Within equity, an example of a contra account is the treasury stock account; it is a deduction from equity, because it represents the amount paid by a corporation to buy back its stock. The net amount – i.e. the difference between the account balance post-adjustment of the contra account balance – represents the book value shown on the balance sheet. In this article, we’re going on a deep dive into what exactly a contra account is, how contra accounts work, why and how you would use contra accounts and more.
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. Allowance for doubtful accounts is a contra asset account that is used to offset the balance of the accounts receivable account. It represents the estimated amount of accounts receivable that will not be collected. The purpose of this account is to reduce the carrying value of the accounts receivable on the balance sheet. For example, when a customer’s cheque bounces, a contra account steps in to reconcile the situation financially.
A contra account is an account with a balance opposite the normal accounts in contra asset definition its category. Contra accounts are usually linked to specific accounts on the balance sheet and are reported as subtractions from these accounts. In other words, contra accounts are used to reduce normal accounts on the balance sheet. The main advantage of using a contra asset account is to separate this reduction from the asset account with which it is paired.
Understanding Contra in Accounting: Definition, Examples, and Applications
The most common contra type, contra assets, records the loss in value of any asset accounts listed in your general ledger. And by comparing these contras against their corresponding parent accounts, you can better understand the actual value of the assets retained by your business. Because contra asset accounts are used so frequently, it’s worth spending a little bit more time on them here, including common subtypes. To illustrate the use of contra accounts, consider a business accounting for bad debt expenses when customers fail to fulfill payment obligations.
How are contra asset accounts recorded in financial statements?
- Depreciation is calculated using methods such as straight-line or declining balance to allocate an asset’s cost over its useful life.
- While accumulated depreciation is the most common contra asset account, the following also may apply, depending on the company.
- This process calculates the decline in value of the natural resource and offsets it against the initial appraisal of the land where the resource is being extracted from.
- The most common one you might encounter is treasury stock—where companies buy back their own shares.
- The hottest retail item of today can be relegated to nostalgia channels on YouTube tomorrow.
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What is a Contra Account? Definition
When the two balances are offset against each other they show the net balance of both accounts. Whether reported as separate lines on the financial report or as a cumulative value, the net amount of the pair of accounts is called the “net book value” of the individual asset. For industries that rely on natural resources — mining, logging, oil, gas — depletion tracks the gradual exhaustion of the raw material in question, offsetting that loss in value against the initial appraisal of the land.
By viewing these accounts — the parent and contra — in tandem, business owners can gain broader insights, preserve the historical figures stored in the parent account, and make accommodations for any relevant changes. This accounting practice not only provides a more accurate picture of a company’s financial health but also aligns with key accounting principles that govern financial reporting. Understanding how businesses account for potential failures to pay makes how a firm manages risk far clearer. A contra account is used to offset the balance of a related account and has an opposite balance.
This method helps a third person identify what the book value was at the time of purchase and the remaining value of an asset. If we show $60,000 as an asset in the third year, it will be challenging to understand whether $60,000 is all new purchases or the remaining value of an asset. This account helps all the stakeholders understand the financial numbers accurately. Contra asset account is an important element of the balance sheet or the books of accounts. This is because it tallies two respective debit-credit entry pairs, thereby figuring out the net balance of the asset account. Contra-assets provide stakeholders with a more nuanced understanding of the company’s true financial health by reflecting the deterioration or reduction in value of assets.
Strategic Financial Decision Making
This type of reporting allows anyone analyzing the balance sheet to understand much more about the company and its assets than if they were to simply look at the net value of the depreciated asset. By reflecting both accounts on the balance sheet, analysts can understand both the original price and the total decrease in value of a certain asset over time. Notes Payable and Discount on Notes PayableFor liability accounts, such as Notes Payable, a contra account can reflect the cost of borrowing over time. A Discount on Notes Payable, for instance, accounts for the difference between the cash received and the note’s face value.
The two most common examples of contra asset accounts are the accumulated depreciation contra account, and the allowance for doubtful debts contra account. The natural balance in a contra asset account is a credit balance, as opposed to the natural debit balance in all other asset accounts. There is no reason for there to ever be a debit balance in a contra asset account; thus, a debit balance probably indicates an incorrect accounting entry. When a contra asset transaction is created, the offset is a charge to the income statement, which reduces profits. This account is paired with and offsets another asset account, so that a net balance is reported on the balance sheet.
- From studying the basics of debit and credit, balance sheet accounts have a healthy balance.
- These methods affect the depreciation expense reported on the income statement and accumulated depreciation, which is the contra-asset account used to reduce the carrying amount of the fixed assets.
- Companies bury them in the footnotes and often don’t break out the actual calculation.
- This account offsets the gross revenue to reflect that not all sales result in final transactions.
This works best when a company’s customer base and economic conditions stay relatively stable. This method is a bit more nuanced since it recognizes that the longer an invoice remains unpaid, the less likely it is to be collected—it’s not just applying a raw percentage to all credit sales. Companies sort their AR by age categories and apply increasingly higher percentages to the older ones.
Contra asset accounts are presented on the balance sheet as reductions from the asset accounts they relate to. They typically appear just below the related asset, with their credit balances reducing the total value of the assets, showing the net amount that’s carried on the books. This presentation separates them from positive asset balances for clear visibility of the adjustments.
As time passes, companies gain better information about which accounts might not be collected. Economic conditions change, customer payment patterns evolve, and the receivables balance fluctuates. For example, if a company has a negative balance in its bank account, it can create a contra account to offset the negative balance. Contra accounts are typically used to show the credit balance of an account that has a debit balance, and vice versa. Home Depot reports that returns are estimated at the time of the sale based on historic returns numbers. The amount is not reported, and the net sales amount is reported on the income statement.
The auditors want to ensure that reserves are adequate, while the controller is more inclined to keep reserves low in order to increase the reported profit level. The amount of this reserve is typically based on the company’s historical loss experience for each reserve. 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. In accounting, contra refers to accounts or transactions that are opposite or contrary to another account.
The account Allowance for Doubtful Account is credited when the account Bad Debts Expense is debited under the allowance method. The use of Allowance for Doubtful Accounts allows us to see in Accounts Receivable the total amount that the company has a right to collect from its credit customers. The credit balance in the account Allowance for Doubtful Accounts tells us how much of the debit balance in Accounts Receivable is unlikely to be collected. Normal asset accounts have a debit balance, while contra asset accounts are in a credit balance. Offsetting the asset account with its respective contra asset account shows the net balance of that asset. Equity recorded as a debit balance is used to decrease the balance of a standard equity account.