Accounting identity

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Accounting identity

In 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 (or construction) must be true. ["Principles of Macroeconomics", Mankiw et al., pp. 211-212, 2002] ["Macroeconomics [Canadian Edition] ", Mankiw & Scarth, p. 25, 2004] The term is also used in economics to refer to equalities that are by definition or construction true, such as the balance of payments. Where an accounting identity applies, any deviation from the identity signifies an error in formulation, calculation or measurement. [ [http://internationalecon.com/Finance/Fch5/F5-9.php Suranovic, "International Finance Theory and Policy"] : "It is important to note that this relationship is an accounting identity. This means that the relationship must be true as long as all variables are measured properly."]

The term "accounting identity" may be used to distinguish between propositions that are theories (which may or may not be true, or relationships that may or may not always hold) and statements that are by definition true. Despite the fact that the statements are by definition true, the underlying figures as measured or estimated may not "add up" due to measurement error, particularly for certain identities in macroeconomics. [See, for example, [http://internationalecon.com/Finance/Fch5/F5-9.php Suranovic, "International Finance Theory and Policy"] : "In practice, this identity rarely adds up, however, because the variables are not typically measured accurately."]

Description

The most basic identity in accounting is that the balance sheet must balance, that is, that assets must equal liabilities (including equity), or that assets must equal debt plus equity. In its most common formulation it is known as the accounting equation:

:"Assets = Debt + Equity"

Since this accounting identity must always hold, any change to one side of the equation must be balanced by an equal change on the other side of the equation: a change to the total value of the assets of a firm must be reflected in a change to the debt or equity of a firm. For example, if a firm has an (uninsured) asset destroyed by a fire, either the debt of the firm must fall or the equity (in this case, the equity). In most cases, each component of an accounting identity can be broken down into further sub-groups that must also respect the identity.

This usage of the term "identity" is similar to the mathematical definition of an identity.

Identities in accounting

Accounting has a number of identities in common usage, and since many identities can be decomposed into others, no comprehensive listing is possible.

Interperiod identities

Accounting identities also apply between accounting periods, such as changes in cash balances. For example::"Cash at beginning of period + Changes in cash during period = Cash at end of period" ["Money, Banking, and Financial Institutions", Siklos, p. 175, 2006]

Value of an asset

Any asset recorded in a firm's balance sheet will have a carrying value. By definition, the carrying value must equal the historic cost (or acquisition cost) of the asset, plus (or minus) any subsequent adjustments in the value of the asset, such as depreciation.

:"Carrying value = Historic cost + Change in value"

Economics

In economics, there are numerous accounting identities. One of the most commonly known is the balance of payments identity, ["Money, Banking, and Financial Institutions", Siklos, pp.145-147, 2006] where::"Current Account + Capital Account = Change in Official Reserve Account"

A common problem with the balance of payments identity is that, due to measurement error, the balance of payments may not total correctly. For example, the Economist magazine has noted that "In theory, individual countries’ current-account deficits and surpluses should cancel each other out. But because of statistical errors and omissions they never do." [ [http://www-personal.umich.edu/~kathrynd/waroftheworlds.pdf "The Economist", May 27, 2000.] ]

Gross domestic product

The basic equation for gross domestic product is also considered an identity, and is sometimes referred to as the National Income Identity ["Macroeconomics", Auerbach and Kotlikoff, pp. 122-23, 1998] :: "GDP = consumption + investment + (government spending) + (exports − imports)"

ee also

Identity

;Accounting : Double entry accounting

;General : Du Pont Identity

;Business : Income statement, Cash flow statement, Balance sheet

;Economics : Balance of payments, National income and product accounts

References

* [http://ashta.free.fr/Teaching%20Handouts/Finance/Understanding%20Financial%20Statements/BasicAccountingIdentity.htm The Basic Accounting Identity]

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