Meaning of Balance of Payments Accounts
In the present era of globalization, every country enters into trade or economic transactions with the countries of the rest of the world. The countries receive or make payments to the other countries because of these cross-border transactions. We prepare a financial statement in a systematic manner that records the payments that a country receives or makes. This statement is known as the Balance of payments account or BOP. The Balance of payment account has three categories or three parts. These are current account, capital account, and financial account. The components or items of the three accounts vary from one another, but they all record the inter-country receipts, transfers and payments of money.
BOP accounts and balances are a reflection of how well an economy is performing vis-à-vis the other countries or economies of the world. It is an indicator of an economy’s growth potential. The accounts show the demand for goods and services in an economy. Also, they are a reflection of the confidence of other countries in the domestic country by choosing it as an investment destination. They may invest in assets such as real estate, make portfolio investments or invest in the country through the route of Foreign Direct Investment (FDI).
- Meaning of Balance of Payments Accounts
- Balance of Payments Accounts – Main Features
- Main Constituents of Balance of Payment Accounts
- Frequently Asked Questions (FAQs)
There is a golden rule with the three Balance of payments accounts. The components of the capital account and financial account should sum up and be equal to the current account. A BOP will be in equilibrium when we achieve this condition. Also, the sum of all three accounts should be equal to zero.
Balance of Payments Accounts – Main Features
Let us now discuss about the main features of BOP accounts.
Accounting System – Double Entry
Similar to other accounts in accounting, we make the Balance of Payments account by following the fundamental principle of the double-entry system. This means that for every debit entry in the account, there will be a corresponding credit entry of the same amount and vice-versa.
Economic transactions that result in foreign exchange inflow into a country are recorded on the credit side of the BOP account. For example, when we export a product from a country, we receive foreign exchange or a payment from a foreign country in return. We will treat this as a credit entry.
Transactions that lead to the outflow of money from a country to other countries of the world are debited in the BOP account. For example, if we buy an asset such as land in a foreign country, we will record this entry as a debit in the BOP account. Or when we import some machinery or consumption goods from other countries. As we need to make payment to other country towards those purchases, hence, it appears on the debit side of the BOP.
Resident / Non-resident
The BOP account takes into consideration the economic interest of an individual or business rather than just nationality. We include all those transactions in the BoP account of the country which have an economic impact and interest in that country.
We consider an individual to be the national of that country only if he has been residing there for a period of 12 months or more. Individuals such as tourists, ship or aircrew, seasonal workers, diplomats, and army men who are in a foreign country for a mission will not come under the category of residents. This will be the case even if they are there for a period of more than 12 months.
We cover only those businesses that have a long-term time horizon of operating in the country under BOP accounts. Hence, we will cover the units or branches of foreign companies set up in a country under its BOP accounts.
Agencies of the government, embassies, military set-ups, etc. come under the purview of BOP accounts of a country even if they are located in a foreign country.
State of Equilibrium
A Balance of Payments account will be in balance or equilibrium when the sum of all debits is equal to the sum of all credits. However, this seldom happens. We have a surplus BOP when the receipts of foreign currency are higher from foreign countries than what a country pays to them. The BOP will be in deficit when the reverse happens. The payments to the foreign countries will be more than what the country receives from them.
Timing of Recording Transactions
Two countries should record any transaction arising between them simultaneously. This is in line with the accrual principle of accounting. For example, entries with regards to payment of interest on a loan should appear in the BOP account on the same day and time between the lending country and borrowing country. They should not wait for actual cash to change hands for the recording of the entry.
Valuation of Transactions in Balance of Payments Accounts
There are some transactions in international trade that do not have a specific monetary value. For example, two countries may agree to exchange a particular quantity of a good for some other goods. We call it the barter system of exchange. We value such transactions at their market value in the BOP accounts.
Main Constituents of Balance of Payment Accounts
We can broadly consolidate the items in the BOP account into four main categories:
Import and Export of Goods
This is the most basic form in which international trade happens and foreign currency changes hands. Countries buy some goods from other countries which their residents require for consumption. We call it import. They sell some goods to other countries which are a specialty or surplus produce over and above what they require for domestic consumption. These are known as exports.
This category of goods is visible and tangible. We can see, touch and exchange them physically. They are also known as merchandise. The value of a country’s exports less its imports from other countries is known as the Balance of Trade. It is favorable for a country when exports exceed imports. It is unfavorable when the imports exceed the exports. Few examples of this category are import and export of leather goods, electronics and electrical components, machines and tools, automobiles, crude oil, defense equipment, etc.
Import and Export of Services
Nowadays, most countries either receive services from a foreign country or render services to a foreign country or do both. The BOP records these services in monetary terms. Services are also known as invisibles as we cannot see or touch them. Invisibles comprise factor services, non-factor services as well as current transfers.
Some of the common examples of services that countries render to one another are banking, shipping, insurance, tours and travels, interest, and dividends, technology and advisories, etc.
The BOP records unilateral transfers which are one-sided transactions across borders. They are gifts and remittances from a country to another. They do not involve financial compensation in return. Some examples of such transfers are gifts to residents from people of other countries, payment of war indemnity, assistance and grants by governments, etc.
In order to record them in BOP, we convert them into a double-entry transaction. The receiving country records the aid or gift as an import. We make a counter entry that may comprise of a cash transfer, a return gift in kind, donations and contributions, and even debt forgiveness.
Capital Payments and Receipts
This constituent of BOP records the transactions that affect the assets and liabilities of a country. Loans and advances between countries, cross-border investments in the form of real estate, stocks, gold, etc. are some of the examples of capital payments and receipts between two or more countries.
Frequently Asked Questions (FAQs)
The countries receive or make payments to the other countries because of these cross-border transactions. We prepare a financial statement in a systematic manner that records the payments that a country receives or makes. This statement is known as the Balance of Payments Account.
• Double entry accounting system
• Record transaction simultaneously
• Equilibrium: Sum of all debits is equal sum of all credits
• Barter transactions at market value
• Import and Export of goods
• Import and Export of services
• Unilateral transfers
• Capital payments and receipts
The Balance of Payment Account has three categories or three parts: current account, capital account, and financial account.