What is equity?

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There are certain principles and concepts that are universal to all students interested in earning an accounting degree online. Understanding these foundational ideas is critical for success in the world of accounting.

Equity in accounting is one of these concepts that accountants of all types must not only recognize, but be comfortable recognizing and working with. It supports many more complicated concepts and is used in a variety of contexts. Let’s review the basic definition of equity, as well as some of the ways in which this term is applied to different accounting concepts and practices.

An accountant reviewing an equity statement on a desktop computer.

Understanding equity in accounting

The most basic equity definition in accounting is a simple equation that provides critical information about an individual or business’s financial position. Equity is what is left over after liabilities are subtracted from available assets, frequently expressed in an equation form as Equity = Assets – Liabilities. This is equally applicable in personal and business accounting, and can be used to measure equity in a specific arrangement as well as for overall financial position. Equity can also be used to describe the value held in a specific asset or ownership interest in a business.

Equity is a vital consideration because it provides an important understanding of the financial health of a specific agreement or overall position of a person or company. If an individual has $5,000 left on a $200,000 mortgage, they have $195,000 of equity in the house. This is a far stronger position than someone who recently purchased a $200,000 home by way of a mortgage and has $195,000 of the loan left to pay off, resulting in just $5,000 of equity in an identically valued asset.

Equity can be either negative or positive. To understand an example of negative equity, consider that a person or business may have a loan for some type of property, such as a car, real estate, or piece of heavy equipment, where the total cost of the loan exceeds the established value of the asset. That may be caused by interest and other costs inflating the value of the loan, especially soon after the loan agreement comes into effect.

As the business or individual pays down the associated debt, assuming this happens faster than the value of the asset depreciates, equity will shift from negative to positive. Negative equity can represent a serious issue. A downturn in real estate prices could create long-term negative equity concerns for mortgage holders. However, it can also be just a short-term reality of taking out a loan tied to a piece of property, where the overall cost of the loan due to interest and fees is almost always more than the cost of directly purchasing the asset outright.

What is the equity method of accounting?

The equity method of accounting specifically refers to a practice that businesses use to measure the positive or negative results of investments into other organizations. Effectively and accurately quantifying the return on that investment is vital for successful accounting efforts and, in turn, to inform financial and operational decisions made using that information. A number of specific considerations, such as accounting for the original purchase of an outside company’s stock and then reassessing the value of that purchase periodically as the stock price moves, are also important to the equity method of accounting.

What is debt and equity financing?

Debt and equity financing are similar on the surface, but represent significantly different methods of securing the funding necessary to operate a business. A simple equity financing definition is exchanging equity, such as ownership in a company, for money. The funding can be used for nearly any legitimate business purpose, from stabilizing finances after a major emergency to providing fuel for diversification and expansion. In equity financing, the new owners of the equity can exert some level of control over the business in proportion to the amount of equity they hold, but there’s no requirement to pay the purchase amount back.

Debt financing, on the other hand, focuses on securing money in the short term in exchange for a promise to pay back the sum, generally with interest, over time. This approach creates a legally binding agreement between the institution or individual providing the financing and the issuing business. There are serious consequences if the company can’t repay the loan, up to and including forfeiting critical assets. However, debt financing also limits the provider’s influence on the business, due to the nature of loan and financing agreements, and includes a firm end point for the relationship between the two parties.

Learning more about accounting at the University of Alabama at Birmingham

A well-rounded, in-depth education should be a top priority for all students considering earning an accounting degree online. The University of Alabama at Birmingham provides both deep dives into core accounting topics like equity and introductions to concepts from across the world of modern business. An online accounting degree from UAB can be especially valuable because it also includes respected, knowledgeable faculty and an asynchronous learning environment that allows students to balance learning with existing personal and professional needs. To learn more, get in touch with an enrollment advisor today.

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