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The accounting identity trap: identification under stock-and-flow rank deficiency

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  • Demetris Christodoulou

Abstract

Empirical research relying on inputs from published company financial statements ignore the fact that the observed accounting data matrix has been purposefully designed to be rank deficient by means of articulation between stocks and flows. This inherent feature of the data-generating process suggests structural non-identification when both stocks and flows appear in the design matrix and a constraint is required to identify parameters. Much financial research has fallen into this ‘accounting identity trap’ and routinely employs implicit constraints to enable estimation, albeit without acknowledgement of the constraints hence the misleading inferences. This article elucidates the problem of parameter identification under stock-and-flow rank deficiency using existing applications on equity pricing. The focus is on the interpretation of slope coefficients that must be anchored on economically defensible parameter constraints.

Suggested Citation

  • Demetris Christodoulou, 2018. "The accounting identity trap: identification under stock-and-flow rank deficiency," Applied Economics, Taylor & Francis Journals, vol. 50(13), pages 1413-1427, March.
    • Handle: RePEc:taf:applec:v:50:y:2018:i:13:p:1413-1427
    DOI: 10.1080/00036846.2017.1363860
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    Cited by:

    1. Ehsan Khansalar & Eilnaz Kashefi-Pour, 2020. "The usefulness of the double entry constraint for predicting earnings," Review of Quantitative Finance and Accounting, Springer, vol. 54(1), pages 51-67, January.
    2. Demetris Christodoulou & Colin Clubb & Stuart Mcleay, 2016. "A Structural Accounting Framework for Estimating the Expected Rate of Return on Equity," Abacus, Accounting Foundation, University of Sydney, vol. 52(1), pages 176-210, March.

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