Still, the dollar amounts are separately broken out in the supplementary sections most of the time for greater transparency in financial reporting. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. If you keep a lot of inventory in stock, chances are that some of the inventory will become obsolete. This frequently happens to manufacturing companies that sell products with an expiration date since any inventory remaining in stock past the expiration date quickly becomes obsolete. 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.

The hottest retail item of today can be relegated to nostalgia channels on YouTube tomorrow. And when your business still has some of these outdated, unwanted, or unusable items in your inventory, you’ll want to offset the lost value of these assets in your general ledger and balance sheet. So rather than adjusting your Inventory account, you would update its contra account — Obsolete Inventory. There is almost always a story behind data; a clarification or historical insight that changes the meaning behind raw figures. In a report, layering on that additional context can be easy, but in a general ledger, you have few options for conveying nuance and subtlety.

To compensate for those potential deadbeat customers, you can use a Bad Debts account to serve as a contra for your A/R. Now, if that sounded like a lot of mumbo-jumbo jargon to you, don’t worry. 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. Rather, it is an adjunct account or a valuation account that is added to the face value of the bonds to arrive at the carrying value (or book value) of the bonds on the balance sheet. Similarly, it allows companies to retrieve original account balances without complicated calculations. For stakeholders, looking at both accounts is also crucial in their decision-making process.

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. In finance, a contra liability account is one that is debited for the explicit purpose of offsetting a credit to another liability account. In other words, the contra liability account is used to adjust the book value of an asset or liability. The following are examples of commonly-used contra asset accounts you could create to better understand your business financials.

  1. In bookkeeping, a contra asset account is an asset account in which the natural balance of the account will either be a zero or a credit (negative) balance.
  2. All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group.
  3. Companies that hold inventories for a long time may face accumulating obsolete inventory.
  4. Accounting software can simplify the management of and reporting from your ledger.

Sometimes, it is important to keep the original balance of the accounts and create the contra accounts to be able to calculate the net value of the account. Whenever the balance of an account needs to be reduced in a company’s ledger, it is not always applicable to credit the account if it is an asset or debit the account if it is a liability. Contra accounts act like regular accounts on the balance sheet but have a unique purpose. The difference between an asset’s account balance and the contra account balance is known as the book value. This general structure can be applied across all contra types, so if the parent account has a credit, the contra account will have a debit. Similarly, if the parent account lists entries as debits, the contra account will appear as a credit.

Likewise, when you pay a bill, your cash account is reduced (credited) because you’re lowering the balance. This means that accounts receivables have a debit balance of $10,000, and the firm credits revenue for $10,000. An important function of contra accounts is to preserve the historical value in the main account while presenting a reduction in the net value. By recording the offset in a separate contra account, accountants can see how much of the value in the main account has been offset. 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.

Understanding the Allowance for Doubtful Accounts

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 are used so frequently, it’s worth spending a little bit more time on them here, including common subtypes. However, the “Allowance for Doubtful Accounts” (or “Allowance for Uncollectible Accounts”) is a contra account related to the concept of bad debts. This contra-asset account reduces the accounts receivable balance on the balance sheet to its net realizable value. The Allowance for Doubtful Accounts carries a credit balance that reduces the total amount of accounts receivable to show the amount that the company expects to collect.

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To obtain a cash payout before the note reaches maturity, you can sell these notes to a bank or other financial institution for some price below the note’s face value. The list of asset accounts on your general ledger and balance sheet conveys the combined, potential value of all of the tangible and intangible items that your organization possesses. But in the real world, converting all of that potential into hard cash is highly unlikely, if not impossible. Instead, you need to record this value gap, and a contra asset account serves that purpose. In its general ledger, the business will want to capture its gross sales figures and the actual value of the discount. Sometimes, the current value of a note receivable will fall compared to its face value.

Whenever the balance of a contra asset account increases (credit to the contra asset account), the increased amount is written off as an expense and is reported in the company’s income statement. In the books, the account of the asset would have a debit value of $100,000, and the contra asset account would have a credit value of $30,000. If the asset account had a credit balance or the contra asset account had a debit balance, this would indicate an error in the journal entries. Contra accounts are used to reduce the value of the original account directly to keep financial accounting records clean.

Contra asset account example

You record the allowance for doubtful accounts by debiting the Bad Debt Expense account and crediting the Allowance for Doubtful Accounts account. You’ll notice the allowance account has a natural credit balance and will increase when credited. The company now has a better idea of which account receivables will be collected and which will be lost. For example, say the company now thinks that a total of $600,000 of receivables will be lost. The company must record an additional expense for this amount to also increase the allowance’s credit balance. Management may disclose its method of estimating the allowance for doubtful accounts in its notes to the financial statements.

Namely, within a ledger, each account is intended to contain transactions and balances of a similar type only. But sometimes, dissimilar transactions are important to consider together within a ledger. After each accounting period, the company records a depreciation expense of the asset. Contra accounts are a significant part of a company’s financial statements.

The accumulated depreciation account plays a vital role in representing the accurate value of an asset in the financial statements. An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid. The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible. However, the actual payment behavior of customers may differ substantially from the estimate. 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).

What is a Contra Account?

Similar to depreciation, this account plays a significant role in representing the book value of a company’s assets. Accumulated amortization is an account similar to accumulated depreciation. This account only relates to a company’s intangible assets rather than tangible. The first step in accounting for the allowance for doubtful accounts is to establish the allowance.

Companies technically don’t need to have an allowance for doubtful account. If it does not issue credit sales, requires collateral, or only uses the highest credit customers, the company may not need to estimate uncollectability. 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.

A contra account enables a company to report the original amount while also reporting the appropriate downward adjustment. Contra accounts provide more detail to accounting figures and improve transparency in financial reporting. Contra accounts help provide more accurate financial information by separating certain items and highlighting their impact on the overall financial position.

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