What is a Contra Account
A contra account is an account used in an account ledger to reduce the value of a related account. A contra account's natural balance is opposite of the associated account. If a debit is recorded in a related account, the contra account record also records a credit.
BREAKING DOWN Contra Account
Contra accounts are reported on the same financial statement as the associated account. For example, a contra account associated with accounts receivable is referred to as a contra asset account which is reported on the balance sheet immediately below the asset account to which it relates, and reduces the net reported value of the asset account.
Examples of Contra Accounts
Numerous contra accounts are used within the financial statements. One of the most common contra accounts is the Allowance for Uncollectible Accounts, a contra account to accounts receivable. The balance in the Allowance for Uncollectible Accounts represents the dollar amount expected to go uncollected and reduces the amount reported in accounts receivable. Any increase to Allowance for Uncollectible Accounts is also recorded in the income statement account Bad Debt Expense.
For example, a company has $40,000 worth of accounts receivable on September 30. It estimates 10% of its accounts receivable will be uncollected, and proceeds to create a credit entry of 10% x $40,000 = $4,000 in the contra account, Allowance for Uncollectible Accounts. In order to adjust this balance, a debit entry will be made in the Bad Debt Expense for $4,000. Even though the accounts receivable is not due in September, the company still has to report credit losses of $4,000 as bad debts expense in its income statement for the month. If accounts receivable is $40,000 and Allowance for Uncollectible Accounts is $4,000, the net amount reported on the balance sheet will be $36,000.
Another example of a contra account is the Accumulated Depreciation Accounts which reduce the reporting value of capital assets. Also, Sales Returns is a contra revenue account as the figure is a negative amount net against total sales revenue. Allowance for Obsolete Inventory and Obsolete Inventory Reserve are examples of contra asset accounts.
Maintenance of Historical Cost
Accountants use contra accounts rather than reduce the value of the non-contra account directly to keep financial accounting records clean. If a contra account is not used, it can be difficult to determine historical costs, which can make tax preparation more difficult and time-consuming. By keeping the original dollar amount intact and reducing the figure in a separate account, the financial information is also more transparent for financial reporting purposes. For example, if a piece of heavy machinery is purchased for $10,000, that $10,000 figure is maintained on the financial statements even as the asset gets depreciated.
Determining Book Value
When accounting for assets, the difference between the asset's account balance and the contra account balance is referred to as the book value. The allowance method of accounting allows a company to estimate what to place in the contra account, while the percentage of sales method assumes that the company cannot collect payment for a fixed percentage of goods or services that it has sold. Both methods result in an adjustment of the original account dollar value to book value.
Financial Statement Presentation
A contra account is presented on the financial statements as a negative figure on a line item directly underneath the main account. For example, a line item on the balance sheet reports the dollar value of accounts receivable. A line directly underneath this line may report Allowance for Uncollectible Accounts. The net of these two figures is typically reported on a third line.