Excess, stored inventory will near the end of its lifespan at some point and, in turn, result in expired or unsellable goods. In this scenario, a write-down is recorded to the reserve for obsolete inventory. In the above example, the debit to the contra liability account of $100 lets the company recognize that the bond was sold at a discount. A doubtful debts contra account allows for future write-offs of accounts receivable. Although you have not officially written off these debts yet, you show them to be a negative balance because you don’t believe the customer will pay you. Although the car is normally an asset because you can sell it for parts or use it for your business, when the car depreciates to a zero or negative balance, it is a contra asset on your balance sheet.
The balance sheet shows the amount in the asset section underneath the accounts receivable. The net value of both these figures is usually reported on a third line. Although they all aim at reducing the balance of some type of account, it is useful to have some general foundational knowledge of the different types of accounts. The definition can be expanded to include contra accounts in general. Contra accounts act like regular accounts on the balance sheet but have a unique purpose. The upright discount on bonds payable represents the difference between the amount of cash a company receives when issuing a bond and the value of the bond at maturity.
The purpose of a contra expense account is to record a reduction in an expense without changing the balance in the main account. For the purpose of financial statement reporting, the amount on a contra account is subtracted from its parent account gross balance to present the net balance. A contra account is an entry on the general ledger with a balance contrary to the normal balance for that categorization (i.e. asset, liability, or equity).
For example, when a line item on your balance sheet presents the balance of accounts receivable, report the value of allowance of uncollectible accounts below the accounts receivable line. Be sure to enter the contra account on the opposite column of the account they’re offsetting. If contra assets appear in the credit column, record contra does everyone need to file an income tax return liabilities on side. In a sales returns and allowances contra revenue account, you offset the balance in the sales revenue account. When the contra account reads $500 and the normal credit balance is $100,000, then your net sales are $99,500. This indicates that out of $100,000 sales, your customers return goods valued at $500.
Understanding a Contra Account
Therefore, it reduces the value of shareholders’ equity by the amount paid for those repurchased stocks. An equity Contra account reduces the total number of outstanding shares listed on a company’s balance sheet. For you to represent these details in the balance sheet, you need a contra account. Only by using this account, you can offset the respective asset account that it is paired in the balance sheet.
If the company repays the loan early, the lender may provide a discount. This discount is subtracted from the total amount borrowed to better reflect the discount given by the lender. A company creates allowances for doubtful accounts to record the portion of accounts receivable which it believes it will no longer be able to collect. The amount in allowance for doubtful accounts is deducted from the accounts receivable account of a company. Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. 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.
Contra accounts help maintain the accuracy of financial records, provide transparency in reporting, and allow for proper tracking and analysis of specific transactions or events. We can see how the $10,000 allowance for doubtful accounts offsets the $100,000 A/R account from our illustrative example above (i.e. the account decreases the carrying value of A/R). A contra account is also known as a valuation allowance, because it adjusts the carrying value of the account with which it is paired. In terms of the journal entries, the debit balance in “Discount on Bonds Payable” is subtracted from the credit balance in the “Bonds Payable”. The first contra liability listed is an original issue discount (OID), a feature of debt financing wherein the issuance price is less than the redemption price. When a company gives a discount to customers in an effort to convince them to buy its goods or services, it is recorded in the discount on sales account.
- However, these accounts do not appear on the financial statement separately.
- However, a contra equity account is a debit balance that reduces the balances reported on equity accounts.
- The percentage of sales method assumes that the company cannot collect payment for a fixed percentage of goods or services that it has sold.
- Both ways of accounting will have the same impact but the later one will give you more information such as purchases cost of machinery; how much depreciation is written off etc.
Thus, the natural balance of a contra account is always the opposite of the account with which it is paired. Given that liabilities have a credit balance, ensure that all your contra liabilities accounts have debit balances. Discount on notes payable and discount on bonds are examples of contra liability accounts. Contra asset accounts include allowance for doubtful accounts and the accumulated depreciation. These items decrease the liability balance on the paired liability account.
Contra Account Definition in Accounting
The difference between an asset’s balance and the contra account asset balance is the book value. Contra liability, equity, and revenue accounts have natural debit balances. These three types of contra accounts are used to reduce liabilities, equity, and revenue which all have natural credit balances. Therefore, for these three, the debit balance actually represents a negative amount. Contra accounts are more commonly paired with asset accounts, such as accounts receivable or inventory, to reduce the carrying values of those assets.
If the related account has a debit as the natural balance, then the contra account will record a credit. Note that the contra liability account has a positive balance (a debit balance), and the liability account normally has a credit balance. Hence, the book value of the liability will be the credit balance of the liability account minus the debit balance of its contra liability counterpart. A contra asset account is an account in the balance sheet that offsets the balance of a regular asset account. When a listed company buys back its own shares from the open market, it records the transaction by debiting the treasury stock account. A company may take the decision to buy back its shares when management feels the stock is undervalued or because it desires to pay stock dividends to its shareholders.
A contra account reduces the reported balance for the paired account. Therefore, this account is the opposite of the amount reported in the original account. For example, assets usually constitute a debit balance on the balance sheet. A contra asset account includes a credit balance that reduces the amount reported for those assets. However, this account does not appear on its own on the balance sheet.
For example, if you bought a car for $10,000 seven years ago and you estimated a seven-year life on the vehicle. Now, the car is worth less than $1,000 and you continue to put more money into upkeep, maintenance, and insurance for the car than the value of the vehicle. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.
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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. As mentioned above, these accounts also pair with a paired account and reduce its carrying balance. 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. 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.
A contra account is a general ledger account with a balance that is the opposite of another, related account that it is paired with. An item on one side of an account which offsets fully or in part on the opposite side of the same account is technically referred to as contra account. A contra account is an account used in a general ledger to reduce the value of a related account when the two are netted together. The term “contra” means “against,” which perfectly describes the role these accounts play in your finances – they are going against the norm. The purpose of the Owner’s Withdrawal account is to track the amounts taken out of the business without impacting the balance of the original equity account. GAAP, the allowance for doubtful accounts represents management’s estimate of the percentage of “uncollectible” accounts receivable (i.e. the credit purchases from customers that are not expected to be paid).
How are Contra Accounts Used and Reported?
However, these accounts do not appear on the financial statement separately. Contra accounts relate to all areas in the balance sheet, including assets, liabilities, and equity. These accounts are crucial in the financial reporting process, as stated above. These balances come from an underlying accounting or accumulation of accounts from the financial systems. However, some items may also reduce the total reported amount on these accounts.
If the values are reported at net value, the users may not able to see how each of the elements has performed over the years. In the realm of accounting, various techniques are used to ensure financial statements provide an accurate and comprehensive view of a company’s financial health. One such method is the use of contra accounts, a type of account that directly correlates and offsets a related account. By reporting contra accounts on the balance sheet, users can learn even more information about the company than if the equipment was just reported at its net amount. Balance sheet readers cannot only see the actual cost of the item; they can also see how much of the asset was written off as well as estimate the remaining useful life and value of the asset.
Taken together, the asset account and contra asset account reveal the net amount of fixed assets still remaining. A contra asset account is not classified as an asset, since it does not represent long-term value, nor is it classified as a liability, since it does not represent a future obligation. Contra accounts are used to reduce the original account directly, keeping financial accounting records clean.