British Accounting Review (2000) 32, 261288

doi:10.1006/bare.2000.0135, available online at http://www.idealibrary.com on

DOUBLE ENTRY BOOKKEEPING, STRUCTURAL
DYNAMICS AND THE VALUE OF THE FIRM
TERRY COOKE AND MARK TIPPETT
University of Exeter
We demonstrate how a parsimonious interpretation of the double entry bookkeeping
system leads to a model under which nancial variables evolve in terms of a (vector)
system of stochastic differential equations. The restrictions imposed by the double
entry bookkeeping system are reected in a structural matrix which summarizes the
sensitivity of instantaneous changes in the rms assets, liabilities, and other nancial
variables to the existing levels of these variables. Given this structure and some
additional simplifying assumptions, we show that the ratio of the book value of debt to
the book value of equity will, except under catastrophic circumstances, have a tendency
to revert towards a long run normal valuea description which conforms with the
empirical evidence. Further, our analysis shows that, under certain circumstances, the
market value of equity can be expressed as a linear function of the rms assets and
liabilities. Under these same circumstances, the ratio of the market value of equity
to the book value of equity also has a tendency to revert towards a long run norm.
We also demonstrate a theoretical basis for identifying the circumstances under which
non-linear relationships exist between a rms bookkeeping summary measures and
the market value of its equity.
2000 Academic Press
INTRODUCTION
The analysis of Garman & Ohlson (1980) and Ohlson (1983, 1990) is
based on a model under which earnings, dividends, book values, and
possibly other information variables evolve in terms of a linear structural
system which, with the addition of assumptions about the discounting
of future dividends, links variations in nancial statement and other
information variables to the underlying equity price. Bernard (1995, p. 733)
The authors are from the Department of Accounting in the School of Business and Economics at the
University of Exeter. The authors gratefully acknowledge comments made on previous drafts by David
Ashton, Haim Falk and seminar participants at the University of Manchester and the University of
Warwick, where Andy Stark and Elizabeth Whalley are worthy of particular mention. It is also a pleasure
to acknowledge the perseverance and insightful comments of the anonymous referees. However, since
we have not always followed the counsel of our advisors, none can be held responsible for what remains.
Received April 1999; revised October 1999 and March 2000; accepted April 2000
08908389/00/030261+28 $35.00/0 2000 Academic Press
262 T. COOKE AND M. TIPPETT
suggests that the GarmanOhlson formulation, as subsequently interpreted
by Ohlson (1995) and Feltham & Ohlson (1995), is among the most
important developments in capital markets research in the last several
years . . . while Lundholm (1995, p. 749) describes them as landmark
works in nancial accounting . . . [which] provide a logically consistent
framework for thinking about . . . accounting numbers. A principal virtue of
the GarmanOhlson framework is that whilst it is based on what many
regard as fairly innocuous assumptions (martingale equivalent pricing,
clean surplus bookkeeping, linear information dynamics)
1
it nevertheless
leads to a powerful measurement based research paradigm which unies
the apparently disparate normative approaches of an earlier generation
(Edwards & Bell, 1961; Mattessich, 1957, 1964; Chambers, 1966; Ijiri,
1965, 1967; Sterling, 1970)
2
but in such a way as to be consistent with the
basic no arbitrage requirements of nance theory (Modigliani & Miller,
1958, 1963; Miller & Modigliani, 1961). Our purpose here is to contribute
to the further development of this literature. Specically, we show how a
parsimonious interpretation of the double entry bookkeeping system based
on the work of Black (1980, 1993) leads to a structural model of stochastic
differential equations which relates variations in bookkeeping summary
measures (book values of equity, assets, liabilities, and their components)
to variations in the market value of the rms equity. A specic version
of the model implies that there will be a simple linear relationship between
the market value of equity and the rms bookkeeping summary measures.
Also, the ratio of the book value of debt to the book value of equity
(the debt to equity ratio) will have a tendency to revert towards a long
run normalized value. Further, and again within a specic version of the
model, we demonstrate a theoretical basis for identifying the circumstances
under which non-linear relationships exist between a rms bookkeeping
summary measures and the market value of its equity.
In the next section, bookkeeping summary measures are characterized as
evolving in terms of the structure imposed by the double entry bookkeeping
systemand the production, investment, and nancing technologies available
to the rm. This in turn allows the evolution of bookkeeping summary
measures such as assets, liabilities, and stockholders equity (and their
components) to be dened in terms of a (vector) system of stochastic
differential equations. Restrictions imposed by the double entry bookkeeping
system are reected in a structural matrix which summarizes the sensitivity
of instantaneous changes in these variables to their existing levels. In
Section 3, we use the dynamic specication of the evolution of bookkeeping
summary measures advanced in Section 2 to investigate the properties of the
debt to equity ratio. Section 4 then develops models of corporate valuation
including one which is linear in the book values of the rms equity, assets,
and liabilities. We also demonstrate that under this linear interpretation of
our model, the market to book ratio has a tendency to revert towards a long
run normalized value. The circumstances leading to non-linear valuation
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 263
relationships are also briey developed in this section. We conclude with a
summary of the papers main points and some suggestions for potentially
protable areas for future research.
THE STRUCTURAL DYNAMICS OF BOOKKEEPING SUMMARY
MEASURES
We begin by dening the vector of balance sheet variables:
3
x(t)=
_
S(t)
A(t)
L(t)
_
where S(t) is the book value of a rms equity, A(t) is the book value of its
assets and L(t) is the book value of its liabilities, all at time t. Furthermore,
we assume that the fundamental accounting identity holds. Dening u by:
u=
_
1
1
1
_
we have, therefore, that:
x
T
t.u=[S(t), A(t), L(t)].
_
1
1
1
_
=S(t)A(t)L(t)=0,
where x
T
t is the transpose of the vector x(t).
Now, the rms transactions and other accounting entries over the interval
from time t to time tt may be summarized by a transactions matrix,
Mt,tt, as follows:
4
Cr
Equity Assets Liabilities
Equity a
11
t,tt a
12
t,tt a
13
t,tt
Dr Assets a
21
t,tt a
22
t,tt a
23
t,tt
Liabilities a
31
t,tt a
32
t,tt a
33
t,tt
where the rows of the above matrix represent accounts which are debited
while the columns are the accounts which are credited. Hence, the element
a
21
t,tt represents all the entries over the interval [t,tt] which involve
a debit to assets and a credit to equity. An example of such an entry would
be the debit to bank and credit to sales arising froma cash sales transaction.
Similarly, the element a
13
t,tt involves a debit to equity and a credit
to liabilities. An example of such an entry would be the debit to operating
expenses and credit to accounts payable arising from the accrual of the
264 T. COOKE AND M. TIPPETT
insurance premium on a rms manufacturing plant.
5
It is also important to
note here that the elements of the transactions matrix, M(t,tt), evolve
stochastically over time.
Now if we dene:
x(t)=xttx(t)=
_
S(t)
A(t)
L(t)
_
as the vector of rst differences in the nancial variables, (i.e., S(t)=
SttS(t) is the rst difference in the book value of equity and A(t)
and L(t) are similarly dened), then we can show that the book value
of equity, assets, and liabilities evolve in accordance with the difference
equation (Tippett, 1978, p. 274):
x(t)=[Mt,ttM
T
t,tt].u
where Mt,ttM
T
t,tt is the difference between the transactions
matrix and its transpose
6
and takes the skew symmetric form:
Mt,ttM
T
t,tt=
_
0 b
12
t,tt b
13
t,tt
b
12
t,tt 0 b
23
t,tt
b
13
t,tt b
23
t,tt 0
_
,
with b
jk
t,tt=a
jk
t,tta
kj
t,tt for j, k=1, 2, 3. Furthermore,
we can divide the rst, second, and third columns of the matrix
Mt,t tM
T
t,t t by the opening values of equity, assets, and
liabilities respectively, in which case:
x(t)=[Mt,ttM
T
t,tt].u=t,ttx(t),
where:
t,tt
_
_
_
_
_
_
_
0
b
12
t,tt
A(t)
b
13
t,tt
L(t)
b
12
t,tt
S(t)
0
b
23
t,tt
L(t)
b
13
t,tt
S(t)
b
23
t,tt
A(t)
0
_
_
_
_
_
_
_
is called the matrix of structural coefcients, related to the underlying
transactions matrix, whose elements summarize the sensitivity of propor-
tionate changes in the bookkeeping variables to the opening levels of these
variables. Furthermore, the structural coefcients will evolve stochastically
through time, since the elements of the transaction matrix from which they
are derived, are all stochastic functions of time. We are now in a position to
develop the properties of the structural coefcients in greater detail.
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 265
Properties of the structural matrix
We begin by noting that the fundamental accounting identity, S(t)A(t)
L(t)=0, implies that the structural coefcients bear particular relationships
one to another. It will help in demonstrating this if we dene g(t)=
L(t)
S(t)
to
be the book value of the rms liabilities divided by the book value of its
equity at time t. We shall henceforth refer to this variable as the debt to
equity ratio. Now, this denition taken in conjunction with the fundamental
accounting identity, shows:
A(t)=1g(t)S(t)
and so, both the book value of the rms liabilities and the book value of
its assets can be determined once the debt to equity ratio and the book
value of equity are known. We can use these denitions in conjunction
with the matrix of structural coefcients, t,t t, given above, to
determine the following more parsimonious expression for the relationship
between the structural coefcients:
Proposition 1
If g(t)=
L(t)
S(t)
is dened as the rms debt to equity ratio at time t, then
the fundamental accounting identity, S(t)A(t)L(t)=0, implies that the
matrix of structural coefcients takes the form:
t, tt=
_
_
_
0 !
12
t,ttt !
13
t,ttt
!
12
t,tt1g(t)t 0 !
23
t,ttt
g(t)!
13
t,ttt !
23
t,tt.
g(t)
1g(t)
(t) 0
_
_
_
where !
12
t,ttt=
b
12
t,tt
A(t)
, !
13
t,ttt=
b
13
t,tt
L(t)
, !
23
t,t
tt=
b
23
t,tt
L(t)
and the !
jk
t,tt are the upper diagonal structural
coefcients which hold over the interval [t,tt].
Proof
See Appendix.
Note that the structural coefcients, !
jk
t,tt, dened here are stated
on a per unit time basis and so their impact over the nite interval from
time t until time tt will be !
jk
t,ttt (Tippett & Warnock, 1997,
266 T. COOKE AND M. TIPPETT
pp. 10761079). Without further assumptions, however, little progress can
be made beyond this point. We thus invoke a convention, followed in the
literature, of assuming that structural coefcients can be partitioned into
intertemporally stationary expected and stochastic components (Garman
& Ohlson, 1980; Ohlson, 1983, 1990, 1995; Tippett & Warnock,
1997). Furthermore, since continuous time models have both analytical
and computational advantages over their discrete time equivalents, we
henceforth assume that all structural coefcients evolve continuously in
time.
7
These considerations lead us to state the following proposition:
8
Proposition 2
Suppose the structural coefcients evolve in accordance with the diffusion
process:
!
jk
(t)dt=m
jk
dts
jk
dz
jk
(t)
for k>j and where m
jk
is the expected value or mean (per unit time) of the
jk
th
structural coefcient, s
2
jk
is its instantaneous variance (per unit time) and
dz
jk
(t) is a standard Gauss-Wiener process. Then instantaneous changes in
the bookkeeping summary measures evolve in accordance with the vector
system of stochastic differential equations:
dx(t)=(t)x(t)dtS(t)dZ(t)
where dx(t)=
_
dS(t)
dA(t)
dL(t)
_
contains the instantaneous changes in the rms
bookkeeping summary measures, x(t)=
_
S(t)
A(t)
L(t)
_
is the vector containing the
levels of these variables, t=
_
_
_
_
0 m
12
m
13
1g(t)m
12
0 m
23
g(t)m
13
g(t)
1g(t)
.m
23
0
_
_
_
_
is the
matrix containing the means or expected values of the structural coefcients
(per unit time) and dZ(t)=
_
_
s
12
1g(t)dz
12
(t)s
13
g(t)dz
13
(t)
s
12
1g(t))dz
12
(t)s
23
g(t)dz
23
(t)
g(t)s
13
dz
13
(t)g(t)s
23
dz
23
(t)
_
_
is a
vector of stochastic error terms.
Proof
See Appendix.
There are some important observations which need to be made about
this proposition. The rst stems from the fact that the exact form of the
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 267
vector system of stochastic differential equations hinges critically on the
assumptions made about the evolution of the structural coefcients, !
jk
(t).
The principal assumption here is that the structural coefcients evolve
in terms of the stochastic constant growth technology which underpins the
standard asset pricing models of nance theory (Merton, 1969, pp. 247248;
Merton, 1973, pp. 870873). However, for pedagogical and computational
efciency we assume that the Gauss-Wiener processes, dz
jk
(t), on which the
structural coefcients are based, are all uncorrelated. There are, however,
reasons to believe that this may not be the case in practice. For example,
bad debt write offs will often be accompanied by the creation of an extra
provision, in which case we can expect the structural coefcients !
12
(t)
and !
13
(t) to be correlated. Given this, it is important to note that a more
general model replaces the dz
jk
(t) with stochastic processes which depend
on factors external to the rm and which have a potentially signicant
effect on the evolution of the rms bookkeeping summary measures. These
could include such things as the rate of growth of gross national product, oil
prices, interest rates, ination etc. The stochastic terms are then serially and
cross-sectionally correlated and non-Markovian, and the vector system of
stochastic differential equations which describes the evolution of the rms
bookkeeping summary measures is not then restricted to just the double
entry bookkeeping variables themselves. Unfortunately, the complexity of
such models means that we cannot develop them in any detail here. It is,
however, important to make this point given that empirical work appears
to have established that there are occasions on which a rms bookkeeping
summary measures are largely value-irrelevant (Amir & Lev, 1996).
A second point arises out of the fact that our assumptions imply
that the vector of stochastic terms, dZ(t), has a mean of zero. Hence,
Proposition 2 implies that E
t
[dx(t)] =(t)x(t)dt, where E
t
() is the
expectations operator taken at time t, is the vector whose elements are
the expected instantaneous increments in the book values of equity, assets,
and liabilities. Thus, the expected instantaneous change in the book value
of equity is E
t
[dS(t)]=[m
12
A(t)m
13
L(t)]dt=m
12
S(t)m
13
m
12
L(t)]dt.
Now suppose the rm follows a convention of instantaneously marking all
its assets and liabilities to market. Then in the absence of taxes, bankruptcy
costs, and other market imperfections, the Modigliani & Miller (1958)
theorem shows E
t
[dS(t)]=[p
u
p
u
rg(t)]S(t)dt=[p
u
S(t)p
u
rL(t)]dt,
where p
u
is the cost of equity for an unlevered rm and r is the cost
of debt. Hence, these assumptions imply p
u
=m
12
is the cost of equity
for an unlevered rm and p
u
r=m
13
m
12
, or that r=m
13
is the cost
of debt. Of course, rms do not instantaneously mark their assets and
liabilities to market and the Modigliani & Miller (1958) theorem holds
only under highly idealised conditions and so in practice, the best we
can say is that m
12
approximates for the cost of equity for an unlevered
rm; likewise m
13
approximates for the cost of debt. Hence, the accuracy
of these approximations depends on the bookkeeping policies invoked by
268 T. COOKE AND M. TIPPETT
the rm and the sensitivity of the model to violations of the assumptions
underlying the Modigliani & Miller (1958) theorem. Note also, that our
analysis here says nothing about the parameter m
23
. However, we now show
how this parameter is best interpreted in terms of the crucial role it plays in
determining the rms debt to equity ratio, g(t).
DISTRIBUTIONAL PROPERTIES OF THE DEBT TO EQUITY
RATIO
There is nothing in the previous analysis which implies that the debt to equity
ratio is an intertemporal constant. We can, however, derive the process
through which the debt to equity ratio evolves over time. Proposition 3
provides a specication of this process.
Proposition 3
If the book values of the rms equity, assets, and liabilities evolve in
accordance with the vector system of stochastic differential equations:
dx(t)=(t)x(t) dtS(t)dZ(t),
given in Proposition 2, then instantaneous proportionate variations in the
debt to equity ratio evolve in accordance with the non-linear stochastic
differential equation:
dg(t)
g(t)
=[s
2
12
s
2
13
1g(t)
2
1g(t)m
12
m
13
s
2
13
m
23
]dt
1g(t)s
12
dz
12
s
13
dz
13
s
23
dz
23
As a consequence, instantaneous proportionate variations in the debt to
equity ratio are normally distributed with mean:
E
t
_
dg(t)
g(t)
_
=[s
2
12
s
2
13
1g(t)
2
1g(t)m
12
m
13
s
2
13
m
23
]dt
and variance:
Var
t
_
dg(t)
g(t)
_
=[1g(t)
2
s
2
12
s
2
13
s
2
23
]dt.
where Var
t
() is the variance operator taken at time t.
Proof
See Appendix.
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 269
This proposition implies that expected instantaneous proportionate changes
in the debt to equity ratio, E
t
[
dg(t)
g(t)
], are zero and thus have no tendency to
change, at the following two roots:
9
1g(t)=
s
2
13
m
13
m
12

_
m
12
m
13
s
2
13

2
4m
23
s
2
12
s
2
13

2s
2
12
s
2
13

Now, previous analysis shows that p

u
=m
12
proxies for the (unlevered)
cost of equity capital whilst r=m
13
proxies for the cost of debt. Hence, we
would normally expect s
2
13
m
13
m
12
>0. Furthermore, if m
23
<0, then
s
2
13
m
13
m
12
>
_
m
12
m
13
s
2
13

2
4m
23
s
2
12
s
2
13
>0
and both the above roots will be positive. Figure I depicts the instantaneous
expected proportionate change in the debt to equity ratio, g(t), under the
assumption that m
23
<0.
Note that if 1g(t) lies between the two roots and thus exceeds the least
positive root, then:
E
t
_
dg(t)
g(t)
_
<0
and so the expected instantaneous proportionate change in the debt to
equity ratio is back towards the least positive root. When 1g(t) is less
0.08
1.85
0.06
(1+ gamma)
d
(
g
a
m
m
a
)
/
g
a
m
m
a
1.15
0.06
0.04
0.02
0
0.02
0.04
1.2 1.25 1.3 1.35 1.4 1.45 1.5 1.55 1.6 1.65 1.7 1.8 1.75
Figure I. Expected value of proportionate changes in the debt to equity ratio as a function
of the normalized book value of assets
270 T. COOKE AND M. TIPPETT
than (or to the left of) the least positive root, however,
E
t
_
dg(t)
g(t)
_
>0
in which case the expected instantaneous proportionate change in the debt
to equity ratio will also be back towards this root. Finally, when 1g(t)
exceeds (or is to the right of) the most positive root, then:
E
t
_
dg(t)
g(t)
_
>0
and so here the expected instantaneous proportionate change in the debt
to equity ratio will be to the right of and away from the root. Hence,
this most positive root is an unstable equilibrium in the sense that should
1g(t) exceed it, our expectation will be for the debt to equity ratio to
become innitely large, thereby signicantly increasing the probability of
catastrophic events such as the rm entering bankruptcy.
When m
23
>0, a similar analysis shows that g(t) will either converge
towards a long term mean of zero (in which case the rms activities are
nanced purely by equity) or become innitely large, in the latter case again
signifying a high likelihood of catastrophic events such as the rm entering
bankruptcy. However, since rms normally nance their operations with
both equity and (non-catastrophic levels) of debt, subsequent analysis is
based on the assumption that m
23
<0 or that g(t) uctuates around a long
term mean which is neither zero nor catastrophically large. This assumption
means that we can summarize our analysis in terms of the following Lemma:
Lemma 1
Let 0_g
L
_g
u
be the two roots of the equation:
E
t
_
1
g(t)
.
dg(t)
dt
_
=s
2
12
s
2
13
1g(t)
2
1g(t)m
12
m
13
s
2
13
m
23
=0
where g(t) is the rms debt to equity ratio at time t. Then expected changes
in g(t) will be towards a long run normal value given by the least positive
root, namely:
g
L
=
m
13
m
12
s
2
13
2s
2
12

_
m
12
m
13
s
2
13

2
4m
23
s
2
12
s
2
13

2s
2
12
s
2
13

provided that:
0_g(t)_g
u
=
m
13
m
12
s
2
13
2s
2
12

_
m
12
m
13
s
2
13

2
4m
23
s
2
12
s
2
13

2s
2
12
s
2
13

.
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 271
In other words, the above Lemma shows that when the debt to equity
ratio, g(t), is less than a given threshold value, g
u
, we would normally expect
it to exhibit the kind of mean reversion properties documented for ratios
by Lev (1969) and others for the United States and Whittington & Tippett
(1995) in the United Kingdom. These papers nd that nancial ratios do
have a tendency to revert towards a long run or industry norm, although
convergence can often be very slow. When the debt to equity ratio exceeds
the threshold value of g
u
however, its statistical behaviour becomes more
problematic and there is a signicant chance that debt levels will become so
large relative to other sources of nancing, that the rm will end up having
no choice but to initiate bankruptcy proceedings.
THE STRUCTURAL MATRIX AND CORPORATE VALUATION
We begin by noting that the standard no-arbitrage and nonsatiation
requirements of nance theory imply that over the non-innitesimal
interval [t,tt] equity value will have to satisfy the recursive relationship
(Rubinstein, 1976, pp. 408409):
B(x(t))=e
r(x(t))t
E
t
{Bxtt]
where B(x(t)) is the value of the equity security at time t and r(x(t)) is the
discount rate implied by a vector, x(t) of continuously evolving information
variables. This formula says nothing more than the price of a unit of equity
today is the expected present value of the price of a unit of equity
tomorrow.
10
Analytical and pedagogical convenience dictates, however,
that we let x(t)=x(S(t), g(t) so that equity value depends exclusively on the
rms bookkeeping summary measures.
11
It then follows that the valuation
equation is compatible with the simpler expression:
B(S(t), g(t)=e
r(S(t),g(t))t
E
t
{B(S(tt, g(tt]
After expanding the right hand side of this equation as a series
expansion, taking limits (t 0) and substituting the means, variances
and covariances implied by the components of the vector dx(t) we end up
with Proposition 4.
12
Proposition 4
If the discount rate, rg, depends only on the debt to equity ratio and the
book value of the rms equity, assets and liabilities evolve in accordance
with the vector system of stochastic differential equations:
dx(t)=(t)x(t)dtS(t)dZ(t)
272 T. COOKE AND M. TIPPETT
given in Proposition 2, then equity value, B(S(t),g(t)), satises the partial
differential equation:
S[m
12
1ggm
13
]
@B
@S
g[s
2
12
s
2
13
1g
2
1gm
12
m
13
s
2
13
m
23
]
@B
@g

1
2
S
2
[s
2
12
1g
2
s
2
13
g
2
]
@
2
B
@S
2
Sg[1g
2
s
2
12
g1gs
2
13
]
@
2
B
@g@S

1
2
g
2
[1g
2
s
2
12
s
2
13
s
2
23
]
@
2
B
@g
2
rgBS, g=0
Proof
Generalize the proof in Karlin & Taylor (1981, pp. 203204) from a
function of one to a function of two, variables.
This result has as its nearest analogue, the Black & Scholes (1973,
pp. 642643) differential (fundamental valuation) equation in options
pricing theory. Here it is well known that riskless hedging implies that
the value of a European call option, C(P(t),t), must satisfy the recursive
relationship C(P(t),t)=e
it
E
t
{C(P(tt),tt], where P(t) is the price
of the underlying equity security at time t and i is the riskless rate of interest.
In continuous time (t0), this leads to the BlackScholes differential
equation (Cox & Ross, 1976, pp. 153155). Now, Proposition 4 is based on
the same ideas as those that lie behind the derivation of the Black & Scholes
(1973) differential equation using this recursive valuation formula.
The derivation of Proposition 4 begins by assuming that equity value
depends on a set of continuously evolving information variables. We then
use this assumption in conjunction with the recursion formula to show that
in continuous time, equity value will have to satisfy a differential equation
based on these information variables. This in turn gives insights into the
relationship between equity value and the assumed information variables
which would not otherwise be available.
To demonstrate this we rst note that two rms, which are identical in the
sense that increments in the book values of their respective equities, assets,
and liabilities are perfectly correlated with each other (and are therefore
based on identical investment, production, nancing, and bookkeeping
strategies or structural matrices, (t)), must also have the same market value
of equity unless the book values of their equities are different. When the
book values of equity are different, the ratio of the market values of the two
equity securities must be equal to the ratio of the book values of the equity
securities. If this were not the case we can use the arbitrage arguments of
Modigliani & Miller (1958, 1963) and Miller & Modigliani (1961) to show
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 273
that it will be possible to construct a perfectly hedged and self nancing
portfolio which returns only positive cash ows in the future thereby
implying the existence of arbitrage prots. Now we can state Proposition 5
which holds only when such arbitrage opportunities do not exist.
13
Proposition 5
The no arbitrage condition:
BlS, g=lBS, g
where l is a real parameter, implies that every solution to the partial
differential equation dened in Proposition 4 takes the form:
14
BS, g=SJg
where J(g) is a differentiable function satisfying the auxiliary equation:
[1gm
13
m
12
rgm
13
]Jgg[1gm
12
m
13
m
23
]J
/
g

1
2
g
2
[1g
2
s
2
12
s
2
13
s
2
23
]J
//
g=0
Proof
See Appendix.
An important application of this result stems from the fact that it provides
a rigorous basis for analysing the book to market ratio,
B(S,g
S
for equity.
The empirical work of Fama & French (1992, 1993, 1995, 1996) amongst
others shows this ratio to be highly correlated with equity returns and
there is, as a consequence, a view that it plays an instrumental role
in generating these returns. We now provide specic interpretations of
Proposition 5 and of the auxiliary equation in particular, which results in
there being a linear relationship between the market value of equity and the
bookkeeping summary measures which underscore it. Here it is important
to note, however, that solutions to the auxiliary equation hinge critically on
specication of the functional relationship between the cost of the rms
equity capital, rg, and its (book) debt to equity ratio, g. This means it is
not possible to write down a general closed form solution for the auxiliary
equation and so the relationship between the market and book values of
equity depends on the accounting and bookkeeping practices employed
by the rmas one might expect. For pedagogical and computational
simplicity the results we report are initially based on the assumption that
the discount rate, rg, is a constant, independent of the debt to equity
ratio.
15
274 T. COOKE AND M. TIPPETT
Lemma 2
Under the transversality condition rg=m
12
>0 for all g,
16
the auxiliary
equation is satised by the simple linear valuation equation:
Jg=
_
1g
gm
23
m
13
rm
23
_
This result also implies:
Jg=
B(S, g
S
=
m
13
r1gm
23
m
13
rm
23
is the ratio of the market value of equity to the book value of equity and is a
linear function of the book debt to equity ratio.
The implications of this Lemma can probably best be understood
by recalling from previous analysis that if assets and liabilities are
instantaneously marked to market then p
u
=m
12
will be an unlevered
rms cost of equity capital. However, the Modigliani & Miller (1958)
theorem says that p
L
=p
u
p
u
rg, where p
L
is the cost of equity for a
levered rm and r=m
13
is the cost of debt. Hence, under a mark to
market bookkeeping strategy and the transversality condition imposed in
the hypothesis, Lemma 2 implies rg=p
L
=p
u
=m
12
irrespective of the
rms debt to equity ratio. It thus follows that the valuation procedures are
based on risk neutral pricing, or equivalently r=m
12
=m
13
=r for all g.
Substituting this equality into Lemma 2 then shows that under a mark to
market bookkeeping strategy, the auxiliary function is identically equal to
unity, or Jg=1. This implies that the linear valuation equation collapses
to B(S,g=S, or that the book value of equity is identically equal to its
market valuewhich, of course, must be the case with a mark to market
bookkeeping strategy. Other bookkeeping strategies, however, will drive a
wedge between the market and book values of equity. Thus, if assets
are instantaneously marked to market (in which case r0=m
12
=p
u
) but
liabilities are recorded using some other (non-market based) bookkeeping
conventions (so that r,=m
13
in general), then in the risk neutral setting
considered here the wedge between the market and book values of equity
will be summarized by the auxiliary function contained in Lemma 2.
17
This Lemma has several other important implications. For example, from
Proposition 3, we know that under fairly general conditions the debt to
equity ratio, g, will have a tendency to revert towards a long term normal
value of g
L
. As a consequence, Lemma 2 implies that the market to book
ratio of equity must have a tendency to revert towards a long term norm
as well.
18
Furthermore, we can use the relationship between S, A, L and
g, to show that the market value of equity can be restated in terms of the
following Lemma:
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 275
Lemma 3
Under the transversality condition rg=m
12
>0 for all g, the market value
of the rm can be stated as a linear function of assets and liabilities as given
by the valuation equation:
B(S, g=B(A,L)=
_
A
m
23
m
13
rm
23

L
_
Thus, Lemma 3 provides some comfort for researchers who would
focus on balance sheet approaches to (linear) valuation modelling.
19
We
should also recall that this result is based on risk neutral pricing and a
mark to market bookkeeping strategy for assets. Liabilities, however, are
not necessarily recorded on a mark to market basis. It thus follows that
m
23
m
13
rm
23
is the coefcient which adjusts the book value of liabilities to
their market value. Note here that a necessary condition for a conservative
bookkeeping strategy (where the book value of liabilities exceeds their
market value) is that
m
23
m
13
rm
23
>1. Further, the risk neutral pricing
assumption implies that the only elements of the structural matrix, (t),
which have value relevance are the expected structural coefcients, r=m
12
,
m
13
and m
23
. However, both intuition and previous research suggests that
there are other characteristics of the structural matrix which ought to hold
value relevance. Black (1980, p. 22), for example, notes that . . . at times,
price-earnings ratios may depend on growth rates and measures of volatility
. . . of past transactions . . . whilst Govindaraj (1992, p. 503) suggests that
there is good reason to believe that the volatility of the of market value
of equity is related to . . . the volatility of . . . accounting variables.
Unfortunately, these considerations lead in general to non-linearities in the
valuation equations.
20
Probably the simplest, most general, and easiest way of assessing the
value relevance of the higher moments and other (risk) parameters is to
employ power series expansions to obtain analytic solutions for the auxiliary
equation contained in Proposition 5. These expansions take the general
form:
Jg=g
q
_
1
o

k=1
a
k
(q)g
k
_
where the a
k
are parameters and q is called the exponent of singularity.
21
Now, there are two exponents of singularity corresponding to the two series
expansions which characterise the general solution of the auxiliary equation
dened in Proposition 5. They are determined by computing the roots of the
indicial equation, which for the auxiliary equation dened in Proposition 5,
276 T. COOKE AND M. TIPPETT
takes the form (Boyce & DiPrima, 1969, pp. 183186):
F(r)=q
2

_
2m
12
m
13
m
23

s
2
12
s
2
13
s
2
23
1
_
q
2m
12
r0
s
2
12
s
2
13
s
2
23
=0
where r(0) is the cost of equity capital for an unlevered rm. Once the
exponent of singularity is determined the series expansion for J(g) and its
derivatives, J
/
g and J
//
g, are substituted into the auxiliary equation; the
a
k
are then determined so that the auxiliary equation is formally satised.
A simple illustration of these procedures is provided by assuming that
the cost of equity for an unlevered rm is given by r0=p
u
=m
12
, or
that the rm follows a bookkeeping policy of marking asset values to
market. The reader will conrm that under this assumption, q
1
=0 and
q
2
=1
2m
12
m
13
m
23

s
2
12
s
2
13
s
2
23
are the two roots of the above indicial equation.
Substitution then shows:
Jg=1
o

k=1
a
k
q
1
g
k
and:
Jg=g
q
2
_
1
o

k=1
a
k
q
2
g
k
_
are two linearly independent series expansions which formally satisfy the
auxiliary equation. Now, the mark to market bookkeeping policy for assets,
on which the above series expansions are based, implies that the value
of an all equity nanced rm is B(S,0) =SJ0=S or J0=1. We
have also previously noted that as the debt to equity ratio grows, the
likelihood of the rm entering bankruptcy proceedings also increases.
In the limit, therefore, we must also have for the value of equity that
Limit
go
B(S, g=S[ Limit
go
Jg]=0, or Limit
go
Jg=0. These two boundary
conditions are sufcient to ensure that there is a unique solution to the
auxiliary equation and that the series expansion for this unique solution
can be expressed as a linear combination of the two series expansions given
above. This, in turn, means that the market value of equity is uniquely
dened in terms of the book value of equity and the rms debt to equity
ratio (Karlin & Taylor, 1981, pp. 203204).
In general, both the exponents of singularity, q
1
and q
2
, as well as
the parameters, a
k
(q
1
) and a
k
(q
2
), are functions not only of the expected
structural coefcients m
12
, m
13
and m
23
but also of the volatility parameters
s
2
12
, s
2
13
and s
2
23
. Hence, whilst the variance parameters will now have an
instrumental role to play in determining the valuation equations, there will
no longer be a linear relationship between the book values of the underlying
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 277
information variables and the value of the rms equity. Fortunately, this
does not detract from the models potential for use in empirical work. The
mild regularity conditions which assure convergence of the series expansions
which satisfy the auxiliary equation (Boyce & DiPrima, 1969, pp. 159162)
means that it will, in general, be possible to base econometric procedures
and empirical work on truncated versions of the series expansions with very
little chance of this resulting in signicant errors.
SUMMARY AND CONCLUSIONS
We demonstrate how a parsimonious interpretation of the double entry
book-keeping system can lead to the evolution of nancial variables being
dened in terms of a (vector) system of stochastic differential equations.
Here, the restrictions imposed by the double entry bookkeeping system
are reected in a structural matrix which summarizes the sensitivity of
instantaneous changes in the rms equity, assets, liabilities, and other
nancial variables to the existing levels of these variables. A specic version
of our model implies that the debt to equity ratio and the ratio of the market
value to the book value of equity will have a tendency to revert towards
long run normal valuesa description which conforms with the empirical
evidence. Further, and again within a specic version of the model, we
demonstrate a theoretical rationale under which there will be a simple linear
relationship between the market value of equity and the rms bookkeeping
summary measures. However, these are special cases of a more general
non-linear pricing relationship implied by our model. Developing this more
general model beyond the embryonic form contained in the text has the
potential to open up fresh insights into the impact a rms production,
investment, nancing, and bookkeeping strategies have on the evolution of
its equity price.
Our analysis also has several other important implications which, due to
space restrictions, cannot be developed in any detail here. First, it can be
shown, under quite general regularity conditions, that our analysis implies
that all the eigenvalues of the matrix of expected structural coefcients, (t),
are real. This resolves an important issue relating to the evolution of a rms
bookkeeping summary measures which was rst identied by Ashton (1995)
and discussed in detail by Tippett &Warnock (1997). And that relates to the
issue of whether a rms bookkeeping summary measures can be expected
to evolve harmonically (in which case the eigenvalues of the structural
matrix are complex) or exponentially (the eigenvalues of the structural
matrix are real). Standard interpretations of the structural models found in
the literature (Ohlson, 1983, 1990, 1995) return empirical evidence which
suggests that whilst real eigenvalues are the norm, a signicant proportion of
companies examined return structural matrices with complex eigenvalues.
However, Ashton (1997) and Tippett & Warnock (1997) argue that the
278 T. COOKE AND M. TIPPETT
modelling procedures employed in these papers are mis-specied and that
it is this which accounts for the existence of the complex eigenvalues. Our
analysis here can only add weight to this assertion.
A second issue relates to the fact that we can use Proposition 3 of the
text in conjunction with the techniques summarized in Biekpe, Tippett &
Willett (1998, pp. 116117) to determine the probability distribution of the
debt to equity ratio itself. The distributional properties of this (and other)
ratios has been the focus of considerable attention over the years and is of
interest to a variety of stakeholders in the rm (Ezzamel, Mar-Molinero &
Beecher, 1987; Ezzamel & Mar-Molinero, 1990; McLeay, 1986). However,
our analysis shows that it is likely the debt to equity ratio will be described
by a distribution which possesses no moments at all. In other words, neither
its mean nor its variance nor any of its higher moments will exist. Here it is
interesting to note that Whittington & Tippett (1995) examine the empirical
evidence relating to a large number of time series models of the evolution
of nancial ratios and show that non-stationarity is a problem with virtually
all of them. Furthermore, Whittington & Tippett (1999) report empirical
evidence which suggests that the components of some commonly employed
nancial ratios do not possess a co-integrating relationship. It may be shown
that empirical evidence like this is compatible with the kind of probability
distribution which our analysis suggests describes the debt to equity ratio.
Probably the most obvious way in which our analysis can be extended,
however, is by considering less aggregated transactions matrices than the
simple 33 matrices based on equity, assets, and liabilities considered here.
This opens up the possibility of determining the role played by ratios other
than the debt to equity ratio and the market to book ratio in the valuation
process. There are also important issues arising from the fact that there is
considerable exibility in the way accounting conventions, rules, and stan-
dards can be applied in practice. An interesting possibility here is to assume
that managers have a degree of discretion in the way they use the double
entry bookkeeping system to adjust nancial variables to conform with their
long term growth rates [Lev (1969), Tippett (1990), Whittington & Tippett
(1995)]. In sum, the embryonic analysis contained here can be extended to
cast further light on the evolution of a rms bookkeeping summary measures
and of the relation these measures have to underlying equity value.
NOTES
1. See Lundholm (1995, pp. 750753) for a more detailed account of these assumptions.
Dixit & Pindyck (1994, pp. 121124) contains an intuitive and very readable discussion
of the ideas which underscore martingale equivalent pricing. Feltham & Ohlson (1995,
p. 694) discuss the meaning and signicance of the clean surplus restriction.
2. Bernard (1995, p. 733) notes that:
The value of Ohlson (1995) and Feltham & Ohlson (1995) can best be appreciated
when one recognizes where the studies t on the evolutionary tree of research.
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 279
These studies return to issues so basic as to render them direct descendants of work
done no later than the 1960s (e.g. Edwards & Bell (1961) . . .). Ohlson (1995) and
Feltham&Ohlson (1995) represent the base of a branch that capital markets research
might have followed but did not. Instead framed within the so called informational
perspective, research since the late 1960s developed without much emphasis on the
precise structure of the relation between accounting data and rm value. In a sense
Ohlson (1995) and Feltham & Ohlson (1995) return to step one and attempt to
build a more solid foundation for further work.
Thus, the normative models alluded to here [Edwards & Bell (1961), Mattessich (1957,
1964), Chambers (1966), Ijiri (1965, 1967), Sterling (1970)] can all be interpreted as
specic applications of the Garman & Ohlson (1980) formulation.
3. A partial and very embryonic form of the analysis contained in this section is to be found
in the articles by Mattessich (1957, 1964, pp. 7477), Tippett (1978, pp. 274275) and
Willett (1987, 1988). Black (1980, p. 22; 1993, pp. 23) notes that past transactions are
a kind of raw material which, in the summary form of the prot and loss account and
balance sheet, constitute basic inputs for many of the valuation procedures employed
by accountants in practice. Hence, models of the evolution of a rms bookkeeping
numbers have the potential to enhance our understanding of the relationship between
the rms accounting system and the way the value of its equity, debt and other capital
instruments evolve over time.
4. We follow Mattessich (1957, 1964, pp. 7477) and Tippett (1978, pp. 274275).
Mattessich (1964, p. 102) and Chambers (1994, p. 78) quote Cayley (1894, p. 5) as
being of the view that the principles of Book-keeping by Double Entry constitute a
theory which is mathematically by no means uninteresting: it is in fact like Euclids
theory of ratios an absolutely perfect one . . .. Since the theory of matrices [was] an
invention of Cayleys [Bell (1937, p. 425)], it is more than likely Cayley was aware
that the double entry bookkeeping system has the matrix interpretation given to it here.
However, Cayleys premature death in 1895 [Bell (1937, p. 450)] meant that further
developments in the matrix interpretation of the double entry bookkeeping system had
to wait until well into the twentieth century, culminating with the pathbreaking analysis
of Mattessich (1957, 1964).
5. Pedagogical considerations dictate that Mt, tt is the aggregated or reduced form
of a transactions matrix containing more than just the three accounts considered here.
One might consider, for example, the nn transactions matrix, n>3 which partitions
the equity account into sales and expense categories; assets into xed and current
categories (stock, accounts receivable, bank, etc.) and liabilities into accounts payable,
bank overdraft, accruals etc. Call this expanded transactions matrix, N. It is easily
shown, however, that there is an adjacency matrix, A, [Wallis, Street & Wallis (1972,
p. 337)] which makes this more detailed transactions matrix, N, equivalent to the
simple 33 transactions matrix, M, in the sense that M=A
T
NA [Finkbeiner (1966,
p. 129)]. In other words, the adjacency matrix serves to close all equity accounts into one
account, all asset accounts into one account and all liability accounts into one account.
Hence, there is not a great loss in generality, but obvious pedagogical convenience, from
considering the simple 33 transactions matrix, M, considered in the text. The seminal
treatment of Mattessich (1957, 1964, pp. 448465) outlines some of the important
properties of the transactions matrices considered here. The Appendix contains further
details on the relationship between the reduced form of the transactions matrix and the
adjacency matrix which generates it.
6. This operation is equivalent to balancing off the accounts in the general ledger [Wood
(1996, Chapter 5)].
7. Sims (1971, p. 559), Karlin & Taylor (1981, p. 356) and Bergstrom (1990, pp. 13),
catalogue the merits of continuous time models relative to their discrete time equivalents.
8. Willett (1987, 1988) was the rst to provide a concrete demonstration of the fact that a
rms production, investment and nancing technologies can be dened in terms of the
280 T. COOKE AND M. TIPPETT
restrictions imposed on the structural matrix, t, tt, by the requirements of the
double entry bookkeeping system and the assumptions one makes about the stochastic
processes which underscore the evolution of the elements of the structural matrix.
9. Both here and in the sections which follow, we assume that the roots of this equation
are both real or that m
12
m
13
s
2
13

2
4m
23
s
2
12
s
2
13
>0.
10. The recursion formula stated here implies that equity valuation can be reduced to a
terminal control problem in dynamic programming [Dreyfus (1965, pp. 2024)]. This
is a methodology which has been extensively applied in the contingent claims valuation
theory of nancial economics [Dixit & Pindyck (1994, pp. 121123)].
11. Recall that once the book value of equity [S(t)] and the debt to equity ratio [g(t)] are
known, both the book value of liabilities [L(t)] and assets [A(t)] can be determined using
the fundamental accounting identity, S(t)A(t)L(t)=0. The relative importance of
accounting (bookkeeping) information in the assessment of equity value is stressed by
Black (1993, p. 2) in the following terms:
. . . information is incorporated into [equity] prices through the accounting process.
Without that process, the price changes would occur later. One way to see the
importance of accounting . . . is to note the time path of the price response to new
information. The response accelerates up to the time of the [statutory] accounting
report, on average. This suggests that the accounting numbers are nding their way
into the market as the rm is preparing its accounting statements. The accounting
process itself is informing the market . . .. If the rm doesnt do its accounting
homework, its stock price will be noisier.
Furthermore, since our analysis implies that equity value is determined as the expected
present value [of dividends] conditional on ideal (but achievable and objective)
accounting rules it follows that every proposed choice of accounting rules denes
a different [equity] value. (Black, 1993, p. 2). Hence, as Black (1993, pp. 56)
observes, restricting accounting policies to those based on the clean surplus identity
(where everything goes through the prot and loss statement) will in general lead to
accounting policies which do not maximise the market value of the rms equity. This,
combined with the fact that Tippett & Warnock (1997, p. 1094) show that the clean
surplus identity does not hold up in practice are the principal reasons why our analysis
places no special emphasis on the clean surplus restriction. For an alternative view,
however, see Ohlson (1995, pp. 665667) and Feltham & Ohlson (1995, pp. 693697)
or the collection of essays in Brief & Peasnell (1996).
12. The coefcients associated with the rst order partial derivatives in Proposition 4 are
the means of the affected variables whilst (apart from a scaling factor), the coefcients
associated with the second order partial derivatives are the variances or covariances
of the affected variables. Thus, from Proposition 2,
E
t
[dS(t)]
dt
=[m
12
A(t)m
13
L(t)]=
S[m
12
1ggm
13
] is the coefcient associated with
@B
@S
. Similarly, Proposition 2
also implies that,
Var
t
[dS(t)]
dt
=
Var
t
[s
12
1g(t)dz
12
(t)s
13
g(t)dz
13
(t)]
dt
.S
2
=[s
2
12
1
g
2
s
2
13
g
2
]S
2
is the coefcient associated with the term
@
2
B
@S
2
. All other coefcients
are similarly derived. Furthermore, the partial differential equation contained in this
proposition is a special case of a very general result known as the Feynman-Kac
killing formula which has been extensively applied in the nancial economics literature
(ksendal, 1985, pp. 9596; Dixit, 1989; Dixit & Pindyck 1994, pp. 121123).
13. See Barth & Kallupur (1996) for empirical evidence which also suggests that book value
acts as a proxy for scale differences.
14. It warrants emphasizing that this result holds for much more general transactions
and structural matrices. That is, if we specify a rms operations in terms of an nn
structural matrix rather than the simple 33 matrix based on equity, assets and liabilities
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 281
considered here, then it may be shown that the solution takes the form:
BS, g
1
, g
2
, , g
n
=SJg
1
, g
2
, , g
n

where the g
j
are a more general set of nancial ratios characterizing the rms
production, investment, nancing, and bookkeeping strategies. Furthermore, if we
dene ES, g
1
, g
2
, , g
n
to be the rms future sustainable, normalized or
permanent earnings, it follows that equity value takes the form BS, g
1
, g
2
, , g
n
=
qES, g
1
, g
2
, , g
n
, where q is an intertemporally constant scaling factor applied
to the permanent earnings [Black (1980, 1993)]. Note that under this specication
permanent earnings, ES, g
1
, g
2
, , g
n
=
SJg
1
, g
2
, , g
n

q
, turns out to be a
function of the bookkeeping variables comprising the transactions matrix (one of which
will be the accounting earnings gure). Hence, as Black (1980, p. 20) notes, the end
result of the current system of accounting . . . is an earnings gure that usually gives
a reliable estimate of value, plus other information that can be used to arrive at an
even better estimate of value. The Black (1980, 1993) specication of the relationship
between equity value and the book gures appearing in a rms accounting records is
radically different from its better known counterpart based on the work of Ohlson (1983,
1990, 1995). Biekpe, Tippett & Willett (1998) provide a simple illustration of the way
Blacks ideas may be applied at an empirical level.
15. We relax this assumption below.
16. The transversality condition ensures that the equity stocks price will always remain
nite. See Dufe (1988, p. 198) or Ingersoll (1987, p. 275) for further details.
17. Note that when rg=m
12
m
12
m
13
g and the rm follows a mark to market
bookkeeping policy for both its assets and liabilities but with p
u
=m
12
>m
13
=r so
that the more general (non-risk neutral) Modigliani & Miller (1958) theorem holds,
then Jg=1 also satises the auxiliary equation contained in Proposition 5. Hence in
this case too, we have BS, g=S or that the market and book values of equity are
identically equal. When other bookkeeping policies are used, however, a wedge is again
driven between the market and book values of equity. Further, we show below that it
is unlikely the relationship will take the linear form given by the simple risk neutral
example considered in Lemma 2.
18. This result might also help to explain why the market to book ratio of equity appears
to be such an important variable in explaining equity returns [Fama & French (1992,
1993, 1995, 1996)]. A market to book ratio in excess of the long term mean of:
m
13
r1g
L
m
23
m
13
rm
23
implies that equity is currently overvalued whilst a market to book ratio belowthis gure
implies that equity is undervalued. Hence, if book values do not reect opportunistic
behaviour on the part of management, then investors will expect future equity returns on
high market to book ratio rms to be depressed whilst they will expect future returns
on low market to book rms to be relatively attractive.
19. A more general version of this Lemma is based on the net book value, S(t), and the
instantaneous accounting rate of return, r(t), where
dS(t)
S(t)
r(t)dt. We could then use a
result similar to that given here to show that the market value of equity is a weighted
average of the balance sheet summary measures and of the instantaneous earnings. Here,
it is interesting to note that basing his analysis on a model very similar to this, Penman
(1998) reports empirical evidence which suggests that periodic earnings is the more
important determinant of equity value, although the relative importance of earnings and
net book value uctuate markedly over time. Burgstahler (1998) provides an interesting
282 T. COOKE AND M. TIPPETT
perspective on the econometric problems that arise in the empirical application of such
models.
20. There are, in fact, a variety of reasons which might lead to non-linearities in the
valuation equations; probably, the most obvious stems from the option rms have to at
least partially reverse their investment, production, nancing and even their bookkeeping
strategies [Dixit (1989), Dixit & Pindyck (1994)].
21. A parenthetical observation is in order here. Much contemporary nance (and to
a lesser extent, accounting) theory proceeds from (difference) differential equations
which saw their earliest applications in (quantum) physics. Bell (1937, p. 480)
notes that the intractability of these equations was such that without the theory
of power series most of mathematical physics . . . as we know it would not exist.
Of course, the power series solution techniques demonstrated here have seldom,
if ever, seen application in the accounting literature. Hence, one cannot help but
wonder whether the current xation with linear information dynamics in accounting
theory is a convenient simplifying assumption which imparts the analytical tractability
necessary to insure the existence of simple closed form solutions to the valuation
equations.
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DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 285
APPENDIX
Adjacency matrices
Suppose we expand the transactions matrix so that in addition to the
equity, assets, and liabilities account categories contained in the text, we
also include an account for earnings. The earnings account records all the
bookkeeping entries relating to sales, income and expenses. The expanded
transactions matrix will then take the form:
Nt,tt=
Cr
Earnings Equity Assets Liabilities
Earnings a
11
t,tt a
12
t,tt a
13
t,tt a
14
t,tt
Dr Equity a
21
t,tt a
22
t,tt a
23
t,tt a
24
t,tt
Assets a
31
t,tt a
32
t,tt a
33
t,tt a
34
t,tt
Liabilities a
41
t,tt a
42
t,tt a
43
t,tt a
44
t,tt
Now, dene the adjacency matrix A=
_
_
_
1 0 0
1 0 0
0 1 0
0 0 1
_
_
_. It then follows that
the reduced form transactions matrix employed in the text, Mt,tt,
is equivalent to Nt,tt in the sense that Mt,tt=A
T
Nt,ttA.
Pre-multiplication by the transpose of the adjacency matrix has the effect
of closing rows 1 and 2 of Nt,t t into row 1 of Mt,tt. Post
multiplication by the adjacency matrix has the effect of closing columns 1
and 2 of Nt,tt into column 1 of Mt,tt. It then follows that:
Mt,tt=A
T
Nt,ttA=
_
_
_
_
_
_
_
_
_
2

j=1
2

k=1
a
jk
2

j=1
a
j3
2

j=1
a
j4
2

j=1
a
3j
a
33
a
34
2

j=1
a
4j
a
43
a
44
_
_
_
_
_
_
_
_
_
or that the earnings account has been closed off to the equity account.
Furthermore, this result implies:
Mt,ttM
T
t,tt=
_
_
_
_
_
_
_
_
_
0
2

j=1
a
j3
a
3j

j=1
a
j4
a
4j

j=1
a
j3
a
3j
0 a
34
a
43

j=1
a
j4
a
4j
a
34
a
43
0
_
_
_
_
_
_
_
_
_
286 T. COOKE AND M. TIPPETT
or that the matrix of structural coefcients is dened by:
t,tt=
_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
0
2

j=1
a
j3
a
3j
A(t)
2

j=1
a
j4
a
4j

L(t)

j=1
a
j3
a
3j

S(t)
0
a
34
a
43

L(t)

j=1
a
j4
a
4j

S(t)
a
34
a
43

A(t)
0
_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
Now, consider the rst column of this matrix. If we assume that the ratio
of the account balance, a
jk
, for earnings to the account balance for equity,
S(t), evolves with the drift parameter, m
jk
t, and a normally distributed
stochastic component, s
jk
z
jk
(t), as in the text, then the closure properties
of the normal distribution insure that the sum of these ratios will also
evolve in terms of a normal process with drift. A similar conclusion applies
to the other two columns of this matrix. Hence, there is virtually no loss
of generality, but obvious pedagogical convenience, from considering the
simple 33 transactions matrix, M, contained in the text.
Proof of proposition 1
By equating the elements of the structural matrix, t,tt, contained in
Section 2 of the text, we have b
12
t,tt=!
21
t,ttS(t)t and b
12
t,t
t=!
12
t,ttA(t)t. Now since A(t)=1g(t)S(t) it follows that
b
12
t,tt=!
12
t,ttA(t)t=!
12
t,tt1g(t)S(t)t. We then
have that !
21
t,ttt=!
12
t,tt1g(t)t. Algebraic manipulations
similar to this also show that !
31
t,t tt =!
13
t,t tg(t)t and
!
32
t,ttt=!
23
t,tt.
g(t)
1g(t)
t.
Proof of proposition 2
We begin by approximating the upper diagonal elements of the structural
matrix, t,tt, dened in Proposition 1 by an intertemporally constant
expected component and a normally distributed stochastic component as
follows:
!
jk
t,ttt-m
jk
ts
jk
z
jk
(t)
for j<k. It thus follows that !
jk
t,ttt has an expected value of m
jk
t and
s
jk
z
jk
(t), the stochastic component, is normally distributed with zero mean
DOUBLE ENTRY BOOKKEEPING, STRUCTURAL DYNAMICS 287
and variance s
2
jk
t. Substitution then shows that discrete time movements
in the rms nancial variables take the form:
x(t)=t,ttx(t)-
_
_
_
0 m
12
m
13
1g(t)m
12
0 m
23
g(t)m
13
g(t)
1g(t)
.m
23
0
_
_
_
_
S(t)
A(t)
L(t)
_
t

_
_
_
A(t)s
12
z
12
(t)L(t)s
13
z
13
(t)
1g(t)S(t)s
12
z
12
(t)L(t)s
23
z
23
(t)
gS(t)s
13
z
13
(t)
g(t)
1g(t)
.A(t)s
23
z
23
(t)
_
_
_
If we now substitute L(t)=g(t)S(t) and A(t)=1g(t))S(t) for A(t) and
L(t) in the stochastic component and take limits such that Limitt
t0
=dt and
LimitS(t)
t0
=dS(t) etc., then the evolution of the bookkeeping variables may
be described by the vector system of stochastic differential equations:
_
dS(t)
dA(t)
dL(t)
_
=
_
_
_
0 m
12
m
13
1g(t)m
12
0 m
23
g(t)m
13
g(t)
1g(t)
.m
23
0
_
_
_
_
S(t)
A(t)
L(t)
_
dt

_
_
s
12
1g(t)dz
12
(t)s
13
g(t)dz
13
(t)
s
12
1g(t)dz
12
(t)s
23
g(t)dz
23
(t)
g(t)s
13
dz
13
(t)g(t)s
23
dz
23
(t)
_
_
S(t)
This is the result reported in the text.
Proof of proposition 3
It os Lemma implies that the debt to equity ratio, g=
L
S
, will evolve in
accordance with the formula (Kloeden & Platen, 1992, pp. 9099):
dg=
@g
@L
dL
@g
@S
dS
1
2
(dL)
2
.
@
2
g
@L
2
(dS.dL)
@
2
g
@L@S

1
2
(dS)
2
.
@
2
g
@S
2
Now, since
@g
@L
=
1
S
,
@g
@S
=
L
S
2
,
@
2
g
@L
2
=0,
@
2
g
@L@S
=
1
S
2
and
@
2
L
@S
2
=
2L
S
3
, substi-
tution results in the following stochastic differential equation:
dg
g
=
dL
L

dS
S

dS
S
.
dL
L

_
dS
S
_
2
288 T. COOKE AND M. TIPPETT
Given the stochastic processes for S, A, and L contained in proposition 2 of
the text, we have:
dS=[m
12
1ggm
13
]Sdt[s
12
1gdz
12
s
13
gdz
13
]S,
dL=[gm
13
gm
23
]Sdt[gs
13
dz
13
gs
23
dz
23
]S,
Var
t
(dS)=[s
2
21
1g
2
s
2
13
g
2
]S
2
dt
and:
Cov
t
dS,dL=s
2
13
g
2
S
2
dt.
Substitution then implies:
dg
g
=[s
2
12
s
2
13
1g
2
1gm
12
m
13
s
2
13
m
23
]dt
1gs
12
dz
12
s
13
dz
13
s
23
dz
23
and by applying the mean and variance operators to this expression, we
obtain the results reported in the text.
Proof of proposition 5
Eulers Theorem for homogeneous functions shows that BlS, g=lBS, g
if and only if S
@B
@S
=BS, g (Apostol, 1969, exercise 9, p. 287). Furthermore,
the method of separation of variables shows that BS, g=H(S)Jg, where
H(S) and J(g) are differentiable functions of S and g, respectively (Boyce &
DiPrima, 1969, pp. 422429). This, taken in conjunction with Eulers
Theorem implies
H
/
(S)
H(S)
=
1
S
or H(S) =aS, where a is a constant of
integration. It thus follows that the equity valuation dynamics are dened
by the equation BS, g=H(S)Jg=SJg, where the constant term, a,
is suppressed into the expression for J(g). Substituting BS, g=SJg,
into Proposition 4 then shows that J(g) must satisfy the auxiliary equation
specied in Proposition 5.