What Is a Contra Account?

A contra account is used in a general ledger to reduce the value of a related account when the two are netted together. A contra account's natural balance is the opposite of the associated account. If a debit is the natural balance recorded in the related account, the contra account records a credit. For example, the contra account for a fixed asset is accumulated depreciation.

Understanding a Contra Account

Contra accounts are reported on the same financial statement as the associated account. For example, a contra account to accounts receivable, often called allowance for doubtful accounts, is a contra asset account.

This type of account could be called the allowance for doubtful accounts or a bad debt reserve. The balance in the allowance for doubtful accounts represents the dollar amount of the current accounts receivable balance that is expected to be uncollectible. The amount is reported on the balance sheet in the asset section immediately below accounts receivable. The net of these two figures is typically reported on a third line.

Accountants use contra accounts rather than reduce the value of the original account directly to keep financial accounting records clean. If a contra account is not used, it can be difficult to determine historical costs, which can make tax preparation more difficult and time-consuming.

By keeping the original dollar amount intact in the original account and reducing the figure in a separate account, the financial information is more transparent for financial reporting purposes. For example, if a piece of heavy machinery is purchased for $10,000, that $10,000 figure is maintained on the general ledger even as the asset's depreciation is recorded separately.

Types of Contra Accounts

There are four key types of contra accounts—contra asset, contra liability, contra equity, and contra revenue.

• Contra asset: Account reported along with other assets that naturally have a credit balance.
• Contra liability: Account reported along with other liabilities that naturally have a debit balance.
• Contra equity: Account reported along with other equity accounts that naturally have a debit balance.
• Contra revenue: Account reported along with other revenue accounts that naturally have a debit balance.

Contra asset accounts include allowance for doubtful accounts and accumulated depreciation. Contra asset accounts are recorded with a credit balance that decreases the balance of an asset. A key example of contra liabilities includes discounts on notes or bonds payable. Contra liabilities hold a debit balance. Contra liability accounts are not as popular as contra asset accounts.

A contra liability is an account in which activity is recorded as a debit balance and is used to decrease the balance of a liability. The balance of a contra liability account is a debit balance. This account decreases the value of the liability. Contra Liability a/c is not used as frequently as contra asset accounts. It is not classified as a liability since it does not represent a future obligation.

The third contra type is contra equity. These contras reduce the equity account and carry a debit balance. Contra equity reduces the total number of outstanding shares on the balance sheet. The key example of a contra equity account is Treasury stock, which represents the amount paid to buyback stock.

Last, for contra revenue accounts there are sales discounts, sales allowances, or sales returns. Contra revenue reduced gross revenue, resulting in net revenue. These contra revenue accounts tend to have a debit balance and are used to calculate net sales.

How to Record a Contra Account

When a contra asset account is first recorded in a journal entry, the offset is to an expense. For example, an increase in the form of a credit to allowance for doubtful accounts is also recorded as a debit to increase bad debt expense.

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.

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. Both methods result in an adjustment to book value.

For example, a company has $40,000 worth of accounts receivable at September month-end. It estimates 10% of its accounts receivable will be uncollectible and proceeds to create a credit entry of 10% x $40,000 = $4,000 in the contra account, allowance for doubtful accounts.

A debit will be made to the bad debt expense for $4,000 to balance the journal entry. Although the accounts receivable is not due in September, the company still has to report credit losses of $4,000 as bad debts expense in its income statement for the month. If accounts receivable is $40,000 and allowance for doubtful accounts is $4,000, the net book value reported on the balance sheet will be $36,000.

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Example of a Contra Account

A major example of a contra account is an allowance for doubtful accounts. This contra asset reduces the balance of gross accounts receivable by an estimate of how many receivables will go uncollected. Notice on Amazon's balance sheet that the balance of accounts receivable is noted as being a net amount.

Amazon sheds more light on that net balance in the notes to the financial statements. The balance of the contra asset is composed of the estimate mentioned below.

The Bottom Line

Contra accounts are used to reduce the original account directly, keeping financial accounting records clean. This allows for the easy determination of historical costs. This is particularly important for contra asset accounts. The difference between an asset's balance and the contra account asset balance is the book value.