For example, when depreciating an asset, the accumulated depreciation account is used to reduce the book value of the asset while also keeping track of the total amount of depreciation that has been posted to date. 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). 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. The allowance method of accounting allows a company to estimate what amount is reasonable to book into the contra account. The percentage of sales method assumes that the company cannot collect payment for a fixed percentage of goods or services that it has sold. When accounting for assets, the difference between the asset’s account balance and the contra account balance is referred to as the book value.
- For example, let’s say your accounts receivable balance is currently $11,500, but you’re not entirely sure that you’ll be able to collect the entire balance due.
- It is paired with the trade accounts receivable account, and contains a reserve for receivables that are unlikely to be paid by customers.
- However, some asset accounts need a negative counterpart to reduce the balance of that account.
- By recording reductions in a separate account, companies can get better insights into their actual accounts.
In either case, the net amount of the pair of accounts is referred to as the book value of the asset account in question. When a contra asset account is not stated separately in the balance sheet, it may be worthwhile to disclose the amount in the accompanying footnotes, where readers can readily see it. Inventory obsolescence is an expense account, while the allowance for obsolete inventory is a contra asset account, which aims to reduce the inventory valuation on your balance sheet. Using the allowance for doubtful accounts, the contra asset account will more accurately reflect your true accounts receivable balance and make sure sure that your financial statements reflect the most accurate information possible.
Allowance for Doubtful Accounts
The accumulated depreciation account is perhaps the most common contra asset account used by business owners. 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. To offset this, the allowance for doubtful accounts balance is adjusted via a credit, while the bad debt account is debited to balance out the AR account.
- Contra asset accounts include allowance for doubtful accounts and accumulated depreciation.
- Usually, companies add to the accumulated depreciation account after every accounting period.
- Including contra revenue accounts is important in the income statement because it shows the original amount of sales the firm has made, along with any factor that has reduced that amount.
- This account serves two purposes — tracking total depreciation expenses while providing you with the accurate book value of the asset being depreciated.
- Thus, netting off both will result in the final amount for the account.
- Every contra asset account on a company’s accounting records will also have a pairing account.
At the end of year 20, the car and the accumulated depreciation accounts will be written off from the balance sheet, as the car will be a fully depreciated asset. Note that the asset account balance represents the purchase price of the asset in question, also known as its historical cost. 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. As your business acquires new assets (e.g., machinery, office equipment, vehicles), you record the initial purchase value in your Fixed Asset account. But these items don’t retain that initial value; if liquidated, they would likely be sold at a loss.
This would let users of the financial statements calculate the book value of the liability. 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. Note that in accounting, the term “book value” is also used interchangeably with net value. Therefore, the book value of an asset in the books is equal to its historical cost (the debit balance of the asset) minus the related amount of contra asset in the balance sheet (the credit balance of the contra asset).
This account is paired with and offsets another asset account, so that a net balance is reported on the balance sheet. They are also helpful for keeping the books balanced and creating a clear trail of financial breadcrumbs for historical review and reporting. For instance, it is common to keep the purchase price of a piece of equipment as a historical cost in the debit asset account when it comes to fixed assets. For the purpose of presentation on primary financial statements, we are often concerned only with the net figure of two similar classes/balances which we determine by subtracting one account from the another.
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. Those who are struggling with recording contra accounts may benefit from utilizing some of the best accounting software currently available. 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. To compensate for those potential deadbeat customers, you can use a Bad Debts account to serve as a contra for your A/R. Consider a business that offers an early payment discount to its customers, cutting their invoiced total by 3% if they pay within 1 week of invoicing.
The Contra Asset Account
Because contra asset accounts 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. The natural balance in a contra asset account is a credit balance, as opposed to the natural debit balance in all other asset accounts.
Contra account examples
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 equity is a general ledger account with a debit balance that reduces the normal credit balance of a standard equity account to present the net value of equity in a company’s financial statements. Examples of equity contra accounts are Owner Draws and Repurchased Treasury Stock Shares. By reporting contra asset accounts on the balance sheet, users of financial statements can learn more about the assets of a company. For example, if a company just reported equipment at its net amount, users would not be able to observe the purchase price, the amount of depreciation attributed to that equipment, and the remaining useful life. Contra asset accounts allow users to see how much of an asset was written off, its remaining useful life, and the value of the asset.
Financial Management: Overview and Role and Responsibilities
Notes receivables are promissory notes that include a promise from a borrower to repay a lender. 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. A contra account enables a company to report the original amount while also reporting the appropriate downward adjustment.
Asset accounts always maintain a debit balance, so anytime that you increase the value of an asset, such as when you deposit customer payments or invoice a customer, that asset account is debited or increased. Likewise, when you pay a bill, your cash account is reduced (credited) because you’re lowering the balance. The allowance for doubtful accounts – often called a “bad debt reserve” – would be considered a contra asset since it causes the accounts receivable (A/R) balance to decline. 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.
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So rather than adjusting your Inventory account, you would update its contra account — Obsolete Inventory. The main advantage of using a contra asset account is to separate this reduction from the asset account with which it is paired. By doing so, you can more clearly see the total amount of the related asset account, which would otherwise have been obscured by the offsetting amount of the reserve. 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.