A contra account is a ledger account related to another specific ledger account. In fact, as the name “contra” suggests, it is the opposite of a specific class of account.
A contra account is used to reduce the value of the opposite related account. This means if the associated account is a debit, the contra account would be credit in nature and vice versa.
This way the company can report an item on the balance sheet at its original amount and show a reduction in value separately in order to report its net realizable value.
A contra account is reported on the same financial statements as its associated account.
For example, if the contra account is related to an asset then it would be referred to as contra asset and reported on the statement of financial position right below the related asset, reducing it to its net realizable value.
3 Examples of contra accounts:
1) Allowance for doubtful debt
Allowance for doubtful debt is a provision created for invoices that are expected to be uncollectible at some point in future years. It is a contra asset account and is directly related to the accounts receivable (asset).
Since we are unsure of exactly which customer would default his payment, we can’t directly credit the accounts receivable account or the accounts receivable subsidiary ledger.
Hence, a contra account i.e. the allowance for doubtful debt account is maintained. Allowance for the doubtful debt has a credit balance since its related account is an asset and has a debit balance.
For example, a company has an accounts receivable balance of $30,000 for the year ended 31st December 2019.
Simultaneously, allowance for doubtful debt account shows a closing balance of $5,000.
This means that the company is owed $30,000 from the customers it made sales to but expects only $25,000 to turn to cash. This would be reported on the balance sheet in the following manner:
|Provision for doubtful debt||(5,000)||25,000|
2) Allowance for (Accumulated) depreciation
Accumulated depreciation or allowance for depreciation is another contra asset account that is associated to fixed assets such as property, plant and equipment.
Instead of reporting the assets at their carrying amount directly, assets are reported at their historical costs and are reduced to book value by reporting the allowance for depreciation along with it.
Netbook value or carrying amount of an asset is its historical cost less accumulated depreciation. This way the records are kept clean and transparent. This method also makes tax preparation easier.
For example, a company has total fixed assets worth of $50,000 for the year ended 2019.
The accumulated depreciation balance is $20,000. This means that the company bought its fixed assets for $50,000 but now after usage the asset’s net book value is $30,000 only.
All of this information is reported on the balance sheet so that it is easier for the readers to understand the financial position of the company.
In the non-current assets section of the balance sheet, this information would be portrayed as follows:
|Property, plant and equipment||50,000||–|
3) Sales Returns and Allowances
Sales return and allowance is a contra revenue account. Instead of reporting the net sales on the income statement directly, the sales returns are shown as well.
This helps the reader to know how many sales were actually made and how many customers had problems with the goods sold.
For example, a company made sales of $60,000 but goods worth of $2,000 were returned due to damage.
This means that the total sales company did were for $60,000 but the customers had a problem with only $2,000. Hence this information shall be reported on the income statement in the following manner: