In bookkeeping, asset accounts report the value of your company's cash, equipment, raw materials and other assets. Their value is normally zero or positive. A contra asset account has a negative balance. These accounts keep track of factors that reduce the worth of your assets.
TL;DR (Too Long; Didn't Read)
A contra asset account is paired with an asset and reduces its value. If your factory equipment represents a $1.7 million asset but it's depreciated by $700,000, you'd record the depreciation in a contra asset account. Comparing the two gives you the book value of $1 million on the equipment.
Examples of Contra Accounts
Contra asset accounts are examples of negative assets. Even though they're listed in the assets section of the balance sheet where accounts are normally positive, contra assets represent negative amounts. Examples of contra accounts include accumulated depreciation, allowance for doubtful accounts and reserve for obsolete inventory.
- Lots of assets, such as buildings, vehicles and equipment, wear down and lose value over time. Depreciation represents that loss of value. The accumulated depreciation account records the total depreciation for the years. Subtracted from the asset account, it shows you the actual book value of the asset.
- The allowance for doubtful accounts appears next to accounts receivable in your books. It represents the amount of money due to the company that you don't think you'll be able to collect.
- The reserve for obsolete inventory is management's guesstimate of how much of the inventory is spoiled or otherwise unusable. It's paired with the inventory account.
You can find other examples of contra accounts in sales. Sales returns is an example of a contra revenue account. If your store sells $15,000 worth of goods this week but has to refund $1,200 for returned merchandise, the $1,200 goes in the sales returns account. The sales discounts account serves a similar purpose.
Why Use Contra Accounts?
Contra accounts are useful for two primary reasons. For one, listing assets and examples of negative assets separately provides more information.
Recording asset accounts and depreciation separately, for instance, tells anyone reviewing your balance sheet how much the asset cost, how much it has depreciated and how much of a useful life remains. They wouldn't know any of that if you just subtracted depreciation and recorded only the asset's net value.
Likewise, separating the allowance for bad debt from accounts receivable lets you calculate the profitability of your sales team. Other examples of contra accounts deal with variables where the exact value is unknown. Sales discounts often depend on how fast your customers pay their bills. You can estimate based on experience, but you won't know for sure until they actually pay.
Too Much? Too Little?
Because many examples of contra accounts are dealing with projected losses and not definite ones, it's tempting to fudge and underestimate the contra amounts so as to make your company look healthier. This is a common issue when companies undergo audits, as auditors usually worry more about adequate contra reserves than how good the company's bottom line looks.
Some companies even use the contra asset accounts to commit a minor amount of fraud. If you increase the inventory reserve during profitable periods, you can reduce it when business slows down. With a smaller contra account, your inventory assets look more valuable, which makes your company look more profitable.
Standard accounting practice is to draw on your past business statistics. If you know that on average, 2% of your accounts receivable go unpaid, that makes a good figure to use for your contra account. This avoids the unpleasant shock you might get if you underestimate potential losses.
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