Definition
Equity is the owners' residual interest in a business: what is left of the assets after all liabilities are deducted. It is made up of capital contributed by owners, reserves and retained earnings. Equity has a credit normal balance and grows with profit and new capital, and shrinks with losses and distributions to owners.
How it works
For a company, equity usually shows share capital, legal or other reserves, and retained earnings, the accumulated profit not yet distributed. For a sole trader it is a single capital account plus the year's profit, less drawings.
Revenue and expense accounts are temporary equity accounts: at year end the closing entry moves their net result into retained earnings. The statement of changes in equity explains every movement during the year.
Formula
Equity = Assets - Liabilities
Closing equity = Opening equity + Net income + New capital - Dividends
Example: equity over one year
A company starts the year with 80,000 of equity. It earns net income of 25,000, raises 10,000 of new share capital and pays dividends of 15,000. Closing equity is 80,000 + 25,000 + 10,000 - 15,000 = 100,000.