In the Statement of Financial Accounting Concepts No. 6, FASB defines both liabilities and equity. “Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events” (FASB 1985, 14). Concept Statement 6 also states that “equity is the residual interest in the assets of an entity that remains after deducting its liabilities” (FASB 1985, 17). Liabilities and equity both have characteristics that help individuals decide which one it is.
Liabilities have three main characteristics; the first is that it represents a current responsibility to one or more other entities that requires settlement by probable future transfer or use of assets at a pre-determined date (FASB 1985, 14). The second main characteristic of a liability is the responsibility obligates a particular entity leaving it no choice on avoiding the future repayment. The third main characteristic of a liability, according to Concept Statement No. 6, is that the transaction or event obligating the particular entity has already occurred. Liabilities have other important features that help identify them but are not required. One instance is that most liabilities have a legally binding contract which states the terms of the liability and when it is to be repaid.
Equity, on the other hand, has one main characteristic. This is that equity can be increased through contributions or investments by owners and the owners may receive distributions of assets from the entity (FASB 1985, 17). Equity ranges from common and preferred stock to retained earnings. Equity also depends significantly on the profitability of the entity. In non-profit organizations, they use the term net assets instead of equity. The main difference between the equity section of business enterprises and the net assets section of non-profit organizations is that not-for-profit organizations do not have an ownership interest in the same sense as a business enterprise. Calculating net assets in a non-profit firm is still the same as calculating equity for a business enterprise, but net assets are not identified as ownership interests.
Trying to distinguish between liabilities and equity is not always cut and dry. Sometimes problems arise in trying to decide if a particular situation is a liability or equity due to the fact that some situations have the characteristics of both liabilities and equity. Some equity transactions, like preferred stock, can potentially have a maturity date where the entity has to pay back the amount of the stock to the party that owns the stock. In that example, the transaction looks like it could potentially be a liability, but it is reported as equity. Another example would be convertible debt. In convertible debt there is an equity component and a liability component. The US GAAP requires the convertible debt to be treated wholly as a liability (Doupnik 2008, 153).
The nature of the entity can also cause problems to arise in trying to determine if the event is a liability or equity. This can be a problem in a non-profit organization mainly because of the nature of net assets. Net assets in a non-profit organization often have stipulations imposed by the donor(s) of the money or asset and can be tough to identify liability or net assets depending on the type of restrictions imposed. The different types of restrictions are permanent, temporary and unrestricted. Permanent restrictions of net assets do not expire through passage of time and cannot be fulfilled or removed from other assets with the same type of condition or reclassification from other types of net assets (FASB 1985, 25). Temporary restrictions of net assets can expire through passage of time and can be fulfilled or removed through actions of the entity towards the conditions from other assets with the same type of condition or reclassification from other types of net assets (FASB 1985, 25). Lastly, unrestricted net assets are the part of net assets that are not permanently or temporarily restricted by conditions. Concept Statement No. 6 says that “the only limits on unrestricted net assets are broad limits from the nature of the organization and the organizations purposes detailed in the articles of incorporation” (FASB 1985, 26) or something similar and perhaps limits from contracts entered into with outside parties.