A contra account is a specific type of account in a general ledger used to reduce the value of a related account when the two are netted together. Its natural balance is the opposite of the associated account. For example, if a debit is the natural balance in the related account, the contra account records a credit. One common example is the contra account for a fixed asset, known as accumulated depreciation.
Key Takeaways
- A contra account reduces the value of a related account in the general ledger.
- They help preserve historical values while separately presenting decreases or write-downs that result in the current book value.
- Typically, they are listed on the same financial statement as the associated account, appearing directly below with a third line for the net amount.
- By using contra accounts, financial records remain clean and transparent without reducing the value of the original account directly.
- Examples include accumulated depreciation and allowance for doubtful accounts.
Comprehensive Understanding of Contra Accounts
Contra accounts are included in the same financial statement alongside the associated accounts. For instance, a contra account for accounts receivable, often referred to as the allowance for doubtful accounts, serves as a contra asset account.
This type of account can also be called a bad debt reserve. The balance of the allowance for doubtful accounts shows the dollar amount of current accounts receivable expected to be uncollectible. This amount is listed under accounts receivable in the asset section of the balance sheet, with the net value reported on a third line.
Accountants prefer using contra accounts to avoid directly reducing the original account value, which helps keep financial records clean. Without a contra account, determining historical costs can become challenging, complicating tax preparation and other financial analyses.
For example, if heavy machinery is purchased for $10,000, that figure remains on the ledger even as it depreciates over time. Contra accounts add more clarity and improve financial reporting transparency.
Types of Contra Accounts
Here are the four key types of contra accounts:
- Contra Asset: Decreases the balance of an asset and typically holds a credit balance. Examples include accumulated depreciation and allowance for doubtful accounts.
- Contra Liability: Decreases the balance of a liability and typically holds a debit balance. An example is discounts on notes or bonds payable.
- Contra Equity: Reduces the balance of an equity account and typically holds a debit balance. Treasury stock is a primary example.
- Contra Revenue: Reduces the balance of revenue accounts and typically holds a debit balance. Examples include sales discounts and sales returns.
Recording a Contra Account
When recording a contra asset account in a journal entry, the corresponding offset is an expense. An increase (credit) to the allowance for doubtful accounts is also recorded as an increase (debit) to bad debt expense.
The book value, which is the difference between the asset’s account balance and the contra account balance, can be determined using two major methods:
- Allowance Method: Estimates a reasonable amount to book into the contra account.
- Percentage of Sales Method: Assumes a certain percentage of sales will be uncollectible.
Example Scenario
If a company has $40,000 in accounts receivable at the end of the month and estimates that 10% will be uncollectible, a credit entry of $4,000 is made in the allowance for doubtful accounts. Simultaneously, a $4,000 debit entry is made to the bad debt expense. This adjustment means the net accounts receivable value reported on the balance sheet would be $36,000.
Real-World Example: Amazon’s Balance Sheet
A significant example is Amazon’s use of an allowance for doubtful accounts to reduce the balance of gross accounts receivable. The balance of the contra account reflects estimated uncollectibles, ensuring transparency in financial statements.
Benefits of Using a Contra Account
Using contra accounts helps in reducing the original account value directly, keeping financial records clean and making historical cost determination straightforward.
Types of Contra Accounts
Four primary types exist:
- Contra Asset: Decreases the balance of an asset (credit balance).
- Contra Liability: Reduces liability balances (debit balance).
- Contra Equity: Decreases equity balances (debit balance).
- Contra Revenue: Reduces revenue balances (debit balance).
Examples of Contra Asset Accounts
Examples include the allowance for doubtful accounts, which reduces accounts receivable, and accumulated depreciation, which reflects the reduction in value of a fixed asset.
Positive or Negative Contra Balances?
Depending on your perspective, a contra balance can be seen as positive or negative. For example, a contra asset like an estimate for uncollectible accounts reduces the corresponding gross account balance when netted together.
Debit or Credit Balances in Contra Accounts
- Contra Assets: Natural credit balances, offsetting positive debit balances of assets.
- Contra Liabilities, Equity, and Revenue Accounts: These usually carry debit balances to reduce the natural credit balances of liabilities, equities, or revenues.
The Bottom Line
Using contra accounts aids in reducing the original account values, ensuring transparent and clean financial records and simplifying the determination of historical costs. This practice is particularly vital for accurately representing book values.
Related Terms: general ledger, financial statements, historical costs, book value.
References
- Accounting Tools. “Contra Asset Account Definition”.
- Accounting Tools. “Contra Accounts Definition”.
- Accounting Tools. “The Allowance Method Definition”.
- Accounting Tools. “Percentage-of-Sales Method Definition”.
