Assets are what you own, liabilities are what you owe and equity is the difference between your assets and your liabilities. In other words, equity is the net worth of a business.

In accounting a clear distinction is made between the owner and the business. Therefore, any funds contributed by the owner is seen as a claim against the business. This means that if the business dissolves, the owner can take its equity out of the business (provided there is any left after paying debtors).

Equity is further broken down into 2 main sources namely:

• Retained earnings – is all past earnings kept in the business. This is computed as previous earnings less withdrawals from the business.
  
• Capital contributions – This is money you and other investors put in the business in exchange for ownership.
  

Retained Earnings: A very important equity account

Retained earnings is the cumulative earnings of the business less distributions. In other words, net income from the profit and loss statement gets added to retained earnings. The retained earnings account increases the equity account and any withdrawals made decreases the retained earnings account.

In most financial software, retained earnings is automatically tracked for you. You do not need to make any entry in your retained earning account. To view your retained earnings, you will have to take a look at the equity section in the balance sheet.

Accumulating retained earnings increases your ability to make investments in assets that can help produce more revenue.

Investments by owners/ contributed capital

Owners frequently transfer assets (usually cash) to the business in exchange for equity (ownership). A contribution of an asset by the owner increases equity. The way you record capital contributions is dependent on your business entity. Also, when you put your personal funds in the business, be careful not to categorize this as revenue.

In summary, the equity account displays the net worth of your business. Equity consists of retained earnings and capital contributions. Care should be taken to keep these accounts accurate over the life of a business. An accurate equity account makes it easier to value your business.