Small businesses using the double-entry accounting method should get well acquainted with the contra account. This is a bookkeeping staple. This type of account helps balance your accounting records to accurately portray expenses that come up through the course of business. For example, a contra account can help you factor in a sales discount or a customer who won’t pay what’s owed.
There's no way around it: Contra accounts are extremely valuable, especially if you’re following generally accepted accounting principles.
TL;DR (Too Long; Didn't Read)
Contra accounts are used in conjunction with related accounts to reduce the value and account for certain assets and liabilities. Unless you're a sole proprietor using a single-entry bookkeeping method, you're going to want to use them.
What Is a Contra Account?
Contra accounts are generally used in double-entry bookkeeping. This type of account should be used in a general ledger to reduce the value of a related account when the two are added together. The contra is the opposite of the related account. In other words, if the related account puts down a credit in a journal entry, the contra account should put down a debit.
Digging deeper, the contra doesn’t have to just appear on a general ledger, though you will frequently see it there. It’s often included on various financial statements like a balance sheet or income statement where the account it’s balancing appears. Typically, it’s listed directly below the account with which it’s paired, though some financial statements may merge the accounts to show a single net amount.
How Do Contra Accounts Work?
Contra accounts should appear on the same financial statements as the accounts to which they’re tied. They’re split into two types of accounts: contra liability accounts and contra revenue accounts (also known as contra asset accounts). Contra liability accounts are paired with related liability accounts, like accounts payable and interest payable. Contra revenue accounts are paired with asset accounts, like accounts receivable, inventory or cash.
Of course, these two main accounts have a number of different subsets. For example, a contra asset account used in conjunction with accounts receivable is called an allowance for doubtful accounts or bad debt reserve. In this case, the contra account might represent outstanding customer debts that you probably won’t be able to collect.
The only way to truly understand how contra accounts work is to see them in action. For example, if accounts receivable has a debit balance of $40,000 and you’re unlikely to be able to claim $5,000 of that, you may put that $5,000 credit balance into a bad debt reserve contra account. Combined, the net accounts would have a total sum of $35,000: the money that’s actually in accounts receivable after you account for consumer negligence.
Accumulated Depreciation Account
There are multiple types of contra asset accounts that can be used to show a company’s true financial picture on a balance sheet. One of these is the accumulated depreciation account, which marks the total amount of a depreciation expense of a specific asset. This should be used when a company has assets that have lost value over time because it allows a company to show both the cost of the asset and the actual value of the asset on a balance sheet. Remember that things don’t always cost what they’re worth.
For example, say a company purchases $100,000 worth of equipment in 2015. The equipment is expected to operate for five years, meaning it depreciates $20,000 each year it’s in use. At the end of the first fiscal year, the accumulated depreciation account should show a balance of $20,000, which would make the net value on the balance sheet $80,000. The following year, the depreciation account would show another $20,000 balance, which would make the net value on the balance sheet $60,000.
This, of course, changes if an asset is sold because the accumulated depreciation account must be zeroed out.
Allowance for Doubtful Accounts
Allowance for doubtful accounts, or a debt reserve, is another type of contra asset account. This account focuses on outstanding debts a company can’t recover or doesn’t expect to recover. The main purpose is to show the true revenue because without this allowance, a company’s balance sheet or income sheet may be inaccurate.
For example, a company’s general ledger account may list 10 customers who paid $100 for a service or product. In accounts receivable, this would show as gross revenue for $1,000. Unfortunately, some of those customers may not pay their invoice. If the company expects a particularly delinquent customer to not pay the invoice, it may credit $100 into a bad debt reserve, making the net revenue of accounts receivable $900.
If a regularly delinquent customer does pay, this company can debit the allowance for doubtful accounts on the following income statement.
Reserve for Obsolete Inventory
Let’s be honest: Sometimes, a business cannot sell all of its inventory. Sometimes, it’s just completely lost. A reserve for obsolete inventory is a contra revenue account that factors in this expense on a balance sheet. If your company follows GAAP accounting, this is a mandatory contra account.
This type of contra account is listed in conjunction with an inventory asset. For example, the asset account may have $5,000 worth of inventory. If that becomes unsellable, you would credit an allowance for $5,000 obsolete. This essentially erases the asset on your financial statement, leaving you with a total amount of $0.
Sales Discount Account
This type of contra account helps businesses deal with sales discounts given to customers. It’s similar to an obsolete inventory account but will offset the revenue affected by sales.
For example, if a business sells $100 worth of inventory to a consumer, the accounts receivable would read $100 in profit. However, what if you gave the customer a 10% discount because he signed up for your email list? In this case, you’d add $10 to the sales discount account, which would show a total revenue of $90.
Liability Asset Accounts
Contra liability accounts are less common than contra asset accounts, but they are used by companies that are issuing bonds. This helps offset credit to another liability account (i.e., it adjusts the book value of liability). Liability accounts may include:
- Discount on bonds payable
- Bond issue costs
- Debt issue costs
- Discount on notes payable
These are used if, for example, companies are selling discount bonds. For example, if a company sells a $1,000 bond for $900, it will have to make a number of entries into the related contra accounts. These journal entries would include a $900 debit to the cash account, a $1,000 credit to the bonds payable account and a $100 debit to the discount on bonds payable account.
Why discount? The word "discount" is used to indicate the literal discount you’re giving on the bonds. In the case of a $900 bond worth $1,000, that discount would be $100.
Contra Equity Accounts
Contra equity accounts are another type of contra account that helps level out losses in stockholders’ equity. It’s made to reduce the amount of equity held by a business and is split into two different types of accounts:
- Treasury stock account: This marks the amount a business pays to buy back shares from stockholders.
- Owner’s drawing account: This shows the amount paid to a business owner.
It works like this: If a company sells treasury stock but wants to buy back those shares, it would add the amount paid for the shares to the contra equity account. This would offset the total value of stocks held by shareholders.
- AccountingTools: Contra Equity Account
- Investopedia: Obsolete Inventory
- Double Entry Bookkeeping: What is a Contra Revenue Account?
- Investopedia: Contra Liability Account
- Corporate Finance Institute: What is a Contra Asset Account?
- Corporate Finance Institute: Accumulated Depreciation
- Corporate Finance Institute: Allowance for Doubtful Accounts
- AccountingTools: Contra Accounts
- Investopedia: Contra Account