A contra account provides missing context by pairing it with a related account. So as values shift depending on real-world factors, rather than making deductions or adjustments to the original or “parent” account, you would record these changes in the contra account instead. By viewing these accounts — the parent and contra — in tandem, business owners can gain broader insights, preserve the historical figures stored in the parent account, and make accommodations for any relevant changes.

In this article, we’re going on a deep dive into what exactly a contra account is, how contra accounts work, why and how you would use contra accounts and more. GAAP, the allowance for doubtful accounts represents management’s estimate of the percentage of “uncollectible” accounts receivable (i.e. the credit purchases from customers that are not expected to be paid). In order to create a balance between the two methods and to give a fuller picture of a company’s financial realities, the LIFO reserve account is necessary.

contra account definition

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Contra accounts are important because they allow a company to follow the matching principle by recording an expense initially in the contra asset account. A contra inventory account is a type of account in financial accounting that offsets the balance of a corresponding inventory account. Contra inventory accounts have a credit balance, which is the opposite of the typical debit balance found in inventory accounts. The purpose of a contra inventory account is to reduce the total inventory value shown on the balance sheet by reflecting specific adjustments, allowances, or write-downs related to the inventory. The most common contra type, contra assets, records the loss in value of any asset accounts listed in your general ledger.

Equity Contra Account

This is an owner’s equity account and as such you would expect a credit balance. Normal asset accounts have a debit balance, while contra asset accounts are in a credit balance. Offsetting the asset account with its respective contra asset account shows the net balance of that asset.

How to Use Contra Asset Accounts

The allowance for doubtful accounts appears on the balance sheet and reduces the amount of receivables. In bookkeeping, a contra asset account is an asset account in which the natural balance of the account will either be a zero or a credit (negative) balance. The account offsets the balance in the respective asset account that it is paired with on the balance sheet.

Contra accounts definition

For example, accumulated depreciation is a contra asset that reduces the value of a company’s fixed assets, resulting in net assets. Whereas assets normally have positive debit balances, contra assets, though still reported along with other assets, have an opposite type of natural balance. 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. 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.

The purpose of inventory management is to ensure that a company has the right amount of inventory on hand at all times. Too little inventory can lead to lost sales and unhappy customers, while too much inventory can tie up valuable resources and result in excess costs. There are many different ways to keep track of inventory, but one of the most important things is to have a system in place that works for your company. This might involve using software to track inventory levels, or it could be as simple as keeping a physical count of what is on hand. 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.

An inventory reserve is also a balance sheet account, but since it is a contra asset account, or one that reduces asset value, you credit it to increase it and debit it to reduce it. When you sell items, you credit inventory and debit a cost of goods sold expense account. An inventory write-off is an accounting term for the formal recognition of a portion of a company’s inventory that no longer has value. It may be expensed directly to the cost of goods sold (COGS) account, or it may offset the inventory asset account in a contra asset account, commonly referred to as the allowance for obsolete inventory or inventory reserve. Contra revenue is a general ledger account with a debit balance that reduces the normal credit balance of a standard revenue account to present the net value of sales generated by a business on its income statement.

By accounting industry standards, inventory reserve is a conservative methodology. It attempts to predict inventory losses even before a loss has been confirmed to have happened. As such, inventories are made up of goods that have future economic value, which qualifies them as assets. The principles of conservative accounting prescribe reporting assets as close to their current value as possible.

The net realizable value of the accounts receivable is the accounts receivable minus the allowance for doubtful accounts. The amount a company records as allowance for doubtful accounts is the amount from its accounts receivable the company considers uncollectible. 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. The purpose of the journal entry for depreciation is to achieve the matching principle.

TechShop performs an inventory review and identifies that a portion of its inventory, worth $10,000, is likely to become obsolete due to new product releases and changing customer preferences. Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Master accounting topics that pose a particular challenge to finance professionals. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent.