Equity as Residual Claims

Equity is simply the difference between assets and liabilities. The owner has positive equity only to the extent that assets exceed liabilities. If a business has $1,000 of assets and $600 of liabilities the $600 of liabilities are, in effect, a claim on the assets. Equity is the difference between the assets and liabilities, or $400.

Equity = Assets - Liabilities

Equity is simply the difference between assets and liabilities. The owner has positive equity only to the extent that assets exceed liabilities. If a business has $1,000 of assets and $500 of liabilities the $500 of liabilities are, in effect, a claim on the assets. Equity is the difference between the assets and liabilities, or $500.

If a business ceases operations remaining assets first go to outside creditors. The claims of owners can be realized only after outside creditors’ claims are satisfied. So equity represents the owners’ residual claim on business assets.