Accounting identity
Encyclopedia
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. 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.
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.
must balance, that is, that asset
s 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
:
where debt includes non-financial liabilities. Because 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
.
. 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
.
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."
is also considered an identity, and is sometimes referred to as the National Income 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
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
and economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, 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. The term is also used in economics to refer to equalities that are by definition or construction true, such as the balance of payments
Balance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...
. Where an accounting identity applies, any deviation from the identity signifies an error in formulation, calculation or measurement.
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.
Description
The most basic identity in accounting is that the balance sheetBalance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
must balance, that is, that asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s 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
Accounting equation
The basic accounting equation' is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits.In a corporation, capital represents the stockholders' equity.-In practice:...
:
- Assets = Debt + Equity
where debt includes non-financial liabilities. Because 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
Identity (mathematics)
In mathematics, the term identity has several different important meanings:*An identity is a relation which is tautologically true. This means that whatever the number or value may be, the answer stays the same. For example, algebraically, this occurs if an equation is satisfied for all values of...
.
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
Value of an asset
Any asset recorded in a firm's balance sheet will have a carrying valueBook value
In accounting, book value or carrying 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...
. 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
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
.
- 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, 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."
Gross domestic product
The basic equation for gross domestic productGross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
is also considered an identity, and is sometimes referred to as the National Income Identity:
- GDP = consumptionConsumption (economics)Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
+ investmentInvestmentInvestment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
+ (government spendingGovernment spendingGovernment spending includes all government consumption, investment but excludes transfer payments made by a state. Government acquisition of goods and services for current use to directly satisfy individual or collective needs of the members of the community is classed as government final...
) + (exportExportThe term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country. The seller of such goods and services is referred to as an "exporter" who is based in the country of export whereas the overseas based buyer is referred to as an "importer"...
s − importInternational tradeInternational trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product...
s)
See also
IdentityIdentity (social science)
Identity is a term used to describe a person's conception and expression of their individuality or group affiliations . The term is used more specifically in psychology and sociology, and is given a great deal of attention in social psychology...
Accounting : Double entry accounting
General : Du Pont Identity
Du Pont Identity
DuPont analysis is an expression which breaks ROE into three parts....
Business
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...
: Income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
, Cash flow statement
Cash flow statement
In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing...
, Balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
Economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
: Balance of payments
Balance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...
, National income and product accounts
National Income and Product Accounts
The National Income and Product Accounts are part of the national accounts of the United States. They are produced by the Bureau of Economic Analysis of the Department of Commerce...