Contra Asset Account

Published by Alex on

Contra asset accounts are, as the name implies, accounts that are contrary to popular belief. Contra asset accounts have a credit balance as compared to a debit balance that most other types of accounts have. Before we start talking about the finer details, it’s important to know what is a contra asset account.

Another question that we get is what is the relationship between a contra asset balance and the book value. Investopedia notes that the difference between the asset’s contra account balance and its account balance is called the book value.

What is a contra asset account?

Contra asset accounts are asset accounts where the balance is a credit balance. They are called “contra” asset accounts because these accounts are contrary to normal accounts. You’d expect a debit balance in a normal account.

Having a debit balance in a contra asset account will violate its cost principle.

Contra asset accounts are associated with assets that have debit balances. One can determine the net book value of the assets with debit balances upon adding the balances of both balances, the contra asset account and debit account of the asset.

Why are contra asset accounts important for business?

Contra asset accounts are used in general ledgers. The importance of contra asset accounts is generally to reduce the value of some related account. This happens by netting the two accounts together. The contra asset account pulls the value of the combined accounts down, which in turn decreases the value of the second account as well, which is a normal account.

The natural balance of a contra asset account, in this case, is exactly the opposite of the balance of the related account. In other words, it’s a negative value or credit.

Contra asset accounts are reported with the related account on the same financial statement.

3 types of contra asset accounts

Contra asset accounts are an integral part of double-entry bookkeeping. Although there are several types of contra asset accounts, three are primary among them: accumulated depreciation, obsolete inventory, and allowance for doubtful accounts.

Accumulated depreciation

This type of contra asset accounts is used for recording the depreciation within the timeframe of a fixed asset. A fixed asset moves or evolves through various stages. Tracking this is critical for keeping tabs on all your assets.

Machinery, physical space, equipment, vehicles, etc., are some examples of common fixed assets. These will be highlighted in accumulated depreciation accounts. These amounts generally appear on the company’s balance sheets. Ultimately, an accumulated depreciation contra asset account helps the company reduce the gross amount of all the fixed assets within a company.

Obsolete inventory

Obsolete inventory or obsolete inventory reserves is another popular type of contra asset accounts. This type of accounts involves the products or goods of a company that is now unusable or obsolete. This can include debited expenses.

The company’s contra asset account will record unusable or obsolete assets. Assets can become obsolete or unusable for a variety of reasons, such as getting sold or retired because of wear or inefficiency. And it’s particularly important to track and manage these assets. Obsolete inventory accounts are very important in dealing with this, especially when many smaller businesses struggle with obsolete assets regularly.

Businesses can also write off many expenses like these from the financial records even if the inventory has been phased out completely.

This can also be combined with a current inventory account. This allows the financial analyst to evaluate the company inventory’s current market value.

Allowance for doubtful accounts

An allowance for a doubtful account is also called an ADA. ADAs are used to create allowances for clients that bought the company’s goods or services but somehow failed to pay the owed amount.

These accounts might also appear on the balance sheets of the company.

The allowance for these doubtful accounts can ultimately result in the total number of receivables.

An example of recording a contra asset

A contra asset account example is: suppose your company purchases a piece of machinery. You will ideally be depreciating the machinery within a month. The journal entry will include debit at first and credit (in case) later. You’ll also create a contra asset account to track the depreciation.

This account will offset the machinery’s current value. The entry will be a depreciation expense in debit. The second entry will be accumulated depreciation, which will be in credit.

It will always end up in a credit balance. This balance will then be used to offset the asset’s value. Within a month, you’d be able to reduce the book value. This will repeat until the machinery has been totally depreciated, sold, or retired.

Reasons to include contra asset accounts on a balance sheet

Hopefully, you have a pretty clear idea of contra asset meaning—no need to ask to define contra asset accounts anymore. Including contra asset accounts on your balance sheets can be hugely beneficial for your business.

Here are some ways in which they help.

  • They can preserve the historical value of the main account while giving a write-down or decrease in an associated contra asset account, ultimately netting the book value.
  • You’ll be able to keep your books clean by using contra asset accounts on your balance sheets. How? Well, generally, the accountant will be forced to reduce the value of the main account. This is a direct method, but it makes determining the historical costs very difficult. In turn, this makes the entire process of the company’s tax preparation tougher and more time-consuming.
  • Another key benefit of credit asset accounts is making the company’s financial reporting more transparent. This is because the original amount remains intact in the original account, whereas it’s reduced in a separate account.

This improvement in the accounting details and transparency is good for any business in multiple ways. The amount of time it saves is also a key benefit.

So, now you know what a contra asset is. Contra asset accounts are hugely beneficial for nearly all types of companies. A contra asset account example is an accumulated depreciation account that will help the company track and offset fixed assets.

A few of the many critical points of implementation of a contra asset account include:

  1. Accumulated depreciation accounts help a company better tackle the depreciation of fixed assets.
  2. Accumulated depletion accounts allow the company to see and evaluate various types of depletion expenses over a period. This includes tools, business resources, equipment, and so on.
  3. Obsolete inventory reserves help a company to understand the company’s current market value by taking into account unusable or obsolete inventory.
  4. Allowance of doubtful accounts helps a company create an allowance for clients that have failed to pay the owed amount for the purchase of goods and products from the company.
  5. Trade accounts receivable accounts enable a company to manage bills for its clients. These can be done on invoices as well.
  6. Discount on notes receivable accounts is created for when the current value of note receivables is less than the note’s face value.

Concluding our talk on contra asset accounts

In accounting lingo, a dual entry account system includes the concept of a contra entry. It’s an entry that’s the offset or reverse of an entry that’s on the other side of the account. An entry will be recorded on the credit side if and when a debit entry is recorded in an account and vice-versa.

Both these aspects of the transaction are although entered in the same account, are mentioned in separate columns. Every entry is a contrary or opposite entry to each other.

A contra asset account uses this same principle. It’s associated with an asset with a debit account, both of which are on the same books.

Using contra asset accounts can sound troubling at first. It’s a bit of advanced accounting for sure. But the benefits outweigh the learning curve. Companies are recommended to use contra asset accounts for their fixed assets. It’s highly likely that your books will benefit from this process in terms of clarity, transparency, and the amount of time it takes to do accounting.

Setting up contra asset accounts is easy with accounting software. Larger general ledgers will take longer for sure. But the process can be automated to nearly perfect efficiency. A bit more work will be required on the accountant’s or account analyst’s behalf if books are done manually without any software.

Even small businesses benefit immensely from contra asset accounts. This is true even for using account receivables. The primary advantage of doing contra asset accounts, in this case, is that the need to write off very big accounts receivable balances at year’s end is eliminated because those transactions have already been taken care of.

So, now you know what a contra asset is. Contra asset accounts are hugely beneficial for nearly all types of companies. A contra asset account example is an accumulated depreciation account that will help the company track and offset fixed assets.

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