Contra Asset Examples, How a Contra Asset Account Works

the allowance for doubtful accounts is a contra asset account that equals

The amount is reported on the balance sheet in the asset section immediately below accounts receivable. Contra equity accounts are accounts in the equity section of the balance sheet that reduce the amount of equity a company holds. Therefore, contra equity accounts have a debit balance to offset their corresponding equity balances. Note that in accounting, the term “book value” is also used interchangeably with net value. Using the example above, let’s say that a company reports an accounts receivable debit balance of $1,000,000 on June 30. The company anticipates that some customers will not be able to pay the full amount and estimates that $50,000 will not be converted to cash.

the allowance for doubtful accounts is a contra asset account that equals

If you’re using accounting software, you’ll be able to create contra accounts when setting up your chart of accounts. But this isn’t always a reliable method for predicting future bad debts, especially if you haven’t been in business very long or if one big bad debt is distorting your percentage of bad debt. If you have $50,000 of credit sales in January, on January 30th you might record an adjusting entry to your Allowance for Bad Debts account for $3,335. Most businesses will set up their allowance for bad debts using some form of the percentage of bad debt formula. Like any other expense account, you can find your bad debt expenses in your general ledger. The accounts receivable aging method is a report that lists unpaid customer invoices by date ranges and applies a rate of default to each date range.

Accounting for the Allowance for Doubtful Accounts

Suppose a company generated $1 million of credit sales in Year 1 but projects that 5% of those sales are very likely to be uncollectible based on historical experience. Otherwise, it could be misleading to investors who might falsely assume the entire A/R balance recorded will eventually be received in cash (i.e. bad debt expense acts as a “cushion” for losses). The allowance for doubtful accounts is management’s objective estimate of their company’s receivables that are unlikely to be paid by customers. Let’s consider a situation where BWW had a $20,000 debit balance from the previous period. There is one more point about the use of the contra account, Allowance for Doubtful Accounts. In this example, the $85,200 total is the net realizable value, or the amount of accounts anticipated to be collected.

For example, if a piece of heavy machinery is purchased for $10,000, that $10,000 figure is maintained on the general ledger even as the asset’s depreciation is recorded separately. In this way, the historical cost, the amount of write-off, and the book value of an asset can always be seen on the balance sheet. When assessing accounts receivable, there may come a time when it becomes clear that one or more accounts are simply not going to be paid. In these cases, the best course of action is often to write off the account. The adjustment process involves analyzing the current accounts, assessing their collectibility, and updating the allowance accordingly.

What is a Contra Liability?

When it comes to bad debt and ADA, there are a few scenarios you may need to record in your books. Your allowance for doubtful accounts estimation for the two aging periods would be $550 ($300 + $250). The purpose of the Sales Returns account is to track the reduction in the value of the revenue while preserving the original amount of sales revenue. The purpose of the Accumulated Depreciation account is to track the reduction in the value of the asset while preserving the historical cost of the asset.

All outstanding accounts receivable are grouped by age, and specific percentages are applied to each group. The aggregate of all group results is the estimated uncollectible amount. Accountants use contra accounts rather than reduce the value of the original account directly to keep financial accounting records clean.

Balance Sheet Method for Calculating Bad Debt Expenses

This means that the $85,000 balance is overstated compared to its real value. At this point, it isn’t known which accounts will become uncollectible so the Accounts Receivable balance isn’t adjusted. Instead, an adjusting journal entry is done to law firm bookkeeping record the estimated amount of bad debt. If you offer credit terms to your customers, you probably know that not all of them will pay. Creating this contra asset account builds in a safeguard against overstating your accounts receivable balance.

On the income statement, Rankin would match the bad debt expense against sales revenues in the period. We would classify this expense as a selling expense since it is a normal consequence of selling on credit. As mentioned, CA accounts are usually listed below their matching asset accounts, and the net values of those assets are written next to the contra accounts.

How to Calculate Units of Activity or Units of Production Depreciation

Let’s say your business brought in $60,000 worth of sales during the accounting period. Based on historical trends, you predict that 2% of your sales from the period will be bad debts ($60,000 X 0.02). Debit your Bad Debts Expense account $1,200 and credit your Allowance for Doubtful Accounts $1,200 for the estimated default payments.

the allowance for doubtful accounts is a contra asset account that equals

The purpose of the allowance for doubtful accounts is to estimate how many customers out of the 100 will not pay the full amount they owe. Rather than waiting to see exactly how payments work out, the company will debit a bad debt expense and credit allowance for doubtful accounts. The allowance represents management’s best estimate of the amount of accounts receivable that will not be paid by customers. It does not necessarily reflect subsequent actual experience, which could differ markedly from expectations.

3 Bad Debt Expense and the Allowance for Doubtful Accounts

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 balance sheet aging of receivables method estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account. The longer the time passes with a receivable unpaid, the lower the probability that it will get collected. An account that is 90 days overdue is more likely to be unpaid than an account that is 30 days past due.

  • This frequently happens to manufacturing companies that sell products with an expiration date since any inventory remaining in stock past the expiration date quickly becomes obsolete.
  • Auditors look for this issue by comparing the size of the allowance to gross sales over a period of time, to see if there are any major changes in the proportion.
  • Finding the proper amount for the allowance for doubtful accounts is not an instant process.
  • In some cases, you may write off the money a customer owed you in your books only for them to come back and pay you.

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