This type of reporting allows anyone analyzing the balance sheet to understand much more about the company and its assets than if they were to simply look at the net value of the depreciated asset. By reflecting both accounts on the balance sheet, analysts can understand both the original price and the total decrease in value of a certain asset over time. Management may disclose its method of estimating the allowance for doubtful accounts in its notes to the financial statements. Within equity, an example of a contra account is the treasury stock account; it is a deduction from equity, because it represents the amount paid by a corporation to buy back its stock.
Regardless of company policies and procedures for credit collections, the risk of the failure to receive payment is always present in a transaction utilizing credit. Thus, a company is required to realize this risk through the establishment of the allowance for doubtful accounts and offsetting bad debt expense. In accordance with the matching principle of accounting, this ensures that expenses related to the sale are recorded in the same accounting period as the revenue is earned. The allowance for doubtful accounts also helps companies more accurately estimate the actual value of their account receivables.
- The Allowance for Doubtful Accounts is directly related to the asset account entitled Accounts Receivable.
- In either case, using these accounts can help you better manage depreciation expense, keep your accounts receivable balance accurate, and properly dispose of and account for obsolete inventory.
- Contra accounts appear in the financial statements directly below their paired accounts.
- The balance sheet would report equipment at its historical cost and then subtract the accumulated depreciation.
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. In response, the firm should decrease its accounts receivable and revenue balances. That is done by crediting accounts receivable by $100 and debiting the contra revenue account sales returns and allowances for $100. Hence, the company will have gross revenue or net sales equal to $9,900.
The company must be aware of outliers or special circumstances that may have unfairly impacted that 2.4% calculation. Regardless of that, allowance for receivables accounts will exist for all companies that have account receivable balances. This account helps companies present a more accurate accounts receivable balance on the financial statements. Every contra asset account on a company’s accounting records will also have a pairing account. For example, accumulated depreciation will go along with related assets.
These three types of contra accounts are used to reduce liabilities, equity, and revenue which all have natural credit balances. Therefore, for these three, the debit balance actually represents a negative amount. 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.
How to Account for the Allowance for Doubtful Accounts
A contra asset is a negative asset account that offsets the asset account with which it is paired. The purpose of a contra asset account is to store a reserve that reduces the balance in the paired account. By stating this information separately in a contra asset account, a user of financial information can see the extent to which a paired asset should be reduced. Whenever the balance of a contra asset account increases (credit to the contra asset account), the increased amount is written off as an expense and is reported in the company’s income statement. Reserve for obsolete inventory is a contra asset account used to write down the inventory account if inventory is considered obsolete. Excess, stored inventory will near the end of its lifespan at some point and, in turn, result in expired or unsellable goods.
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. This depreciation is saved in a contra asset account called accumulated depreciation. The accumulated depreciation account has a credit balance and is used to reduce the carrying value of the equipment. The balance sheet would report equipment at its historical cost and then subtract the accumulated depreciation. The most common contra account is the accumulated depreciation account, which offsets the fixed asset account.
- If the related account is a liability account, then a contra liability account is used to offset it with a debit balance.
- Management may disclose its method of estimating the allowance for doubtful accounts in its notes to the financial statements.
- Accountants use contra accounts rather than reduce the value of the original account directly to keep financial accounting records clean.
- Contra asset accounts are a type of contra account that net off against asset accounts.
- Allowance for doubtful accounts (ADA) is a contra asset account used to create an allowance for customers who are not expected to pay the money owed for purchased goods or services.
- Contra asset accounts are reported with the related account on the same financial statement.
Whether reported as separate lines on the financial report or as a cumulative value, the net amount of the pair of accounts is called the “net book value” of the individual asset. A Pareto analysis is a risk measurement approach that states that a majority of activity is often concentrated among a small amount of accounts. In many different aspects of business, a rough estimation is that 80% of account receivable balances are made up of a small concentration (i.e. 20%) of vendors.
Are Allowance for Doubtful Accounts a Current Asset?
Accumulated depreciation reflects the reduction in value of a fixed asset. 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. 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. However, the “Allowance for Doubtful Accounts” (or “Allowance for Uncollectible Accounts”) is a contra account related to the concept of bad debts.
By reporting contra accounts on the balance sheet, users can learn even more information about the company than if the equipment was just reported at its net amount. Balance sheet readers cannot only see the actual cost of the item; they can also see how much of the asset was written off as well as estimate the remaining useful life and value of the asset. The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense. An allowance for doubtful accounts is a contra account that nets against the total receivables presented on the balance sheet to reflect only the amounts expected to be paid.
Let’s consider a fictional example of a small business called “GreenThumb Nursery” to illustrate the use of contra asset accounts in financial accounting. 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. Then, the company establishes the allowance by crediting an allowance account often called ‘Allowance for Doubtful Accounts’. Though this allowance for doubtful accounts is presented on the balance sheet with other assets, it is a contra asset that reduces the balance of total assets. Accumulated depreciation is the most prevalent type of contra-asset account.
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. The same is true for other asset accounts like accounts receivable. Accounts receivable is rarely reported on the balance sheet at its net amount. Instead, it is reported at its full amount with an allowance for bad debts listed below it. Maybe more importantly, it shows investors and creditors what percentage of receivables the company is writing off.
Accounts Receivable Aging Method
Note that if a company believes it may recover a portion of a balance, it can write off a portion of the account. The accounting entries for accumulated amortization are as follows. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. Get instant access to video lessons taught by experienced investment bankers.
The contra asset account, accumulated depreciation, is always a credit balance. This balance is used to offset the value of the asset being depreciated, so as of how to close a business September 1, your $8,000 asset now has a book value of $7,866.67. If you offer credit terms to your customers, you probably know that not all of them will pay.
Establishing the Allowance
Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. In other words, accumulated depreciation will be $10,000 each year until the car depreciates to $0 twenty years later. Treasury stock differs from other stocks in that it has no voting rights, and no dividends are paid to the treasury stock. The auditors aim to keep the balances at their adequate levels, but the controller might want to keep them as low as possible to reduce expenses and maximize profit levels. When researching companies, the financial statement is a great place to start.
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. The allowance for doubtful accounts is a contra asset because it reduces the value of the accounts receivable (AR) account on the general ledger. Often when a company extends goods on credit, management expects some of those customers not to pay and so anticipates writing off bad debt.
The allowance for doubtful accounts estimates the percentage of accounts receivable that are expected to be uncollectible. However, the actual payment behavior of customers may differ substantially from the estimate. Sometimes, the current value of a note receivable will fall compared to its face value.