How is 'equity' defined in financial accounting?

In financial accounting, 'equity' represents the ownership interest in a company, which is essentially defined as the residual interest in the assets of an entity after all liabilities have been deducted. This captures the concept that equity is what remains for the owners of the business once all debts and obligations have been satisfied.

For example, if a company has total assets worth $1 million and total liabilities of $600,000, the equity would be $400,000. This figure indicates the net worth of the company and reflects the amount that would be returned to the owners if the assets were liquidated and all debts paid off.

This definition is critical for understanding various financial metrics and ratios used in assessing a company's financial health, such as return on equity, which measures the profitability relative to the equity invested by the owners. It is a cornerstone concept that ensures clarity in financial reporting and provides stakeholders with insight into the financial standing of the business.