What Is Deficit Equity?

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Deficit equity, more commonly referred to as negative owners' equity, results when the total value of an organization's assets is less than the sum total of its liabilities. In any company, "equity" represents the amount the owners would theoretically have left over if they were to liquidate the company's assets and pay off all its debts. When liabilities exceed assets, equity is a negative number, and the company is in a deficit equity situation.

The Accounting Equation

  • The basic accounting equation holds that "Assets = Liabilities + Equity," which is easily rearranged as "Equity = Assets - Liabilities." In either version, assets and liabilities are the "real" numbers: Assets are the things the company owns, and liabilities are the company's financial obligations. Equity is simply a remainder in the equation. It's defined by the other two elements. When assets exceed liabilities, then the owners have equity in the company. When it's the other way around, then there's negative or deficit equity.

How It Comes About

  • Deficit equity can occur for any number of specific reasons, but all causes boil down to either a decline in the total amount of assets, an increase in the total amount of liabilities, or a combination of the two. Assets themselves can lose value through depreciation or impairment (an acknowledgment that they're not worth as much as stated on the balance sheet) -- or, if things are really bad, because the company is selling off assets in a fire sale. A firm suffering operational losses will also see its assets shrink as it burns through cash. When a company borrows money to do something besides acquire assets -- to finance operations, for example, or to buy back shares of stock -- then liabilities will increase.

Handling the Accounting

  • Any losses as a result of decreases in asset value are charged against a company’s retained-earnings account in the owners’ equity section of the balance sheet. If losses accumulate over time, eventually the retained-earnings account becomes negative and is relabeled as accumulated deficit. As losses continue to mount, the negative number in the accumulated-deficit account increases, which is added against the accounts of owners’ contributed capital, effectively reducing the amount of total equity. When the accumulated deficit exceeds the amount of owners’ contributed capital, the entire equity account is reduced to a deficit.

Consequences

  • Deficit equity doesn't necessarily mean a company is insolvent. For example, young companies often start out with a lot of debt, but as long as they have enough cash to keep going while they build up the business and become sustainable, they can survive. Still, deficit equity is never a "good" thing. It suggests a company that may not be able to meet its financial obligations, which points to the risk of bankruptcy. Owners may have to inject fresh capital to bring asset value at least back into balance with total liabilities. Depending on negotiations with creditors, owners may continue to operate and try to generate some profits, which will also increase asset value and reduce equity deficit. After all, asset liquidation is unlikely to satisfy all liabilities.

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