In plain English
Equity includes owner contributions, retained earnings or current-year earnings, less draws or distributions.
It can be negative if the business owes more than it owns.
Why it matters
Equity shows how much of the business truly belongs to the owners after debts. It moves with profits, losses, contributions and draws. If owners take out more than the business earns over time, equity shrinks and can turn negative, which is a warning sign for lenders and for the owners themselves.
Clean equity accounts also make tax work easier. Your preparer needs to know each owner's contributions and withdrawals, and messy equity often leads to questions at year end that take time and fees to sort out.
Worked example
Assets $29,000 minus liabilities $16,000 equals equity of $13,000.
How to handle it
- Set up separate equity accounts for contributions, draws or distributions, and retained earnings.
- Use a separate contribution and draw account for each owner if there are several.
- Record owner money in and out to those accounts, never to income or expense.
- At year end, confirm that profit has rolled into retained earnings as expected.
- Review the equity section each quarter and ask about any unfamiliar account or balance.
Common mistakes
- Recording owner draws as an expense, which understates profit and confuses the tax return.
- Leaving opening balance equity with a large balance, which hides errors from setup or old entries.
- Editing transactions in a closed prior year, which changes retained earnings after your return has been filed.
- Lumping all owners together, which makes it hard to show each person's share.
Not the same as: Retained earnings
Equity is the total owner stake in the business. Retained earnings is one part of equity, the profits kept in the business over time. See Retained earnings.
Go deeper
- Owner Equity and Capital Contributions Explained: How to record money an owner puts into a business, what equity accounts do, and how contributions differ from loans and income in your books.
- Closing Entries and Retained Earnings Explained: How the year-end close resets income and expense accounts to zero, rolls profit into retained earnings, and what to watch if numbers look wrong.
Try it
Related terms
- Expense: A cost of running the business, subtracted from revenue to find profit.
- Fixed asset: A long-lived item the business uses, such as equipment, vehicles or buildings.
- Double-entry bookkeeping: A system where every transaction is recorded in at least two accounts so the books stay in balance.
Common questions
What is equity?
The owner's stake in the business: what is left after liabilities are subtracted from assets.
Can you give an example of equity?
Assets $29,000 minus liabilities $16,000 equals equity of $13,000.
Can equity be negative?
Yes. If losses and withdrawals are larger than contributions and profits, equity goes below zero. It means the business owes more than it owns.
Is equity the same as what my business is worth?
Not exactly. Equity is a book value based on recorded costs. A buyer might value the business very differently based on earnings and market factors.
General information, not tax, legal or accounting advice. Confirm rules with the IRS, the NJ Division of Taxation or a licensed professional.