What it means
Most accounts have a natural side. Assets normally have debit balances, while liabilities, equity and income normally have credit balances.
A contra account sits on the opposite side from its partner, so the pair nets down to a more accurate figure. The reason for keeping a separate account, instead of simply changing the original, is transparency.
If a machine cost $90,000 and the accumulated depreciation is $30,000, the balance sheet can show both numbers and the reader sees how old and how heavily used the asset is. Writing the machine straight down to $60,000 would lose that information.
Common examples include accumulated depreciation against fixed assets, the allowance for doubtful accounts against receivables, sales returns and allowances against sales revenue, and discount on bonds payable against the bond liability. Treasury stock, which is the company's own shares bought back, works as a contra account within equity.
In a business setting, contra accounts let managers measure real performance. A gross sales figure with a separate line for returns and discounts shows how much revenue is being given back, which can point to quality or pricing problems.
A receivables balance with a separate allowance shows how much of the money owed management does not expect to collect. On the financial statements, the original account and its contra are usually presented together as a net figure, with the details shown in the notes or on the face of the statement.
The net amount is called the carrying value or book value. Auditors pay attention to these accounts, because the estimates behind them, such as how many debts will go unpaid, involve judgement and can be used to smooth profit.
In practice
Real-world examples
Example 1
A delivery firm bought vans for $300,000. After three years, the accumulated depreciation account holds $135,000, so the vans appear at a net book value of $165,000 while the original cost remains visible. A lender reading the accounts can see that the fleet is nearly half way through its useful life.
Example 2
An online clothing retailer records $2,000,000 of gross sales. Customers return goods worth $240,000, which is recorded in a sales returns account, so net sales are $1,760,000 and management can watch the return rate.
Example 3
A construction company issues bonds with a face value of $5,000,000 for $4,800,000. The $200,000 gap is recorded as a discount on bonds payable, a contra liability that is released to interest expense over the life of the bonds.
Think of it
A contra account is like keeping track of both a gift card's original value and what you've spent. The contra balance shows what's been used up.
Formula
Calculation
Net carrying amount = gross account balance - contra account balance
A distributor has trade receivables of $480,000. Past experience suggests that 5% of this will never be collected, so it sets up an allowance for doubtful accounts of $480,000 x 5% = $24,000. The balance sheet shows receivables of $480,000 less the allowance of $24,000, giving a net carrying amount of $456,000. The $24,000 allowance is also charged as an expense in the income statement.Case study
Seen in the real world
Fernside Medical Supplies is an illustrative, fictional wholesaler whose receivables had grown to $1,500,000. The bookkeeper had been writing off bad debts only when customers formally went bust, so the receivables balance always looked healthy.
The new financial controller introduced an allowance for doubtful accounts as a contra account, set at a percentage of each ageing band. At the first review, the allowance came to $135,000, which cut reported profit for the quarter but gave a more honest picture.
The bank, which lent against receivables, welcomed the change because it could see the quality of the balance. In this illustrative example, the contra account made a hidden problem visible early enough to deal with it, and collections staff were redirected to the oldest invoices first.
Watch out
Common mistakes
- Treating a contra account as an error because its balance is on the opposite side to what is normal for the category.
- Reducing the original account directly and losing the record of original cost, gross sales or face value.
- Forgetting to adjust the contra account periodically, so the allowance or accumulated depreciation no longer reflects reality.
Questions
People also ask
Is a contra account an asset or a liability?
It takes the classification of the account it offsets, so a contra asset sits in the asset section and reduces total assets. A contra liability, such as a bond discount, reduces the liability in the same way.
Does a contra account change profit?
Many do, because the related charge, such as depreciation or bad debt expense, flows through the income statement, but the contra balance itself is a balance sheet figure. Sales returns and discounts reduce reported revenue directly.
Can a contra revenue account be negative?
It carries a debit balance, which is the opposite of revenue, and it is deducted from gross sales to arrive at net sales.
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