It is a specific statistical concept, also known as net investment, used in national accounts statistics, econometrics and macroeconomics. In that sense, it refers to a measure of the net additions to the (physical) capital stock of a country (or an economic sector) in an accounting interval, or, a measure of the amount by which the total physical capital stock increased during an accounting period. To arrive at this measure, standard valuation principles are used.[1]
It is used also in economic theory, as a modern general term for capital accumulation, referring to the total "stock of capital" that has been formed, or to the growth of this total capital stock.[2]
In a much broader or vaguer sense, the term "capital formation" has in more recent times been used in financial economics to refer to savings drives, setting up financial institutions, fiscal measures, public borrowing, development of capital markets, privatization of financial institutions, development of secondary markets. In this usage, it refers to any method for increasing the amount of capital owned or under one's control, or any method in utilising or mobilizing capital resources for investment purposes. Thus, capital could be "formed" in the sense of "being brought together for investment purposes" in many different ways. This broadened meaning is not related to the statistical measurement concept nor to the classical understanding of the concept in economic theory. Instead, it originated in credit-based economic growth during the 1990s and 2000s, which was accompanied by the rapid growth of the financial sector, and consequently the increased use of finance terminology in economic discussions.
"Total capital formation" in national accounting equals net fixed capital investment, plus the increase in the value of inventories held, plus (net) lending to foreign countries, during an accounting period (a year or a quarter). Capital is said to be "formed" when savings are utilized for investment purposes, often investment in production.
In the US, statistical measures for capital formation were pioneered by Simon Kuznets in the 1930s and 1940s,[4] and from the 1950s onwards the standard accounting system devised under the auspices of the United Nations to measure capital flows was adopted officially by the governments of most countries. International bodies such as the International Monetary Fund (IMF) and the World Bank have been influential in revising the system.
Different interpretations
The use of the terms "capital formation" and "investment" can be somewhat confusing, partly because the concept of capital itself can be understood in different ways.
Firstly, capital formation is frequently thought of as a measure of total "investment", in the sense of that portion of capital actually used for investment purposes and not held as savings or consumed. But in fact, in national accounts, the concept of gross capital formation refers only to the accounting value of the "additions of non-financial produced assets to the capital stock less the disposals of these assets". "Investment" is a broader concept that includes investment in all kinds of capital assets, whether physical property or financial assets. In its statistical meaning, capital formation does not include financial assets such as stocks and securities.
Secondly, capital formation may be used synonymously with the notion of capital accumulation in the sense of a reinvestment of profits into capital assets. But "capital accumulation" is not normally an accounting concept in modern accounts (although it is sometimes used by the IMF and the United Nations Conference on Trade and Development), and contains the ambiguity that an amassment of wealth could occur either through a redistribution of capital assets from one person or institution to another, or through a net addition to the total stock of capital in existence. As regards capital accumulation, it can flourish, so that some people become wealthier, although society as a whole becomes poorer, and the net capital formation decreases. In other words, the gain could be a net total gain, or a gain at the expense of loss by others that cancels out (or more than cancels out) the gain in aggregate.
Thirdly, gross capital formation is often used synonymously with gross fixed capital formation but strictly speaking this is an error because gross capital formation refers to more net asset gains than just fixed capital (it also includes net gains in inventory stock levels and the balance of funds lent abroad).
Capital formation measures were originally designed to provide a picture of investment and growth of the "real economy" in which goods and services are produced using tangible capital assets. The measures were intended to identify changes in the growth of physical wealth across time. However, the international growth of the financial sector has created many structural changes in the way that business investments occur, and in the way capital finance is really organized. This not only affects the definition of the measures, but also how economists interpret capital formation. The most recent alterations in national accounts standards mean that capital measures and many other measures are no longer fully comparable with the data of the past, except where the old data series have been revised to align them with the new concepts and definitions. US government statisticians have admitted frankly that "Unfortunately, the finance sector is one of the more poorly measured sectors in national accounts".[5] The main reason is that national accounts were at first primarily designed to capture changes in tangible physical wealth, not financial wealth (in the form of financial claims).
Gross and net capital formation
In economic statistics and accounts, capital formation can be valued gross, i.e., before deduction of consumption of fixed capital (or "depreciation"), or net, i.e., after deduction of "depreciation" write-offs.
The gross valuation method views "depreciation" as a portion of the new income or wealth earned or created by the enterprise, and hence as part of the formation of new capital by the enterprise.
The net valuation method views "depreciation" as the compensation for the cost of replacing fixed equipment used up or worn out, which must be deducted from the total investment volume to obtain a measure of the "real" value of investments; the depreciation write-off compensates and cancels out the loss in capital value of assets used due to wear & tear, obsolescence, etc.
Because of government tax-incentives and valuation issues, depreciation charged by businesses is rarely a true reflection of the loss in value of their capital stock. Hence, statisticians often revalue actual depreciation charges according to data about asset values and average service lives of assets, in order to obtain measures of true "economic depreciation".
Technical measurement issues
Capital formation is notoriously difficult to measure statistically, mainly because of the valuation problems involved in establishing what the value of capital assets is. When a fixed asset or inventory is bought, it may be reasonably clear what its market value is, namely the purchaser's price. But as soon as it is bought, its value may change, and it may change even before it is put to use. Things often become more complicated to measure when a new fixed asset is acquired within some kind of lease agreement. Finally, the rate at which the value of the fixed asset depreciates will affect the gross and net valuation of the asset, yet different methods are typically used to value what assets are worth and how fast they depreciate. Capital assets can for instance be valued at:
A business owner may in fact not even know what his business is "worth" as a going concern, in terms of its current market value. The "book value" of a capital stock may differ greatly from its "market value", and another figure may apply for taxation purposes. The value of capital assets may also be overstated or understated using various legal constructions. For any significant business, how assets are valued makes a big difference to its earnings and thus the correct statement of asset values is a perpetually controversial subject.
During an accounting period, additions may be made to capital assets (including those that disproportionately increase the value of the capital stock) and capital assets are also disposed of; at the same time, physical assets also incur depreciation or Consumption of fixed capital. Also, price inflation may affect the value of the capital stock.
The sales/purchases of one enterprise can be the investment of another enterprise. Therefore, to obtain a measure of the total net capital formation, a system of grossing and netting of capital flows is required. Without this, double counting would occur.
Capital expenditure must be distinguished from intermediate expenditure and other operating expenditure, but the boundaries are sometimes difficult to draw.
There exists nowadays a large market in second-hand (used) assets. In principle, statistical measures of gross fixed capital formation are supposed to refer to the net additions of newly produced fixed assets, which enlarge the total stock of fixed capital in the economy. But if a substantial trade occurs in fixed assets resold from one enterprise or one country to another, it may become difficult to know what the real net addition to the stock of fixed capital of a country actually is. A precise distinction between "new" and "used" assets becomes more difficult to draw. How to value used assets and their depreciation consistently becomes more problematic.
The general trend in accounting standards is for assets to be valued increasingly at "current market value", but this valuation is by no means absolutely clear and uncontroversial. It might be understood to mean the price of the asset if it was sold at a balance date, or the current replacement cost of the asset, or the average price of the asset type in the market at a certain date, etc.
Perpetual Inventory Method
A method often used in econometrics to estimate the value of the physical capital stock of an industrial sector or the whole economy is the so-called Perpetual Inventory Method (PIM). Starting off from a benchmark stock value for capital held, and expressing all values in constant dollars using a price index, known additions to the stock are added, and known disposals as well as depreciation are subtracted year by year (or quarter by quarter). Thus, an historical data series is obtained for the growth of the capital stock over a period of time. In so doing, assumptions are made about the real rate of price inflation, realistic depreciation rates, average service lives of physical capital assets, and so on. The PIM stock values can be compared with various other related economic variables and trends, and adjusted further to obtain the most accurate and credible valuation
Controversy
According to one popular kind of macro-economic definition in textbooks, capital formation refers to "the transfer of savings from households and governments to the business sector, resulting in increased output and economic expansion" (see Circular flow of income). The idea here is that individuals and governments save money, and then invest that money in the private sector, which produces more wealth with it. This definition is however inaccurate on two counts:
Firstly, many larger corporations engage in corporate self-financing, i.e., financing from their own reserves and undistributed profits, or through loans from (or share issues bought by) other corporations. In other words, the textbook definition ignores that the largest source of investment capital consists of financial institutions, not individuals or households or governments. Admittedly, financial institutions are, "in the last instance", mostly owned by individuals, but those individuals have little control over this transfer of funds, nor do they accomplish the transfer themselves. Few individuals can say they "own" a corporation, any more than individuals "own" the public sector. James M. Poterba (1987) found that changes in corporate saving are only partly offset (between 25% and 50%) by changes in household saving in the United States.[6] Social accountants Richard Ruggles and Nancy D. Ruggles established for the USA that "almost all financial savings done by households is used to pay for household capital formation - particularly, housing and consumer durables. On net, the household sector channels almost no financial savings to the enterprise sector. Conversely, almost all the capital formation done by enterprises is financed through enterprise savings - particularly, undistributed gross profits."[7]
Secondly, the transfer of funds to corporations may not result in increased output or economic expansion at all; given excess capacity, a low rate of return and/or lacklustre demand, corporations may not in fact invest those funds to expand output, and engage in asset speculation instead, to obtain property income that boosts shareholder returns. To illustrate, New Zealand's Finance Minister Michael Cullen stated that "My sense is that there are definite gains to be made, both economic and social, in increasing the savings level of New Zealanders and in encouraging diversification in assets away from the residential property market."[8] This idea is based on a flawed understanding of capital formation, ignoring the real issue - which is that the flow of mortgage repayments by households to financial institutions is not being used to expand output and employment on a scale that could repay escalating private sector debts. In reality, more and more local income and assets are appropriated by foreign share-holders and creditors in North America, Europe, Australia and Japan . In December 2012, managed funds statistics compiled by the NZ Reserve Bank indicated that New Zealanders have 49.8% of their KiwiSaver money invested overseas. These managed fund figures include capital contributions, capital gains and losses and dividends and interest received.[9]
The concept of "household saving" must itself also be looked at critically, since a lot of this "saving" in reality consists precisely of investing in housing, which, given low interest rates and rising real estate prices, yields a better return than if you kept your money in the bank (or, in some cases, if you invested in shares). In other words, a mortgage from a bank can effectively function as a "savings scheme" although officially it is not regarded as "savings".
Example of capital estimates
In the 2005 Analytical Perspectives document, an annex to the US Budget (Table 12-4: National Wealth, p.201), an annual estimate is provided for the value of total tangible capital assets of the US, which doubled since 1980 (stated in trillions of dollars, at September 30, 2003):
Publicly owned physical assets:
Structures and equipment . . . . . . $5.6 Federally owned or financed . . . $2.2 Federally owned . . . . . . . . . . .$1.0 Grants to state and local govt . . . $1.0 Funded by state and local govt . . . $3.3 Other federal assets . . . . . . . . $1.4
(Note: these data obviously do not include financial assets, such as estimated by the McKinsey Quarterly, only "tangible" assets in US territory. The total value of marketable financial assets in the USA was estimated in 2007 at about US$46 trillion . This total obviously does not include assets, deposits and reserves that are not traded. The data series on national wealth provided in the budget annex were discontinued by the administration of President Barack Obama).
A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross national product (GNP), net national income (NNI), and adjusted national income. All are specially concerned with counting the total amount of goods and services produced within the economy and by various sectors. The boundary is usually defined by geography or citizenship, and it is also defined as the total income of the nation and also restrict the goods and services that are counted. For instance, some measures count only goods & services that are exchanged for money, excluding bartered goods, while other measures may attempt to include bartered goods by imputing monetary values to them.
Cash flow, in general, refers to payments made into or out of a business, project, or financial product. It can also refer more specifically to a real or virtual movement of money.
In accounting, fixed capital is any kind of real, physical asset that is used repeatedly in the production of a product. In economics, fixed capital is a type of capital good that as a real, physical asset is used as a means of production which is durable or isn't fully consumed in a single time period. It contrasts with circulating capital such as raw materials, operating expenses etc.
Wealth is the abundance of valuable financial assets or physical possessions which can be converted into a form that can be used for transactions. This includes the core meaning as held in the originating Old English word weal, which is from an Indo-European word stem. The modern concept of wealth is of significance in all areas of economics, and clearly so for growth economics and development economics, yet the meaning of wealth is context-dependent. A person possessing a substantial net worth is known as wealthy. Net worth is defined as the current value of one's assets less liabilities.
In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be tangible book value.
Fixed investment in economics is the purchasing of newly produced fixed capital. It is measured as a flow variable – that is, as an amount per unit of time.
Tobin's q, is the ratio between a physical asset's market value and its replacement value. It was first introduced by Nicholas Kaldor in 1966 in his paper: Marginal Productivity and the Macro-Economic Theories of Distribution: Comment on Samuelson and Modigliani. It was popularised a decade later by James Tobin, who in 1970, described its two quantities as:
One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.
National accounts or national account systems (NAS) are the implementation of complete and consistent accounting techniques for measuring the economic activity of a nation. These include detailed underlying measures that rely on double-entry accounting. By design, such accounting makes the totals on both sides of an account equal even though they each measure different characteristics, for example production and the income from it. As a method, the subject is termed national accounting or, more generally, social accounting. Stated otherwise, national accounts as systems may be distinguished from the economic data associated with those systems. While sharing many common principles with business accounting, national accounts are based on economic concepts. One conceptual construct for representing flows of all economic transactions that take place in an economy is a social accounting matrix with accounts in each respective row-column entry.
Consumption of fixed capital (CFC) is a term used in business accounts, tax assessments and national accounts for depreciation of fixed assets. CFC is used in preference to "depreciation" to emphasize that fixed capital is used up in the process of generating new output, and because unlike depreciation it is not valued at historic cost but at current market value ; CFC may also include other expenses incurred in using or installing fixed assets beyond actual depreciation charges. Normally the term applies only to producing enterprises, but sometimes it applies also to real estate assets.
Gross fixed capital formation (GFCF) is a component of the expenditure on gross domestic product (GDP) that indicates how much of the new value added in an economy is invested rather than consumed. It measures the value of acquisitions of new or existing fixed assets by the business sector, governments, and "pure" households minus disposals of fixed assets.
The value product (VP) is an economic concept formulated by Karl Marx in his critique of political economy during the 1860s, and used in Marxian social accounting theory for capitalist economies. Its annual monetary value is approximately equal to the netted sum of six flows of income generated by production:
Operating surplus is an accounting concept used in national accounts statistics and in corporate and government accounts. It is the balancing item of the Generation of Income Account in the UNSNA. It may be used in macro-economics as a proxy for total pre-tax profit income, although entrepreneurial income may provide a better measure of business profits. According to the 2008 SNA, it is the measure of the surplus accruing from production before deducting property income, e.g., land rent and interest.
Net output is an accounting concept used in national accounts such as the United Nations System of National Accounts (UNSNA) and the NIPAs, and sometimes in corporate or government accounts. The concept was originally invented to measure the total net addition to a country's stock of wealth created by production during an accounting interval. The concept of net output is basically "gross revenue from production less the value of goods and services used up in that production". The idea is that if one deducts intermediate expenditures from the annual flow of income generated by production, one obtains a measure of the net new value in the new products created.
Cash-flow return on investment (CFROI) is a valuation model that assumes the stock market sets prices based on cash flow, not on corporate performance and earnings.
The following outline is provided as an overview of and topical guide to finance:
In accounting, finance and economics, an accounting identity is an equality that must be true regardless of the value of its variables, or a statement that by definition must be true. Where an accounting identity applies, any deviation from numerical equality signifies an error in formulation, calculation or measurement.
In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything that can be used to produce positive economic value. Assets represent value of ownership that can be converted into cash . The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.
A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.
In economics, depreciation is the gradual decrease in the economic value of the capital stock of a firm, nation or other entity, either through physical depreciation, obsolescence or changes in the demand for the services of the capital in question. If the capital stock is in one period , gross (total) investment spending on newly produced capital is and depreciation is , the capital stock in the next period, , is . The net increment to the capital stock is the difference between gross investment and depreciation, and is called net investment.
The annual United Kingdom National Accounts records and describes economic activity in the United Kingdom and as such is used by government, banks, academics and industries to formulate the economic and social policies and monitor the economic progress of the United Kingdom. It also allows international comparisons to be made. The Blue Book is published by the UK Office for National Statistics alongside the United Kingdom Balance of Payments – The Pink Book.
↑ Yanovsky, M.: Anatomy of Social Accounting Systems, London; Chapman & Hall, 1965.
↑ Ruggles, Richard; Ruggles, Nancy D.: National Income Accounts and Income Analysis. New York: McGraw-Hill, 1956.
↑ Kuznets, Simon et al., National income and capital formation, 1919-1935. National Bureau of Economic Research, 1937. Kuznets, Simon: Commodity flow and capital formation. New York: National Bureau of Economic Research, 1938. Kuznets, Simon: Gross capital formation, 1919-1933. New York: National Bureau of Economic Research, 1934. Kuznets, Simon: "Proportion of capital formation to national product". American Economic Review, 1952. Kuznets, Simon: Capital in the American Economy Princeton: Princeton University Press, 1961.
↑ Dennis J Fixler, Marshall B Reinsdorf and Shaunda Villones, "Measuring the services of commercial banks in the NIPA." IFC Bulletin No. 33 (Irving Fisher Committee on Central Bank Statistics, Bank of International Settlements), 2007.
↑ Poterba, James: "Tax Policy and Corporate Saving", in Brookings Papers on Economic Activity, 2, 1987, pp.455–503.
↑ Edward N. Wolff, "In Memoriam: Richard Ruggles 1916-2001", in: Review of Income and Wealth, Series 47, Number 3, September 2001, p.414.
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