An accounting identity is an equality that must be true regardless of the value of its variables in accounting, finance, and economics, or a statement that must be true by definition (or construction). Any deviation from numerical equality indicates an error in formulation, calculation, or measurement when an accounting identity is used.
Accounting identity can be used to differentiate 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 true by definition. Despite the fact that the statements are true by definition, the underlying figures as measured or estimated may not add up due to measurement error, particularly in macroeconomics.
Description
The most fundamental identity in accounting is that the balance sheet must balance, that is, assets must equal liabilities (debts) plus equity (the value of the firm to the owner). It is known as the accounting equation in its most common form:
Assets = Liabilities + Equity
where debt includes both financial and non-financial liabilities Balance sheets are typically presented as two parallel columns, each totaling the same amount, with assets on the left and liabilities and owners’ equity on the right. The Assets and Equities columns are, in effect, two perspectives on the same set of business facts.
The balance of the balance sheet reflects the conventions of double-entry bookkeeping, which are used to record business transactions. Every transaction in double-entry bookkeeping is recorded by paired entries, and a transaction will typically result in two or more pairs of entries. The sale of a product, for example, would record both a receipt of cash (or the creation of a trade receivable in the case of an extension of credit to the buyer) and a reduction in the inventory of goods for sale; the receipt of cash or a trade receivable is an addition to revenue, and the reduction in goods inventory is an addition to expense. In this case, a “expense” is the “spending” of an asset.
Thus, there are two pairs of entries: an increase in revenue balanced by an increase in cash, and a decrease in inventory balanced by an increase in expense. The asset accounts are cash and inventory; the revenue and expense accounts will close at the end of the accounting period to affect equity.
For the National Accounts, double-entry bookkeeping conventions are also used. Accounting identities are involved in economic concepts such as national product, aggregate income, investment and savings, as well as the balance of payments and balance of trade.
The use of double-entry bookkeeping conventions in measuring aggregate economic activity stems from the understanding that every purchase is also a sale, every payment made translates income received, and every act of lending is also an act of borrowing. The term identity here refers to a mathematical identity or a logical tautology, as it defines an equivalence that is independent of the values of the variables.
