Though the Pareto Analysis can not be used on its own, it can be used to weigh accounts receivable estimates differently. For example, a company may assign a heavier weight to the clients that make up a larger balance of accounts receivable due to conservatism. Some companies may classify different types of debt or different types of vendors using risk classifications. For example, a start-up customer may be considered a high risk, while an established, long-tenured customer may be a low risk. In this example, the company often assigns a percentage to each classification of debt. Then, it aggregates all receivables in each grouping, calculates each group by the percentage, and records an allowance equal to the aggregate of all products.

1. Because contra asset accounts are used so frequently, it’s worth spending a little bit more time on them here, including common subtypes.
2. This balance is used to offset the value of the asset being depreciated, so as of September 1, your $8,000 asset now has a book value of $7,866.67.
3. The allowance for doubtful accounts is a contra asset because it reduces the value of the accounts receivable (AR) account on the general ledger.
4. In finance, a contra liability account is one that is debited for the explicit purpose of offsetting a credit to another liability account.

Usually, companies add to the accumulated depreciation account after every accounting period. The allowance for doubtful accounts is a general ledger account that is used to estimate the amount of accounts receivable that will not be collected. A company uses this account to record how many accounts receivable it thinks will be lost. Allowance for doubtful accounts is contra asset accounts that offset the accounts receivable. They are used in case some customers won’t be able to pay the money they owe to the business. As mentioned, contra asset accounts are usually listed below their matching asset accounts, and the net values of those assets are written next to the contra accounts.

What is the importance of Contra Asset Accounts?

Contra liability, equity, and revenue accounts have natural debit balances. These three types of contra accounts are used to reduce liabilities, https://business-accounting.net/ equity, and revenue which all have natural credit balances. Therefore, for these three, the debit balance actually represents a negative amount.

The accounting entries for a discount on notes receivables are as follows. Accounts use this method of estimating the allowance to adhere to the matching principle. The matching principle states that revenue and expenses must be recorded in the same period in which they occur. Therefore, the allowance is created mainly so the expense can be recorded in the same period revenue is earned. Because the allowance for doubtful accounts is established in the same accounting period as the original sale, an entity does not know for certain which exact receivables will be paid and which will default. Therefore, generally accepted accounting principles (GAAP) dictate that the allowance must be established in the same accounting period as the sale, but can be based on an anticipated or estimated figure.

Contra assets decrease the balance of a fixed or capital asset, carrying a credit balance. Contra equity accounts carry a debit balance and reduce equity accounts. Contra revenue accounts reduce revenue accounts and have a debit balance. Contra asset accounts include allowance for doubtful accounts and the accumulated depreciation.

Example of a Contra Account

Contra asset accounts allow users to see how much of an asset was written off, its remaining useful life, and the value of the asset. The contra liability account is less common than the contra asset account. An example of a contra liability account is the bond discount account, which offsets the bond payable account. A contra liability account is not classified as a liability, since it does not represent a future obligation. Note that the debit to the allowance for doubtful accounts reduces the balance in this account because contra assets have a natural credit balance.

Contra assets

It is not classified as a liability since it does not represent a future obligation. Contra asset accounts are a type of contra account that net off against asset accounts. These include accumulated depreciation, accumulated amortization, allowance for receivables, obsolete inventory, and discount on notes receivables.

There are three contra asset accounts that commonly appear in an organization’s chart of accounts. It is paired with the trade accounts receivable account, and contains a reserve for receivables that are unlikely to be paid by customers. By combining the balances in these two accounts, one can determine the net amount of receivables that the reporting entity expects to receive. The size of the reserve also reveals the amount of bad debt that the company expects to experience from the current set of receivables.

If you find managing contra asset accounts to be a daunting task, there lies a solution in outsourcing. Partnering with an outsourced accounting firm such as NOW CFO provides the specialized expertise necessary to manage these accounts effectively, allowing you to make informed decisions with confidence. Therefore, contra-asset accounts differ from other accounts that have a credit balance. To offset this, the allowance for doubtful accounts balance is adjusted via a credit, while the bad debt account is debited to balance out the AR account.

Specific Identification Method

The allowance for doubtful accounts – often called a “bad debt reserve” – would be considered a contra asset since it causes the accounts receivable (A/R) balance to decline. You may not need to use contra asset accounts right now, but as your business grows, using contra asset accounts will likely become a necessity. Writing off your obsolete inventory in this manner allows you to expense the cost of the obsolete inventory while also decreasing your current inventory balance using the contra asset account. Far less common is the obsolete inventory reserve, which reduces the overall inventory value on the balance sheet. This contra account holds a reserve, similar to the allowance for doubtful accounts. For each debit against the inventory account, there will be a corresponding credit against the obsolete inventory contra account.

This account is paired with and offsets another asset account, so that a net balance is reported on the balance sheet. Properly documenting these contra accounts in your ledger can sometimes feel counter-intuitive since they operate in an opposite manner from their parent accounts. Consider an asset account, where the values are listed as debits, and the account itself will present a positive total. Conversely, for a contra asset account like depreciation, you would list all entries as a credit, carrying a negative total balance for the overall account. Contra liability accounts are less commonly used than contra asset accounts.

These contra revenue accounts tend to have a debit balance and are used to calculate net sales. Some of the most common contra assets include accumulated depreciation, allowance for doubtful accounts, and reserve for obsolete inventory. Contra asset accounts represent a realistic picture of your business’s financial health and ensure adherence to accounting standards.

For example, a company may know that its 10-year average of bad debt is 2.4%. Therefore, it can assign this fixed percentage to its total accounts receivable balance since more often than not, it will approximately be close to this amount. The company must be aware of outliers or special circumstances that may have unfairly impacted that 2.4% calculation.