What is Contra Asset Account?
Contra asset account is an asset account having credit balance which is related to one of the assets with debit balance and when we add the balances of two of these assets together, it will show us the net book value or carrying value of the assets having the debit balance.
List of Components of Contra Asset Account
#1 – Assets
It is prepared when there is a reduction in the value of assets due to wear and tear continuous use, or when we expect that a certain percentage of accounts receivable will not be received. Fixed assets like plant & equipment are depreciated every year, and this balance is transferred to accumulated depreciation account. So, in this case, accumulated depreciation is a contra asset account related to plant & equipment.
#2 – Reduction in Value
We know that assets have a debit balance; however, the contra assets account has credit balances. It means that this account shows the balance, which is a reduction in the value of assets. Let’s say we expect 2% of our total receivable of $100,000 has gone bad. So we show $2,000 ($100,000*2%) as provision for doubtful debts, which is a reduction from debtors value and means that only $98,000 is expected to be received from debtors.
#3 – Prudence
It is only prudent to show the reduction or reserve in a separate account, and at any point, it gives us the netbook value explaining what the actual cost was and how much of that has been depreciated. It also helps in creating reserves, and later any change in the expected number can be adjusted through allowances and reserves.
#4 – Accumulated Depreciation
Whenever an organization buys an asset and depreciated it over the useful economic life of the asset, the reduction in value every over accumulates over the year, which is called accumulated depreciation. We get the remaining value of assets by deducting the accumulated depreciation balances from the book value of an asset. The accumulated depreciation balance cannot exceed the book value of the asset.
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#5 – Allowances for Doubtful Debts
When good is sold on credit, the amount receivable from customers is shown under the debtor’s balance in the balance sheet. It is a standard business practice to prepare an estimate for the amount which is likely to go bad. This amount is shown as provision or reserve for doubtful debts. The provision for doubtful debts is a contra asset account which is related to debtors.
#6 – Others
Provision for a discount from creditors and discount on bills receivable are other examples which are widely used.
Example of Contra Asset Account
Let us understand how the accounting entry is posted for the contra asset account and how it is shown in the books. Let us consider that ABC Ltd. recently bought machinery for $100,000, and it plans to depreciate the machinery over five years by using the straight-line method. In this case, the depreciation each year for this machinery will be $100,000/5 = $20,000.
Accounting Entry
By the end of the first-year machinery, balance will be $100,000, and accumulated depreciation will show $20,000. By the end of 2nd-year, the machinery balance will still be $100,000, and accumulated depreciation will show $40,000. The netbook value of the machinery by the end of the first year will be $80,000 ($100,000-$20,000) and $60,000 ($100,000-$40,000) by the end of the second year. This method helps a third person in identifying what the book value was at the time of purchase and what is the remaining value of an asset. If we just show $60,000 as an asset in the third year, it will be challenging to understand whether $60,000 is all new purchases or the remaining value of an asset. This account helps all the stakeholders in understanding the financial numbers accurately.
Advantages
Some of the advantages are a follows:
- It helps in quick calculation of net book value.
- The annual reports are prepared for various parties; some of them might not be accounting versed; they help them in identifying the reduction in total value.
- It helps in audit facilitation and annual filings.
- It is a globally accepted policy.
Disadvantages
Some of the disadvantages are a follows:
- It is a time-consuming process.
- Many organizations find it challenging to implement.
- Need a robust accounting system; else, operational difficulties may arise.
Points to Note
Conclusion
With increasing globalization and companies operating in many countries, the books of accounts must be compatible with a global platform. They are also the result of globally accepted accounting principles for accurate reporting of financial numbers. As we have seen in the above discussion, how reporting contra assets account helps in a better understanding of financial statements of any organization. So, an organization looking for a robust accounting process must move to this type of reporting for better understanding.
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