In certain situations, an offset account is required to provide greater clarity to readers of financial information. This offset account is referred to as a ‘Contra’ account for bookkeeping purposes.
There are several different definitions used in the accounting world to explain ‘Contra’ accounts. The following are three of the more commonly used interpretations:
- An account set up to carry the exact opposite balance that is traditionally carried in that type of an account. As an example, revenue accounts are designed to have credit balances, therefore a contra revenue account will carry a debit balance.
- An account designed to offset or adjust its parent account to the correct amount; in accounting this is referred to as ‘Netted’ amount.
- An account that is used as an allowance or as a holding ledger for adjustments to maintain the original balance in the primary account. Examples include allowance for doubtful accounts, depreciation, amortization and discounts.
There is no single correct definition as all three apply frequently in a business chart of accounts. Basically, contra accounts are utilized to help present clearer information to readers of financial reports. They are used to improve the decision model.
To help you understand some of the uses of contra accounts here are some methods and corresponding examples:
Adjustments – to fully appreciate performance or processes in place, contra accounts are used to identify potential issues. The best example of this is in retail. If a customer is sold the wrong product or a bad product, the customer returns the item. An adjustment is used in the Sales section to reflect the returns. Returns is a contra account to sales. Sales traditionally have credit balances and so, returns have debit balances. See this presentation format below:
– Returns ($8,409)
Net Sales $201,598
This same concept is used for allowances and discounts related to sales. For an in-depth understanding of adjustments in the revenue section please read: Returns, Allowances and Discounts in Accounting.
Allocation – in business management often has to ‘guess’ how much utility was consumed during an accounting cycle related to an asset. Whenever a fixed asset is purchased businesses use depreciation to estimate how much utility was consumed or used during the period of time. Sometimes this guess is based on physical use but most often is determined based on time utility. Depreciation is accumulated or added together over several accounting cycles and is recorded in an offsetting or contra account called ‘Accumulated Depreciation’. The primary account identifies the full amount paid for the original assets within that group and the accumulated depreciation identifies the ‘GUESS’ of how much has been consumed since the initial purchase.
On the balance sheet in the fixed assets section there is one account with a credit balance that identifies this – Accumulated Depreciation.
Allowances – very similar to depreciation, allowances adjust an asset for future issues. Depreciation is an estimation of utility used in the PAST, allowances is an estimate of amount that will be lost in the FUTURE. A good example is with accounts receivable. Historically larger operations know based on experience that some customers can’t or refuse to pay their debts to the company. Utilizing historical patterns, a business will guess how much of the current receivables will go uncollected. This is a contra account to customer receivables and is called ‘Allowance for Uncollectible Accounts’. On the balance sheet it looks like this:
Accounts Receivable 42,202
Allowance for Uncollectible Accounts (6,350)
Sub-Total Current Assets $85,861
Notice that the contra account value is in parenthesis? Also, assets always have debit balances except for their corresponding contra accounts. In this case, the allowances account carries a credit balance.
Performance – another method is using contra accounts to evaluate performance. Often performance measurements include acting in a timely fashion or having the capital available to take advantage of an opportunity. Here a good example is early payment discounts for the purchase of materials or inventory. Over on the profit and loss statement in the cost of sales section, discounts are included as a contra account to materials purchased. When the two accounts are netted together the reader can determine the actual amount paid for materials. Looking at each separately tells the reader 1) what is the normal cost for materials, and 2) how much money is saved by paying for the purchases before the required date. Here the performance measured is the ability to process the paperwork and having capital available to take advantage of discounts.
Contra accounts are commonly used in the asset types of accounts. In addition, you’ll find them in the revenue section related to returns. It is rare to see them in the expense types of accounts; however, they do and can happen. Remember, sometimes the industry involved dictates what is normal and uncommon. For example, in the service industry it is not uncommon for administration payroll (in the expense account section) to have a contra account for those hours worked by front office staff to generate revenue. There is a contra entry (credit) in the expense section and debit entry in the Cost of Services Rendered section of the P&L.
For you, you simply need to understand that contra accounts are the exact opposite in the form of balance (credit or debit) to the primary account of origin. Secondly, contra accounts are used to adjust existing balances, allocate out financial value over time or use, allow for future issues or determine performance. ACT ON KNOWLEDGE.
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