By combining the balances in these two accounts, one can determine the net amount of receivables that the reporting entity expects to receive. The size of the reserve also reveals the amount of bad debt that the company expects to experience from the current set of receivables. To illustrate, let’s use the contra asset account Allowance for Doubtful Accounts.
- Though the Pareto Analysis can not be used on its own, it can be used to weigh accounts receivable estimates differently.
- Learn why contra accounts, when utilized correctly along with a paired account, are a crucial component of accurate accounting and financial review.
- The second method of estimating the allowance for doubtful accounts is the aging method.
- Regardless of that, allowance for receivables accounts will exist for all companies that have account receivable balances.
- An account with a balance that is the opposite of the normal balance.
- For example, a company may assign a heavier weight to the clients that make up a larger balance of accounts receivable due to conservatism.
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. A company, ABC Co., purchased a depreciable asset worth $100,000.
Contra liability accounts
Whenever the balance of an account needs to be reduced in a company’s ledger, it is not always applicable to credit the account if it is an asset or debit the account if it is a liability. 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.
You can estimate the total to record in the allowance for doubtful accounts based on uncollectible revenue totals from the previous year or you can conservatively estimate the amount. By keeping the original dollar amount intact in the original account and reducing the figure in a separate account, the financial information is 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 general ledger even as the asset’s depreciation is recorded separately. Accounts use this method of estimating the allowance to adhere to the matching principle. The matching principle states that revenue and expenses must be recorded in the same period in which they occur.
Contra asset accounts are asset accounts where the balance is a credit balance. They are called “contra” asset accounts because these accounts are contrary to normal accounts. 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.
What Is an Allowance for Doubtful Accounts?
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For example, Accumulated Depreciation is a contra asset account, because its credit balance is contra to the debit balance for an asset account. This is an owner’s equity account and as such you would expect a credit balance. Other examples include (1) the allowance for doubtful accounts, (2) discount on bonds payable, (3) sales returns and allowances, and (4) sales discounts. For example net sales is gross sales minus the sales returns, the sales allowances, and the sales discounts.
While accumulated depreciation is the most common contra asset account, the following also may apply, depending on the company. The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense.
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Since it is a contra asset account, this allowance account must have a credit balance (which is contrary to the debit balances found in asset accounts). The Allowance for Doubtful Accounts is directly related to the asset account entitled Accounts Receivable. Therefore, the net amount of the accounts receivable that is expected to turn to cash is $38,000. The most common contra account is the accumulated depreciation account, which offsets the fixed asset account. Taken together, the asset account and contra asset account reveal the net amount of fixed assets still remaining. 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 Asset Accounting & Examples
The net amount is often referred to as the carrying amount or perhaps the net realizable amount. The allowance for doubtful accounts is not specifically reported, but the 10(K) reported that the allowance is immaterial to the amount. This make sense because Home Depot wouldn’t be carrying accounts receivable with long payment terms.
This frequently happens to manufacturing companies that sell products with an expiration date since any inventory remaining in stock past the expiration date quickly becomes obsolete. This improvement in the accounting details and transparency is good for any business in multiple ways. These accounts might also appear on the balance sheets of the company.
The company’s contra asset account will record unusable or obsolete assets. Assets can become obsolete or unusable for a variety of reasons, such as getting sold or retired because of wear or inefficiency. And it’s particularly important to track and manage these assets. Obsolete inventory accounts are very important in dealing with this, especially when many smaller businesses struggle with obsolete assets regularly.
Contra asset accounts are hugely beneficial for nearly all types of companies. A contra asset account example is an accumulated depreciation account that will help the company track and offset fixed assets. 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 this reduces the balance of their bonds payable.
Last, for contra revenue accounts there are sales discounts, sales allowances, or sales returns. These contra revenue accounts tend to have a debit balance and are used to calculate net sales. This account appears next to the current asset Accounts Receivable.
Contra accounts act like regular accounts on the balance sheet but have a unique purpose. Rather, it is an adjunct account or a valuation account that is added to the face value of the bonds to arrive at the carrying value (or book value) of the bonds on the balance sheet. Therefore, these companies must maintain an obsolete inventory reserve account to net off any unusable stock from the account.