Question

Company A was sued by Company B. The management of Company A feels that it is probable that it will have to pay the full amount to Company 8. What is the effect of this contingent event on Company A's accounting equation?

a. Increase liabilities and decrease stockholders' equity.
b. Increase assets and increase stockholders' equity.
c. No effect on the accounting equation.
d. Decrease assets and decrease liabilities.

Answer 1

Answer: a. Increase liabilities and decrease stockholders' equity.

Step-by-step explanation:

Contingent Liabilities are obligations that the company may owe if a future event happens such as them being ruled against in a case in court.

Contingent Liabilities are to be recorded in the financial statements only when it is probable that it will happen and that the amount to be paid is reasonably estimable.

Company A's management feels like the loss is probable and that they would have to pay the full amount to company B which means that the loss is both likely and estimable.

Company A should therefore increase their liabilities and debit loss which will come from the Equity thereby reducing it.