Introduction to Contra Asset Accounts
You may think that every financial account on the balance sheet functions additively with each other, but this is not true. In some occasions, we can use an account to counterbalance the effect of another account which is similar to it. The so-called contra accounts use this functioning system against other accounts. The word contra means against. So, a contra asset account is usually paired alongside an asset account, and it serves to minimize the asset account’s balance.
You can treat contra asset accounts as negative accounts since they typically have a negative or zero balance. On the contrary, assets accounts possess debit balances. Counterbalancing the asset account with its analogous contra asset account shows the net balance of a particular asset. The aim of using a contra asset account is to gather a stockpile that reduces the balance in the account that matches it. By showing these particulars separately in a contra asset account, those who use this financial information may determine the amount that they should reduce in the paired asset.
Examples of contra asset accounts include a reserve for obsolete inventory, accumulated depreciation, as well as the allowance for doubtful accounts.
Reserve for Obsolete Inventory
If you keep inventories for business purposes, you would know that there is a possibility that you may not sell or use all of them to generate profit. A few factors may cause this to happen, which includes a lack of demand for that product, perishable goods, as well as obsolete technology. Hence, engaging an accounting firm in Johor Bahru is the right choice as they will help you to create a reserve for obsolete inventory to grab this fact. In general, a reserve for obsolete inventory forecasts inventory losses and keeps an allowance as a company has predicted to experience a loss in inventory.
For instance, a company has inventory that worth RM400, 000 and predicts that 2% of the inventory are going to be bad. The accountant will record the gross inventory as an asset that has a value of RM400, 000 on the balance sheet. Then, he will create a negative balance of RM8,000, that is 2% of RM400,000, in reserve for obsolete inventory. Thus, the company will claim a net inventory at RM392, 000 (RM400, 000 minus RM8,000). In the end, the company is going to represent the reserve for inventory by posting an adjusting entry of RM8,000 outgoings on its profit and loss statement.
An accountant can document the level of decrease or depreciation on any fixed asset up until the present point in an accumulated depreciation account. Fixed assets include machines, furniture and fixtures, building structures, office equipment, computer equipment, vehicles and more. Typically, this account has a credit balance, and it works by counterbalancing the fixed asset account (Also see FRS 16: Property, Plant and Equipment), which always has a debit balance. Hence, the net balance of the accumulated depreciation account and the fixed asset account shows the net book value of a particular asset.
For example, for a lorry that has a price of RM85,000 and an accumulated depreciation of RM60,000, its book value will be RM25,000. If you use both accounts, you will be able to report the information about the original price of the fixed asset on the account for the fixed asset and report the details of the decrease or depreciation of the asset on the accumulated depreciation account.
Allowance for Doubtful Accounts (ADA)
There is the fact that you may find it cruel, that is, not all your clients are going to pay the amount they owe you. Typically, your accounts receivable (Also see An Overview of Receivable Turnover) will decrease due to the existence of an allowance for doubtful accounts. The objective of developing this account is to consider the situation where some clients are unable to pay the cash they owe to you. In such a condition, the amount in your bad debt costs account will increase.
You will write off a bad debt officially. It is the amount that you suppose you would obtain, yet you end up receiving nothing. Hence, it affects your overall bottom line. On the other hand, you are not going to write off doubtful debt officially, unlike bad debt. Instead, you predict this loan to become a bad debt; however, there is still a possibility that you can receive the amount.
When you let your clients purchase any goods or services from you on credit, you need to make an ADA. The unsettled loan becomes bad debts. Creating ADA aids you in forecasting the sum of accounts receivables which your customers will not pay to predict the losses you may suffer as a result of bad debt.
Engage accounting services in Johor Bahru who can utilize contra asset accounts to check the reduction in assets separately from the claimed asset. Ultimately, the balance sheet summarises the original value of the asset, the extent of its depreciation, as well as its net value.