The allowance method of accounting allows a company to estimate what amount is reasonable to book into the contra account. The percentage of sales method assumes that the company cannot collect payment for a fixed percentage of goods or services that it has sold. We must show the accounts payable fully paid off, so we must debit Accounts Payable for $5,000. With cash, so we must credit Cash for the amount of cash being paid. Therefore, the amount of cash needed to fulfill the obligation is $4,850.

Types of Contra Accounts

Accumulated Depreciation acts as a subaccount for tracking the ongoing depreciation of an asset. A Fixed Asset is a Long-term Asset used by a company to create revenue. Examples of Fixed Assets are Vehicles, Equipment, and Buildings.

In the financial statements the purchases account would be offset against the contra expense accounts to show the net purchases. Contra asset accounts adjust asset values on the balance sheet to reflect their true economic value. A key example is accumulated depreciation, which offsets the cost of tangible fixed assets like machinery or buildings. Depreciation is calculated using methods such as straight-line or declining balance to allocate an asset’s cost over its useful life.

• Emilie is a Certified Accountant and Banker with Master’s in Business and 15 years of experience in finance and accounting from corporates, financial services firms – and fast growing start-ups.
• We will look at this transaction under both methods so you can see the difference.
• To illustrate the use of contra accounts, consider a business accounting for bad debt expenses when customers fail to fulfill payment obligations.
• Bills payable or notes payable is a liability that is created when a company borrows any specific amount of money.

These categories include asset, revenue, and liability accounts. When accounting for assets, the difference between the asset’s account balance and the contra account balance is referred to as the book value. There are two major methods of determining what should be booked into a contra account. Of that amount, it is estimated that 1% of that amount will become bad debt at some point in the future.

Purchase Returns, or Returns Outwards, is a contra expense account with a credit balance used by a buyer to record the value of previously purchased goods returned to a seller due to being damaged, defective, or otherwise undesirable. Bills payable or notes payable is a liability that is created when a company borrows any specific amount of money. If the company repays the loan early, the lender may provide a discount. This discount is subtracted from the total amount borrowed to better reflect the discount given by the lender. A company creates allowances for doubtful accounts to record the portion of accounts receivable which it believes it will no longer be able to collect. The amount in allowance for doubtful accounts is deducted from the accounts receivable account of a company.

AccountingTools

Therefore, contra accounts, though they represent a positive amount, are used to net reduce a gross amount. For this reason, contra accounts are primarily seen as having negative balances because they are used to reduce the balance of another account. Contra accounts are used to reduce the value of the original account directly to keep financial accounting records clean. When an account has a balance that is opposite the expected normal balance of that account, the account is said to have an abnormal balance. For example, if an asset account which is expected to have a debit balance, shows a credit balance, then this is considered to be an abnormal balance.

Revenue Contra Account

The difference between the gross balance of a main account and its contra accounts reported as the net balance in a company’s financial statements is also referred to the contra account purchases discount has a normal debit balance. as a book value, current value, carrying value, or net realizable value. Sales returns, sales allowance and sale discounts are different examples of contra revenue accounts. Contra accounts such as these have a debit balance and are deducted from the total amount of a company’s revenue.

It records a $10,000 allowance for doubtful accounts by debiting Bad Debt Expense for $10,000 and crediting Allowance for Doubtful Accounts for the same amount. This practice adheres to the matching principle, which requires expenses to be recorded in the same period as the related revenues. This adjustment reduces net accounts receivable on the balance sheet and increases expenses on the income statement, providing a comprehensive view of the company’s financial health. Key examples of contra asset accounts include allowance for doubtful accounts and accumulated depreciation. Accumulated depreciation reflects the reduction in value of a fixed asset.

Let’s look at both entries together, since we already discussed the methodology. Again, the only difference is that we do not track the changes in inventory under the periodic system. When the company pays the cost of having the flyer printed, a journal entry is done. The purpose of the Sales Returns account is to track the reduction in the value of the revenue while preserving the original amount of sales revenue.

In case a customer returns a product, the company will record the financial activity under the sales return account. The use of contra accounts ensures the accuracy of financial accounting records, as the value of the original accounts is not directly reduced. In the event that a contra account is not utilized, it can become increasingly troublesome to determine historical costs, which makes tax preparation time-consuming and difficult. The balance in the allowance for doubtful accounts is used to find out the dollar value of the current accounts receivable balance that is deemed uncollectible. A contra expense account is a type of account in financial accounting that offsets the balance of a corresponding expense account.

Gross Profit vs. Net Income: Key Differences and How to Calculate

After 30 days, your payment is now late and the seller can add on late charges or interest, depending on state law. Notice that we used Inventory, because under the perpetual method, whenever the value of inventory is changing, we must show that change in the account.

Contra expense accounts have a credit balance, which is the opposite of the typical debit balance found in expense accounts. The purpose of a contra expense account is to reduce the total expenses shown on the income statement by reflecting specific adjustments, recoveries, or reimbursements related to the expense. To illustrate the use of contra accounts, consider a business accounting for bad debt expenses when customers fail to fulfill payment obligations. The Allowance for Doubtful Accounts, a contra asset account, estimates uncollectible receivables. Under accounting standards like those outlined by the Financial Accounting Standards Board (FASB), businesses estimate and record these allowances to report accounts receivable at their net realizable value. Suppose a company estimates that 5% of its $200,000 accounts receivable balance is uncollectible.