What are contra accounts?
Contra accounts are simply linked to another account. They match up with a General ledger account to bring the balance of that account down. Items recorded in the contra account are specifically designed to offset other transactions. To achieve this, records made in contra accounts always have an opposite balance compared to the primary account.
What are contra assets?
You could describe a contra asset as a negative asset and that it has a credit balance, unlike regular assets that normally have a debit balance. Allowance for obsolete inventory, for example, reduces its associated account Inventory. Purchase discounts and returns will work against the company’s Purchases expense account.
There are several reasons why contra asset accounts are used. Accountants usually use this type of account to reduce the amount of a long-lived asset. One of the common contra accounts is Accumulated depreciation, which reduces a fixed asset.
Companies depreciate a lot of things because it obviously cannot sell, for instance, a piece of equipment for the same price it purchased it after using it for several years. Note that while a business can depreciate a building, it cannot depreciate land.
Allowance for doubtful debts is another contra account that you can find on the business reports. It is working against the Accounts receivable account. This particular account is created to account for debts that a company does not expect to be able to recover. Since it doubts that these people are actually going to pay it, the business is going to bring down its assets just in case.
For example, we are given the following data.
Balance sheet 12/31/2020
Accumulated depreciation ($10,000)
Net Vehicle $40,000
Income statement 2020
Depreciation expense $5,000
On the Balance sheet, the company has a vehicle for $50,000. Let’s assume that they depreciated it on a straight-line basis over 10 years. So, the depreciation expense is $5,000 a year. Currently, the Accumulated depreciation (the contra account) has a negative $10,000 balance. This means that the company depreciated the vehicle last year for $5,000 and this year for $5,000. Accordingly, the vehicle value is reduced to $40,000.
As you can see, the contra asset account balance is deducted from the balance of the primary asset account in the financial statement. The accountants call the resulting difference the book value of the asset.