the Canadian economy at any time are routed through financial institutions, with a generally smaller portion moving directly between primary lenders and borrowers. The principal business of the financial institutions, the borrowing and lending of money, and the profitable matching of the requirements of both lenders and borrowers is highly specialised. This has led to a detailed classification system for financial intermediaries.

The flow accounts provide information on about twenty types of financial intermediaries or institutions, ranging from the banks through to venture capital companies and based on the type of service provided. Although the net financial investment of the financial intermediaries is generally small, their importance in providing the lubricant in the economic system is indicated by the substantial value of the offsetting changes in their financial assets and liabilities recorded in each time period. For example, the chartered banks may record virtually no net financial investment, yet changes in financial assets and liabilities run into billions of dollars as bank deposits and loans respond to changing economic and financial prospects.

The sectoring in the financial flow accounts is of a hybrid nature. At their most aggregative level, sectors correspond to the institutional definition employed in the income and expenditure accounts; the economic units assigned to a sector exhibit similar patterns of behaviour and the transactions between units in different sectors are analytically significant. However, for the subdivision of the corporate and government business enterprise sector, the definition of the sectors begins to look much more like an industrial classification with respect to the financial institutions. The sectoring is dependent not on similar patterns of behaviour and motivations - most of the financial institutions are profit motivated - but on the type of product or service rendered. The merit of this hybrid classification is that it enhances the analytical usefulness of the accounts in that most of the financing associated with the institutionally defined sectors passes through the hands of the finance industry.

iii) Extension of transactions detail

The other statistical extension attributable to the flows is the systematic classification of financial transactions into categories or types of financial instrument. The net financial investment of each sector is broken down and fitted into a classification scheme composed of just over twenty types of financial claims.

Net assets and net liabilities are shown separately, that is, for any single asset or liability, increases and decreases are offset. A positive change in an instrument held as an asset indicates net investment or lending in that form, while positive change in the same instrument held as a liability means that debt has been incurred or borrowing taken place in that category. Negative entries in the asset and liability categories imply either net disinvestment or reduction of claims or debt outstanding.

The classification of financial instruments employed in the Canadian accounts is pragmatic, leaning heavily on the importance of the instrument in the context of Canadian financial markets and its analytical usefulness, rather than on pure principle. A number of different levels of classification have been suggested, including one based on the degree of liquidity of the instrument, another based on the length to maturity of debt and yet another which attempts to portray the markets in respect of different types of financial claims. The Canadian classification might be regarded as a blend of all three of the above. Individual categories used in the Canadian matrix will be discussed in a later section.

iv) The framework and organization of the accounts

The Canadian accounts set out the financial flow matrix in a form in which the transactions of each sector are shown in a single column. Row entries in each column record saving followed by acquisition of non-financial capital, the balance between these two aggregates represents the sectors lending or borrowing. Net increases in financial assets by type of instrument appear next and is followed by net increases in liabilities, also classified by type of instrument.

The categories used for classifying assets and liabilities are identical -they are in fact opposite sides of the same coin. The difference between the increases in assets and liabilities, net financial investment, represents the lending or borrowing activity of the sector derived from financial statistics.

A highly condensed matrix with data for 1981 is given in Table 4A. Table 4B includes the balance sheet matrix so that the similarities in format can readily be seen.

In theory and with perfect statistics, the lending or borrowing estimate derived from the non-financial data and the net financial investment figure derived from the financial data should be identical. Because of different source material and data deficiencies the two estimates normally do not coincide. A discrepancy entry appears at the foot of the column to balance the financial and non-financial data in the sector account.

The structure of the Canadian matrix is such that transactions for each sector appear in a single column and are grouped according to whether they affect assets or liabilities. An alternative arrangement is to display the data according to whether they represent a source of funds or a use of funds. The different presentations simply require a reshuffling of the data.

In order to look at a sector's transactions in terms of sources and uses of funds, it is necessary to regroup transactions by combining increases in assets and decreases in liabilities into a use column, and decreases in assets plus increases in liabilities into a source column. Funds are used in the process of acquiring assets or reducing liabilities, while the liquidation of assets or increase in liabilities provides a source of funds. No matter which presentation is selected the same net financial investment estimate is produced.

The matrix rows, as previously noted, provide information for a single type of transaction across all sectors. The upper portion of the matrix deals with saving and non-financial capital acquisition arising out of current production; totals for the main sectors are taken directly from the income and expenditure capital finance accounts. The statistical discrepancy necessary to equate the income and expenditure based gross domestic product estimates is also required to equate saving and investment and forms two distinct rows in the upper portion of the matrix.

Because the error cannot be assigned to any single sector of the economy it appears in a separately identified column in the financial flow matrix. One additional row for transactions in existing assets is required to complete the upper half of the matrix and arrive at a measure of sector lending or borrowing. It includes such items as land and mineral rights, fixed assets and inheritances and migrants funds. Transfers between sectors of existing nonfinancial assets in the Canadian accounts is somewhat incomplete because of data availability.

The row sums to zero as acquisitions by sectors of existing assets are exactly offset by the disposition of those same assets by other sectors. The rows covering net lending or borrowing and net financial investment also sum to zero. Given total saving equal to investment, any imbalance at the individual sector must offset in the aggregation process, that is, lending by sectors must match the borrowing of other sectors.

The main contribution of the financial flows system is recorded in the rows showing transactions in types of financial assets and liabilities. Just as in the sector classification process where each family, firm or government unit is assigned to a single sector, so each individual financial claim is classified to a particular type of financial instrument category. Each category appears twice in the system, once as an asset and once as a liability. For example, a new issue of government bonds will appear as a 'bond liability' of the government and as a 'bond asset' of the sector purchasing the bond. This double entry means that the sum of a particular financial instrument held as an asset is equal to the sum of that same instrument held as a liability, assuming identical valuation.

Maintaining the equality of claims held as assets and as liabilities allows the residual derivation of flows for some instruments for which direct measurement is difficult. For example, changes in holdings of federal government short-term paper reported by all sectors except persons and unincorporated business can be deducted from the federal government's net new issues to derive a sector estimate. The balancing of asset and liability transactions is in some respects analogous to the commodity balancing that takes place in constructing the input-output system where, in addition to confronting all available data, in the final analysis the compiler's skill and judgement play an important role.

Constraints in the construction of the accounts

There are certain constraints built into the financial flows framework, some general, and some peculiar to the Canadian accounts. The effect of the horizontal balancing requirements for saving and investment and for financial claims held as assets and liabilities, as well as the vertical requirement that each sector's saving be equal to its nonfinancial plus net financial investment, places rigid accounting constraints on the system.

i) The four entry constraint

Any single transaction requires four entries in the financial flows matrix in order to maintain a balanced system. For each transaction there are two sectors involved and within each sector there is a source and a use of funds entry. Assuming the transaction to be the purchase and sale of a government bond, the first entry records the purchase by the investing sector; the second records the offsetting sale by the government sector; the third entry records the source of funds for the investing sector's purchase; the final entry records the government's use of funds raised by the sale. If any of the above entries are not made, or if the transactions are recorded at different times or at different valuations, the system will not balance.

Because of the diverse sources of financial data there is no method by which complete coverage of all related transactions can be ensured. The degree to which, say, short-term paper liabilities are matched on the asset side of the account hinges on a large number of independent surveys of asset holding sectors, all of which may have different sample sizes and inflation factors. The problem of matching data derived from different sources is not a problem unique to the financial flow accounts but one which pervades all systems that present balanced accounts with data drawn from different sources. Given existing knowledge it is impossible to say what part of the initial difference between direct measures of asset and liability changes is due to survey coverage.

ii) Timing difficulties

The problem of timing is familiar to all compilers of financial data. Often a transaction is not entered in the books of the buyer and seller on the same day and because of this, the basic accounting records of outstanding assets and liabilities for a particular financial instrument will not be in balance. This discrepancy is known as 'float'. The most familiar example of this type of discrepancy occurs in deposit claims on financial institutions.

Deposit liabilities as seen in bank records, and counterpart assets recorded in holder-sector accounts, will differ by the value of cheques drawn on the accounts of senders but not yet entered on the books of receivers. The problem undoubtedly occurs in most categories of assets and liabilities and is likely to be important in such transactions as trade credit.

iii) Obtaining correct figures from balance sheet statements

Changes in the value of assets and liabilities derived from balance sheet statements frequently reflect more than the flow of funds arising from transactions. Changes due to these other influences, such as revaluations, are inappropriate for the financial flows.

Conceptually the financial flows aim to record only actual transactions at the price at which the claim is exchanged. For example, the sale and purchase price of an asset should be identical so that they are consistent with corresponding changes in, say, the bank balances of the transactors. In the case of certain transactions such as securities, there will be a difference in the sale and purchase price equivalent to brokers' commissions and costs; when possible, adjustments are made to exclude these current costs which more properly belong in the production accounts. A major problem faced when using balance sheet statements is that the balance sheet value of an asset written off when it is sold may differ from the cash received from its sale.

Capital gains and losses constitute the most important valuation changes captured on balance sheets which must be excluded from the financial flow accounts. For example, the sale of shares for $100 will result in a realized capital gain of $10 for the seller if they were originally purchased at $90. In the financial flow accounts the transaction should be recorded by the seller as a decrease in shares of $100, offset by an equal increase in, say, bank deposits - the flows should record the transaction at the price at which it took place. However, change data derived from the seller's balance sheets spanning the sale would record a decrease in securities valued at only $90(original cost), a corresponding increase in cash or deposits of $100 (sales price), and an increase in total assets of $10 due to capital gains. Unrealized capital gains or losses may also be reflected in changes based on balance sheets.

Corporations or governments may choose to recognize changes in the market value of assets, either in land, plant and equipment or financial investments. No transaction has taken place and the revaluation should not give rise to an entry in the financial flow accounts. It is not always easy, however, to detect changes of this nature.

Revaluations that are inadvertently recorded in the flows contribute to the discrepancy between the income and expenditure and financial flow accounts.

Such items as capital gains are not recognized as income arising from current production and are omitted from the income and expenditure estimates.

To permit revaluations to remain in the flows would result in a higher net financial investment figure than the equivalent lending or borrowing figure derived from the capital finance account of the income and expenditure system.

An important adjustment in the Canadian system arising from the use of balance sheet data is that relating to the conversion of claims denominated in foreign currency to Canadian dollars. As a result of floating exchange rates, recorded changes in Canadian dollars of foreign assets and liabilities incorporate changes in the value of the dollar. These valuation-type changes are not relevant for the flow accounts. Ideally the flows in Canadian dollars should be calculated from data on each transaction at the exchange rate governing at the time of the transaction. Clearly this is not feasible and adjustments to balance sheet changes are made at the aggregate level, taking into account movements in the relevant exchange rates.

The movement of economic units from one sector to another and changes in accounting or reporting procedures are reflected in balance sheet changes but should not be included in the flow accounts.

Changes in ownership of economic units, in regulations governing operations, or in type of activity may all give rise to the movement of units from one sector to another. When this occurs, recorded decreases and increases in the affected sectors' assets and liabilities are omitted to the extent that they are related only to resectoring. Any changes that represent the unit's true financing activities will, of course, be taken into account in the sector to which the unit has been reassigned.

A wide variety of changes in accounting practices produce changes in balance sheet levels which should not be recorded in the financial flow accounts. An example is the change arising from the reclassification of a financial instrument. This might occur because of the separate identification of an asset previously grouped in a miscellaneous category. A further example is the switch that occurs when unconsolidated accounts are consolidated, an event that normally occurs after a merger or take-over; a loan from one entity to another disappears when the balance sheets of two separate units are consolidated.

iv) Consolidation or combination of accounts

In order to construct financial accounts on a sector by sector basis the transactions of all units classified to a specific sector must be summed. In the process of summing a decision must be taken as to whether transactions between units within the sector should be included or excluded. If such transactions are excluded, the accounts are on a consolidated basis; if they are included, the accounts are considered to be combined. For example, a loan from company A to company B would be eliminated in a consolidated account but would remain in the aggregate loan figures for the sector in a combined account.

It may be argued that consolidated accounts preserve the analytically significant inter-sector flows while internal transactions, which may or may not have great analytical value, are eliminated. The principle is similar to that governing business accounting, but in practice there is a considerable difference. In business, consolidation relates to the accounts of companies closely related and in situations where the transactions may be at less than arm's length. This is not true in the case of the financial flows, where transactions between units in the same sector are quite likely to be at arm's length, and have equal analytical significance to those between units in different sectors. The consolidation of accounts tends to simplify the analysis of data by reducing the number of transactions recorded both within sectors and at the aggregate level.

Despite a preference for consolidated accounts the method of recording is frequently determined by the availability of data. In order to prepare consolidated sector accounts it would be necessary to identify assets and liabilities on a 'from-whom, to-whom' basis and such detailed data are usually unavailable. In the Canadian accounts, because of data limitations, most sectors are prepared on a combined basis. For example, in the government sector, provincial and federal government bond issues held as assets by other levels of government or government agencies appear in the sector totals and are not cancelled out.

There are exceptions to the combined accounting approach in the Canadian system. These occur in the non-resident sector where data are presented entirely on a consolidated basis. The data base for this sector is the balance of payments which records only transactions between Canadian residents and nonresidents.

In the non-financial corporate business sector the data are presented on a partially consolidated basis. The survey upon which the data depend permits consolidated reports for parent corporations and their subsidiaries. The sector therefore consists of a mixture of consolidated results where the transaction is between closely related companies, and combined results where corporations are unrelated. Where corporations grouped in a consolidated report cross sector boundaries, unconsolidated accounts are specifically requested.

Relationship of economic and business accounting

Like the income and expenditure accounts, financial flows have their origins in business accounting. The link is most easily forged for the corporate and government business enterprise sector, but the same principles apply to other sectors, with modifications in approach.

The business statements most closely linked to the financial flow accounts are the balance sheet and the statement of changes in financial position. If a choice existed, the changes in financial position statement would be the preferred data source as it more directly fits the requirements of the flow accounts. In most cases however, only balance sheet figures, which require more manipulation and adjustment, are available.

The corporate balance sheet consists of a valuation of a firm's assets against which are set its liabilities - the balance, normally an excess of assets over liabilities, represents the stockholders' equity. The asset side of the balance sheet shows fixed assets net of depreciation, securities and other financial investments with long-term maturity dates, and current assets or resources that can be converted into cash or consumed in the short-term, such as cash, bank deposits, trade receivables and inventories. The liability side of the balance sheet is also subdivided into longer-term debts such as bonds and shorter-term debts such as trade payables and short-term bank loans. The balancing item, representing the equity of the stockholders, is usually shown in two parts, the capital contributed by the owners in exchange for stocks and the part attributable to the earnings of the firm which have not been paid to the owners, the retained earnings.

To construct the financial flow accounts, balance sheet levels are required at different points in time to permit the calculation of flows or changes. Although the basic structure of the flows and balance sheets coincide, some reformatting is required. The single major drawback, previously noted, arises because changes derived from balance sheet levels may contain changes other than those attributable to the flow of funds, such as revaluations of assets and liabilities, realized capital gains and losses, and reclassification of assets and liabilities. A 'changes in financial position' statement provides information on the sources of funds becoming available to the firm and how they were used. It is based either on cash transactions or on working capital but also includes transactions that affect neither, such as the exchange of capital stock or long-term debt for long-lived assets such as land or buildings. Typical of the entries found under sources of funds are those attributable to net income from operations, borrowing, investment by owners and sales of productive assets. Under uses of funds the most common entries are purchases of productive assets, repayment of debt, investment in securities and the distribution of funds to owners of the firm.

The statement of changes in financial position converts readily to the financial flow format, and indeed provides for the national accounts sectors the same sort of analytical tool that it provides individual firms. The only steps required in using the data are the selection of appropriate entries and the regrouping of data. In the first case, for example, if net income appears as a source of funds and distribution of dividends as a use, dividend payments must be netted from income in order to provide the retained earnings figure required as a component of saving in the flow accounts. In the second case, a particular asset category may appear both as a source and use of funds in the business accounting statement, whereas in the flows these two asset transactions would be shown as one entry on a net basis.

The sectors

The discussion on sectors combines descriptions for both the financial flow and national balance sheet systems. The number of sectors separately identified in the financial flows is considerably greater than in the income and expenditure accounts. At the highest level of aggregation, the four sectors used in the financial accounts, persons and unincorporated business, corporate and government business enterprises, government and the rest of the world are compatible with those found in the income and expenditure accounts, using identical concepts and definitions. It is within the corporate and government business enterprise sector that the financial accounts provide much greater detail.

The primary sub-division of the corporate and government business enterprise sector is between non-financial and financial corporations. The financial sector identifies separately the main groups of financial intermediaries, defined as those principally engaged in obtaining and redistributing funds. Since the main purpose of the financial flow accounts is to provide an analytical tool that links financial and non-financial activities and illuminates the way in which the economy is financed, a full exposure of the financial institutions is necessary.

Non-financial corporations are only split into two groups, privately-owned and government-owned enterprises. The private sector includes the operations of foreign controlled corporations in Canada but excludes the foreign operations of resident Canadian corporations. Some investment holding companies, due to consolidated reporting with their operating companies, are included in the sector, although they more properly belong with financial corporations; real estate developers and operators are considered as part of the sector. Included in the nonfinancial government enterprise sector are corporations owned by government, selling primarily to outside government purchasers, and attempting to meet costs through their pricing policies. Government-owned corporations not meeting these criteria are consolidated in the general government sector.

The financial sector contains close to twenty sub-sectors, each identifying a type of financial service or institution. The titles are largely self-descriptive and the units of classification are company or enterprise data. The following paragraphs briefly describe the type of subsectors under five broad groupings.

The first group, the monetary authorities, contains those institutions bearing responsibility for the implementation monetary policy and official transactions in foreign exchange. The three sub-sectors are the Bank of Canada, the Exchange Fund Account in which are recorded foreign exchange transactions carried out on behalf of the federal government, and 'other monetary authorities', a sub-sector covering transactions in official international reserves held by the federal government.

The banks and near-banks group contains five subsectors sharing the characteristic of being deposit accepting institutions. They are the chartered banks, Quebec savings banks, credit unions and caisses populaires, trust companies, and mortgage loan companies. The chartered banks sub-sector relates only to domestic or 'booked-in-Canada' banking operations and excludes the operations of their majority-owned subsidiaries not involved in banking. The credit unions and caisses populaires sub-sector comprises savings and loan co-operatives owned by members and, in many cases, serving members only; members normally work for the same company, or belong to the same church, trade union or residential district. Trust companies accept deposits and lend funds, predominantly in the form of mortgages; they also administer estate, trust and agency funds on behalf of clients. In the latter case, because the clients retain ownership of assets administered, transactions in these assets are not included in the subsector but appear in the persons and unincorporated business sector, or in the trusteed pension plans sector in the case of pooled pension funds administered by trust companies. Transactions in mutual funds handled by trust companies are recorded either in the personal or the mutual funds sector depending on the type of fund.

Mortgage loan companies accept deposits and invest principally in mortgages; to this extent they resemble the trust companies, but they are not permitted to engage in the fiduciary activities open to trust companies.

The major group, life insurance and pension funds, contains three sub-sectors: life insurance business, segregated funds of life insurance companies and trusteed pension funds. National accounting conventions characterize these three sectors as 'associations of individuals' insofar as they accumulate assets on behalf of policy-holders, annuity and pension beneficiaries. The principal liability of all three sub-sectors is to the personal sector. The life insurance sector includes fraternal benefit societies. As in banking, the operations relate only to domestic activity, or insurance underwritten on Canadian residents. Segregated funds are separate investment accounts not subject to the same restrictions imposed on life insurance business by regulatory authorities (90% of segregated funds' assets are held for group pension plans). The trusteed pension plans sector covers trustees who accept and invest contributions, pay out benefits and administer pension plans according to the terms of trust agreements. The sector is not inclusive of all pension funds which may also be included with government, life insurance, mutual funds and various other financial institutions.

The fourth major grouping, 'other private financial institutions', contains six sub-sectors: investment dealers, open-ended mutual funds, property and casualty insurance companies (principally fire and automobile), sales finance and consumer loan companies including those providing loans to customers of their parent companies, accident and sickness branches of life insurance companies and a catch-all 'other' subsector which includes venture capital and other business financing companies, investment and holding companies, closed-end funds and finance leasing companies.

The final major grouping, public financial institutions, covers the two remaining sub-sectors within the overall financial sector. The institutions, controlled by the federal and provincial levels of government, have the same characteristics as non-financial government enterprises except that their activities are primarily of a financial nature, such as the Canada Mortgage and Housing Corporation or the Export Development Corporation at the federal level, and the Insurance Corporation of British Columbia or Caisse de dépot et placements du Québec at the provincial level.

Classification of financial instruments

As with financial sectors, readers are likely to be less familiar with the classification of financial instruments than other classification systems. Because no officially recognized standard classification exists for financial instruments, it is necessary to itemise the categories. Full descriptions are contained in the publication “A Guide to the Financial Flow and National Balance Sheet Accounts”, Statistics Canada, Catalogue 13-585.

The financial flow accounts distinguish over twenty categories of financial instruments in the main matrix.

The classification is based mainly on the sector issuing the debt instrument and on the type of instrument. Other characteristics are also evident in some categories and these provide information on whether the instrument is denominated in domestic or foreign currency and, to some extent, the liquidity of the instrument. The liquidity criterion is difficult to apply in a classification scheme for the instrument may have an initial long term retirement date but be close to maturity, or despite its long term it may have a high degree of marketability.

The classification system used in the Canadian financial flow accounts has been developed partly on the basis of the analytical importance of the instrument, partly having regard to the available data and partly with an eye on the need to keep the matrix of manageable dimensions.

However, having to fit all financial instruments within a fairly restricted number of categories results in some less pure than others.

The categories can be grouped into five broad classes, each possessing some analytical usefulness in its own right. These are Canada's official international reserves, currency and deposit claims on financial institutions, credit market instruments, life insurance and pension reserves and miscellaneous other claims.

• Canada's official international reserves include gold; convertible foreign currency denominated deposits and securities held as assets by the monetary authorities; loans by Canada to the International Monetary Fund (IMF) and Canada's contributed quota to the IMF less the Fund's holdings of Canadian dollars; and the allocation and transactions in existing Special Drawing Rights, a form of reserve asset created by the IMF to be used within certain prescribed limits for settlement of balance of payments obligations.
• Currency and deposit claims on financial institutions include Canadian dollar deposits booked at chartered banks in Canada and at the Bank of Canada plus currency outstanding and coin in circulation; deposits held at the near-banks and public financial institutions including shares and retained earnings in credit unions and caisses populaires considered to be the institutions' liabilities to depositors; and foreign currency holdings and deposits booked at chartered banks in Canada and the Quebec Savings Bank, plus foreign currency deposits booked abroad at branches, agencies and subsidiaries of Canadian chartered banks and at foreign banks and other deposit accepting institutions.
• Credit market instruments represent the core of financial claims and the principal means by which the non-financial sectors raise funds through formal credit channels; although used by the financial sectors they are relatively less important as a source of funds. This broad grouping of instruments includes government bonds and treasury bills, private sector bonds, stocks, bank loans and loans by all other sectors, mortgages, consumer credit, finance and other short-term paper. Although not formally a component category of the credit market sub-group, 'claims on associated enterprises' is noted because the links between parent and affiliated enterprises are mainly composed of a mix of categories of credit market instruments such as stocks, marketable debt and loans. The category 'foreign investments' is more descriptive of the sectors involved in the transactions than of the instruments but it represents in fact Canadian residents' investments in a composite of foreign credit market instruments.
• Life insurance and pensions is a special category representing the excess of current income over current expenditure of life insurance and pension funds. Under national accounting conventions this surplus belongs to the personal sector and is recorded as part of the saving of that sector. The financial flows record the surplus as an asset of the persons and unincorporated business sector and as a liability of the various financial sectors managing the life insurance and pension plans. These savings represent the largest sources of investment funds in Canadian financial markets.
• The final group includes 'trade payables/receivables' and 'other assets/liabilities'. The former category covers short-term credit associated with the normal buying and selling of goods or services. The latter covers a wide variety of miscellaneous transactions not included elsewhere. Accrued interest is an important entry for banks and government while accrued corporate income tax less taxes paid is required to maintain the system in balance. Similar adjustments are made to allow for the difference between transactions entered in the current and capital accounts when the payment becomes due and the payments entered in the financial accounts when they are actually made. Prepaid expenses and dividends declared but not paid are included in the category as are unearned premiums and unpaid claims of some branches of the insurance industry.

The final line in the flows matrix is the sector discrepancy representing the difference between net lending/borrowing from the income and expenditure accounts and net financial investment based on financial data. In sectors in which all data come from consistent financial statements there is no discrepancy, but in those sectors where the capital accumulation and financial data come from different sources, discrepancies exist. The discrepancy row reflects the statistical errors and omissions arising in three components of the System of National Accounts, the income and expenditure accounts, the financial flows and the balance of payments, and may provide some clues as to the nature of the problem areas.

Other features of the financial flow accounts

To provide a succinct picture of financial markets a summary table is prepared in which the principal sectors' borrowing and lending activity are highlighted. By focussing on market instruments and omitting intermediary activity like deposit taking and transactions such as the extension of trade credit and claims on associated enterprises, it provides an approximation of final borrowing through organized markets for securities and negotiated loans. Funds raised by non-financial domestic sectors constitute by far the greater part of this domestic credit market activity.

Although the intermediation process is vital to the system insofar as it increases liquidity in the economy and lubricates production and demand, it is analytically useful to be able to see the primary user and source of funds. In total, the amount of funds lent by non-financial sectors tends to be similar to the amounts borrowed by them even though most of the funds flow through the financial intermediaries. The financial flow matrix focusses on the intermediaries and the spectrum of debt instruments designed to satisfy both lenders and borrowers. The credit market table short-circuits intermediation and shows the flow of funds from the primary lenders to the ultimate borrowers, eliminating the doubling of lending activity that takes place when funds flow through intermediaries.

Although almost all intermediation is undertaken by financial institutions, non-financial sectors engage in intermediation to the extent that they borrow in excess of their non-financial investment needs, using the surplus for financial purposes; financial institutions, on the other hand, borrow to meet their own investment needs. This cross-over activity is, however, not sufficiently important to negate the analytical usefulness of the financial/nonfinancial split.

Uses of the financial flow accounts

A review of users revealed the accounts were being used by a wide range of analysts but with varying degrees of success and intensity. The financial flows system has been, or is being used, in the federal finance department, the Bank of Canada, some provincial government departments and enterprises, and by a number of financial and academic institutions.

The system as it stands provides a consistent and comprehensive framework for studying and describing the role of institutional sectors and financial instruments and their relationships in financing economic activity in Canada. The framework and the constraints that are built into it make it a valuable tool for assessing the impact of changes in 'real' or financial variables on the overall financial system. For example, if government borrowing or business non-financial investment is forecast to rise sharply, the impact of these events on financial markets can be traced in the accounts through are reiterative process by which the markets are brought into equilibrium at the new level of government borrowing or business investment.

Although not used extensively in Canada for forecasting or projecting financial market developments, interest rates, or the impact of financial conditions on 'real' economic activity, the flows framework can be, and is being used for these purposes in other countries. The following depicts the role of the flows in this type of analysis.

Projections of income, current expenditure, saving and capital formation for each sector in the income and expenditure accounts provide, residually, estimates of net financial investment undertaken by each sector. Within the framework of the flows these estimates can be allocated to selected financial instruments or categories on the basis of past experience and assumptions regarding monetary policy. The resulting estimates of sources and uses of funds by the non-financial sectors provide the basis for estimating the flow of funds through the financial intermediaries - the non-financial sectors' changes in certain types of claims being largely reflected in counter part asset and liability changes of financial intermediaries.

This first round of projections may produce results for the intermediaries which are outside the range of likely behaviour patterns. Successive rounds of adjustment are continued until reasonable results are achieved. This process may force the analysts back to the production accounts and are-assessment of the projected savings estimate. The whole exercise not only links the 'real' and financial forecasts, but reveals likely financial developments, pressure points and the direction of interest rate changes.

The evidence suggests that the financial flow accounts are used in conjunction with outstanding levels of financial claims to assist in debt management, and to monitor changes in requirements for funds and the financial market's ability to absorb new demands. These assessments of the demand for and supply of financial instruments also provide another backcloth against which the likely path of interest rates can be forecast. The scheduling of new market issues is sometimes influenced by an analysis of capital markets as portrayed in the accounts.

The flow accounts are used in some financial institutions to determine their market share of saving and investment flows; because of their comprehensiveness, the accounts lend themselves to market-share type analysis particularly well. For example, the degree to which new funds are flowing to the banks, trust companies, mutual funds and other competing institutions is readily discernible in the matrix presentation.

Two features have mitigated against the more general use of the flow accounts. First, they are difficult to popularise and therefore receive limited publicity; no single figure readily emerges upon which to focus attention, such as the gross domestic product or the current account deficit or surplus in the balance of payments. Secondly, and of greater importance, because they lack a theoretical construct they are in some respects more complex and difficult to interpret than other branches of the national accounts.

The financial flows are positioned between the capital finance accounts of the income and expenditure system and the national balance sheets. They are linked directly to the income and expenditure accounts through the net lending or borrowing of each sector, and to the balance sheets through wealth and portfolio changes. The choices made by economic units regarding production, consumption, physical investment, financial investment and borrowing are related to one another, and decisions made in any of these areas may be reflected in the financial flow matrix, constrained only by the income and net worth of the unit.

The full potential of the flows awaits a better understanding of the relationships between income, money and wealth. As noted at the beginning of this chapter financial transactions recorded in a single cell in the matrix may be the result of decisions having to do with new capital projects, the purchase or sale of existing physical assets, current consumption or production, or transactions in outstanding financial claims. Each of these decisions may be affected by income, the availability of credit and net wealth.

Links and reconciliation with balance sheets

This section deals primarily with the relationship of the financial flow accounts to national balance sheet accounts. Links with the income and expenditure accounts were dealt with in the previous chapter, and those with the balance of payments will be dealt with in the chapter describing that system.

The basic format of the financial flows and the national balance sheets is very similar with identical sector detail and financial asset and liability categories. Some differences occur in the presentation of non-financial assets and an additional line recording the net worth (total assets less liabilities) of each sector appears in the balance sheet system. The essential difference between the two systems is that the flows record financing during successive time periods while the balance sheets relate to outstanding levels of assets, liabilities and net worth at points in time.

The conceptual link is clear - changes in assets and liabilities during a period affect the levels of those same assets and liabilities between the beginning and end of that period. In practice, the linking of the two systems cannot be achieved by simply taking the flows during the period and adding them to the opening balance sheet to arrive at a closing balance sheet. Other events occur which have an impact on the balance sheet figures. In order to understand the precise relationship between the two systems a formal reconciliation of the numbers is required. The reconciliation will be explained in two parts: that relating to non-financial assets and that dealing with financial assets and liabilities.

Investment in non-financial assets in the flow accounts covers gross new capital formation in residential and nonresidential construction, machinery and equipment and the value of physical change in inventories. The balance sheet system extends the definition to include consumer durable goods. This difference in coverage and significant definitional differences between 'land' in the balance sheets and 'net purchases of existing and intangible assets' in the flows account for a large part of the disparity between the opening to closing balance sheet change and the investment flows recorded for nonfinancial assets.

The inclusion of consumer durables as part of the nation's wealth in the balance sheets is an important conceptual departure from the treatment accorded them in other parts of the system. In the income and expenditure accounts they are regarded as part of consumption and not investment. If consideration were to be given to reconciling the systems by adopting the balance sheet treatment, the implications would be profound. Among other things, the value of gross domestic product would be raised by the value of the service imputed to consumer durables over their lifetime and personal saving would be significantly higher. For the present, it has been agreed to live with the different conceptual treatments and to continue to treat the difference as an item in the reconciliation statement.

Even for those non-financial assets where coverage is comparable, sharp differences exist between flows and changes in levels. The reconciliation necessary in these cases focuses on two major items and a number of smaller and less important ones. First, the flows record gross investment in construction and machinery and equipment, while the balance sheet change is derived from figures net of depreciation. In order to put the two estimates onto a comparable basis the flow figure must be adjusted downward by the depreciation allowance for the period.

The second major reconciliation item relates to revaluations of non-financial assets which take place between balance sheet dates. Revaluations due to price changes have impacts on levels that are not reflected in the flow data. For the national balance sheet accounts the stock of non-financial assets is revalued each year at current prices. When prices are rising or falling, a portion of the value of the change in stocks between the opening and closing balance sheet reflects price movements alone. To reconcile the stock and flow data an allowance must be made for this revaluation difference.

Other reconciliation adjustments are due to definitional or conceptual differences, unforeseen events and structure and classification changes which are reflected in balance sheets but not recorded as flows. The discrepancy items published in the financial flows and income and expenditure accounts are also part of the reconciliation process.

The reconciliation required in the financial asset and liability categories tends to be centred on conceptual and revaluation differences. An example of an important conceptual difference is the treatment of corporate equity in the balance sheets and in the flows; changes in the former include retained earnings, whereas in the latter the estimate relates only to net new issues. Revaluations due to price change are most apparent in the area of foreign currency exchange rates. Balance sheet claims denominated in foreign currencies are converted to Canadian dollars at the current exchange rate and therefore the year-to-year changes reflect movements in exchange rates that are not included in the flows series.

As with the non-financial series, and for the same reasons, other reconciliation items are required. Published national balance sheet accounts provide a detailed reconciliation statement in which the flow estimates are harmonized with the change in balance sheet estimates. Tables appear for each of the four main national accounts sectors, plus a sub-division of the corporate and government business enterprise sector between non-financial and financial corporations. For each sector, each category of non-financial and financial asset and liability is reconciled. The tables provide explicit links between the balance sheets and financial flows both in terms of concepts and absolute dollar values. The process of compiling reconciliation statements has led to improvements in the quality of both flow and balance sheet data.