When a contra asset transaction is created, the offset is a charge to the income statement, which reduces profits. To illustrate, let’s use the contra asset account Allowance for Doubtful Accounts. Since it is a contra asset account, this allowance account must have a credit balance (which is contrary to the debit balances found in asset accounts).
- Contra accounts serve an invaluable function in financial reporting that enhances transparency in accounting books.
- This type of account can also be called the bad debt reserve or allowance for doubtful accounts.
- Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology.
- Offsetting the asset account with its respective contra asset account shows the net balance of that asset.
You can estimate the total to record in the allowance for doubtful accounts based on uncollectible revenue totals from the previous year or you can conservatively estimate the amount. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.
Allowance for doubtful accounts
However, that $1.4 billion is used to reduce the balance of gross accounts receivable. Therefore, contra accounts, though they represent a positive amount, are used to net reduce a gross amount. For this reason, contra accounts are primarily seen as having negative balances because they are used to reduce the balance of another account. Contra accounts are used to reduce the value of the original account directly to keep financial accounting records clean. A contra account is an account that is paired with another account to offset its balance.
Although the accounts receivable is not due in September, the company still has to report credit losses of $4,000 as bad debts expense in its income statement for the month. If accounts receivable is $40,000 and allowance for doubtful accounts is $4,000, the net book value reported on the balance sheet will be $36,000. When a contra asset account is first recorded in a journal entry, the offset is to an expense. For example, an increase in the form of a credit to allowance for doubtful accounts is also recorded as a debit to increase bad debt expense. Last, for contra revenue accounts there are sales discounts, sales allowances, or sales returns. These contra revenue accounts tend to have a debit balance and are used to calculate net sales.
Example of a Contra Account
The first time a contra asset account is recorded in a journal entry, it is to be deducted from the expense. For example, when the credit amount in allowance for doubtful accounts increases, it is also recorded in the bad debt expense as a debit increase. As asset accounts have debit balances, contra asset account will have credit balance.
Contra accounts appear on the same financial statement as the related account. For example, an accounts receivable’s contra account is a contra asset account. This type of account can also be called the bad debt reserve or allowance for doubtful accounts. Unlike the three previously mentioned contra accounts, contra revenue accounts are not listed in the balance sheet but are written near the top of the income statement.
For example, accumulated depreciation is a contra asset that reduces the value of a company’s fixed assets, resulting in net assets. Far less common is the obsolete inventory reserve, which reduces the overall inventory value on the balance sheet. This contra account holds a reserve, similar to the allowance for doubtful accounts. For each debit against the inventory account, there will be a corresponding credit against the obsolete inventory contra account. A contra account is an asset account that is kept at either a negative or zero balance and is used on a balance sheet to offset the positive balance of a paired asset.
Why should one include contra accounts on a balance sheet?
To compensate for those potential deadbeat customers, you can use a Bad Debts account to serve as a contra for your A/R. Contra accounts provide more detail to accounting figures and improve transparency in financial reporting. In this way, the historical cost, the amount of write-off, and the book value of an asset can always be seen on the balance sheet.
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Contra accounts are used to reduce the balance of the related account, and they are typically used to account for things like accumulated depreciation, allowances for doubtful accounts, and unearned revenue. The most common contra equity account is called “treasury stock.” This special account decreases the number of shares outstanding in the market because the company repurchases some of the shares from its buyers. Therefore, it reduces the value of shareholders’ equity by the amount paid for those repurchased stocks. If a listed company purchases its own shares from the open market, it will have to debit the treasury stock account in order to record the transaction. A company might decide to purchase its stock when the board of directors feel the stock is undervalued or when it wishes to pay its shareholders dividends.
Definition of Contra Asset Account
Consider an asset account, where the values are listed as debits, and the account itself will present a positive total. Conversely, for a contra asset account like depreciation, you would list all entries as a credit, carrying a negative total balance for the overall account. As mentioned, https://business-accounting.net/ usually have a negative value which is the same as a credit balance. That is to completely or partially offset the balance of their related asset accounts. Asset accounts usually have a positive value which is the same as a debit balance.
To put it another way, a contra account is an account listed within a general ledger with the purpose of capturing the reduced value of a paired or related account when the two are added together. Accountants use contra accounts rather than reduce the value of the original account directly to keep financial accounting contra asset accounts records clean. If a contra account is not used, it can be difficult to determine historical costs, which can make tax preparation more difficult and time-consuming. Note that the contra liability account has a positive balance (a debit balance), and the liability account normally has a credit balance.
A contra liability is an account in which activity is recorded as a debit balance and is used to decrease the balance of a liability. It is not classified as a liability since it does not represent a future obligation. Contra liability accounts such as discount on bonds payable and discount on notes payable usually carry debit balances. A contra asset account is an account that is paired with and offsets the balance of a related asset account.
However, some asset accounts need a negative counterpart to reduce the balance of that account. The debit balance of the asset account and the credit balance of the contra asset account determine the net value of the asset. Most accountants choose to record the depreciation over the useful life of an item in the accumulated depreciation contra asset account, which is a credit account. The balance sheet would show the piece of equipment at its historical cost, then subtract the accumulated depreciation to reflect the accurate value of the asset. Normal asset accounts have a debit balance, while contra asset accounts are in a credit balance.
Any products that are sold at a discount or returns are deducted from gross revenue to produce net revenue as the top line on the income statement. For example, a contra account for accumulated depreciation is used to reduce the balance of the fixed asset account. The contra account for accumulated depreciation tracks this decrease in value, and it is subtracted from the balance of the fixed asset account on the balance sheet.