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

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.