This first criterion means that the car will have a net value or book value of $0 once it is fully depreciated. The main reason is to make the remaining shares more valuable, as their prices are expected to rise after the stock buyback. The money left over after a company supports operations can be a snapshot of its financial health. Contra accounts are confusing at first, but, with a little study, understanding them becomes second nature. Let’s go over how they work and what the main types are, and then finish with an example.

• It’s highly likely that your books will benefit from this process in terms of clarity, transparency, and the amount of time it takes to do accounting.
• Accounts receivable is rarely reported on the balance sheet at its net amount.
• Similarly, allowance for receivables will pair with accounts receivable balances.
• For example, based on previous experience, a company may expect that 3% of net sales are not collectible.

In other words, contra accounts are used to reduce normal accounts on the balance sheet. 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. Assume a company has 100 clients and believes there are 11 accounts that may go uncollected. Instead of applying percentages or weights, it may simply aggregate the account balance for all 11 customers and use that figure as the allowance amount.

However, this account does not represent actual irrecoverable debts. However, a contra-asset account usually has a credit or nil balance. This account offsets the balance in the respective asset account that they pair with on the balance sheet. This account serves two purposes — tracking total depreciation expenses while providing you with the accurate book value of the asset being depreciated. Accounts receivable (A/R) has a debit balance, but the allowance for doubtful accounts carries a credit balance.

A contra account is an account that companies use to reduce the value of a related account. It usually nets off against related accounts and provides an opposite effect to the balance. Therefore, contra accounts are the reverse accounts that decrease a specific account’s balance.

This means that accounts receivables have a debit balance of $10,000, and the firm credits revenue for $10,000. A customer returned $100 worth of items, claiming them to be defective. Contra liability accounts are special accounts in the liabilities section of the balance sheet. They aim to reduce the balance of some related liability accounts.

Companies bury them in the footnotes and often don’t break out the actual calculation. Still, it is important when possible to consider how the net accounts are calculated and be wary of companies that are reporting a ton of bad debts. Revenue is an income statement account, but it flows through to the equity section of retained earnings as well. 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.

The Contra Asset Account

There are four key types of contra accounts—contra asset, contra liability, contra equity, and contra revenue. Contra assets decrease the balance of a fixed or capital asset, carrying a credit balance. Contra liabilities reduce liability accounts and carry a debit balance. Contra equity accounts carry a debit balance and reduce equity accounts. Contra revenue accounts reduce revenue accounts and have a debit balance. A contra account offsets the balance in another, related account with which it is paired.

• The auditors aim to keep the balances at their adequate levels, but the controller might want to keep them as low as possible to reduce expenses and maximize profit levels.
• The matching principle states that revenue and expenses must be recorded in the same period in which they occur.
• Similarly, it allows companies to retrieve original account balances without complicated calculations.
• 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.
• By recording reductions in a separate account, companies can get better insights into their actual accounts.

Companies often have a specific method of identifying the companies that it wants to include and the companies it wants to exclude. Accounts Receivable is an asset account that represents the amount of money due to a business for goods or services that have been delivered or used but not yet paid for by customers. Contra asset accounts are necessary for companies for various reasons. The most prominent of these include allowing companies to present a more accurate picture of their assets. Instead, the existence of contra-asset accounts for companies will differ based on a company’s requirements.

The credit balance in this account is amortized or allocated to Interest Income or Interest Revenue over the life of a note receivable. 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.

Contra liability accounts are less commonly used than contra asset accounts. Contra liability accounts are mainly used by corporations that issue bonds frequently. That is because some of the bonds are issued at a discount, so job costing accounting software this reduces the balance of their bonds payable. Allowance for doubtful accounts is netted from the accounts receivable balance. The company predicts which accounts receivable won’t be paid by customers and writes those off.

Financial Management: Overview and Role and Responsibilities

These accounts can significantly reduce balances on the balance sheet. You’ll continue to use the contra asset account until the equipment has been completely depreciated, retired, or sold. 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). The second entry will be accumulated depreciation, which will be in credit. The proper size of a contra asset account can be the subject of considerable discussion between a company controller and the company’s auditors. 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.

Understanding contra accounts

Contra assets are still recorded along with other assets, though their natural balance is opposite of assets. While assets have natural debit balances and increase with a debit, contra assets have natural credit balance and increase with a credit. Even small businesses benefit immensely from contra asset accounts.

Example Contra Account – Allowance for Doubtful Accounts

Obsolete inventory accounts are very important in dealing with this, especially when many smaller businesses struggle with obsolete assets regularly. To oppose the revenue made by a company, contra revenue accounts must have a debit balance. Sometimes, both accounts can be written in a single line if they don’t represent a large portion of the assets. In case the contra asset account is not listed in the balance sheet, it must be listed in the footnotes of the financial statement for the users to be informed. As you saw in the example, contra accounts can be an important part of your financial statement analysis, but they are hard to find.

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. A contra asset account is an asset account with a natural credit balance. This account is paired with and offsets another asset account, so that a net balance is reported on the balance sheet.

What are Contra Accounts?

The first step in accounting for the allowance for doubtful accounts is to establish the allowance. This is done by using one of the estimation methods above to predict what proportion of accounts receivable will go uncollected. For this example, let’s say a company predicts it will incur $500,000 of uncollected accounts receivable. Though the Pareto Analysis can not be used on its own, it can be used to weigh accounts receivable estimates differently. For example, a company may assign a heavier weight to the clients that make up a larger balance of accounts receivable due to conservatism.