Inventory Reserve: Definition, Purpose, and Use in Accounting

Examples of revenue contra accounts are Sales Discounts, Returns and Allowances. This use of Sales Returns and Allowances (instead of debiting Sales) enables management to see that its customers had a problem with $3,000 of the company’s goods. To increase the value of your inventory, you debit it, and to reduce its value, you credit it.

Excess, stored inventory will near the end of its lifespan at some point and, in turn, result in expired or unsellable goods. In this scenario, a write-down is recorded to the reserve for obsolete inventory. Under periodic inventory, we do not use the Inventory account to record day-to-day transactions. Since we are now discussing returns and allowances, can you figure out what account we will use? Most of the time in accounting, the account names describe what is going on.

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Instead, you need to record this value gap, and a contra asset account serves that purpose. Accumulated deprecation represents the cumulative amount of depreciation expense charged against an asset. Another example of a contra asset account is the accumulated depreciation account which reduces the reporting value of capital assets. If you offer credit terms to your customers, you probably know that not all of them will pay.

  • The Allowance for Doubtful Accounts is directly related to the asset account entitled Accounts Receivable.
  • Two common contra asset accounts include allowance for doubtful accounts and accumulated depreciation.
  • Note that the asset account balance represents the purchase price of the asset in question, also known as its historical cost.
  • Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology.
  • That is to completely or partially offset the balance of their related asset accounts.
  • To oppose the revenue made by a company, contra revenue accounts must have a debit balance.

Using the allowance for doubtful accounts, the contra asset account will more accurately reflect your true accounts receivable balance and make sure sure that your financial statements reflect the most accurate information possible. If you’re still using manual accounting systems, you’ll need to do a bit more work by recording your accumulated depreciation expense in your general ledger while also reporting it on your balance sheet as a contra asset account. 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. When the actual inventory goes obsolete, the company has to quantify them in the dollar value and make the adjustment. By this time, the obsolete inventory will be disposed, so it should be removed from the balance sheet.

The purpose of contra accounts

Allowance for doubtful accounts offsets a company’s accounts receivable account. Accumulated depreciation offsets a company’s real property assets, such as buildings, equipment and machinery. 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.

Contra inventory account — AccountingTools

The expense account is reflected in the income statement, reducing the firm’s net income and thus its retained earnings. A decrease in retained earnings translates into a corresponding decrease in the shareholders’ equity section of the balance sheet. For the purpose of financial statement reporting, the amount on a contra account is subtracted from its parent account gross balance to present the net balance. In its general ledger, the business will want to capture its gross sales figures and the actual value of the discount.

If the asset account had a credit balance or the contra asset account had a debit balance, this would indicate an error in the journal entries. Nor would it count as a liability as it does not reflect a future 110 tax humor ideas obligation. A contra revenue represents any deductions or offsets that need to be removed from gross revenue to provide a clearer understanding of actual income  —  such as in the example just provided.

Contra account examples

Contra revenue accounts typically offset revenue accounts in a firm’s income statement. Inventory refers to assets owned by a business to be sold for revenue or converted into goods to be sold for revenue. Generally accepted accounting principles (GAAP) require that any item that represents a future economic value to a company be defined as an asset.

Similarly, if the parent account lists entries as debits, the contra account will appear as a credit. When considering all of the money currently owed to your business that’s recorded in your Accounts Receivable (A/R) line item as an existing asset, there’s a good chance that not all of those customers are going to pay you back in full. To compensate for those potential deadbeat customers, you can use a Bad Debts account to serve as a contra for your A/R. Consider a business that offers an early payment discount to its customers, cutting their invoiced total by 3% if they pay within 1 week of invoicing. If every single buyer had taken advantage of the early payment discount, the company would have provided roughly $10 thousand in discounts during that same timeframe.

Accounting for Inventory Write-Off

There is almost always a story behind data; a clarification or historical insight that changes the meaning behind raw figures. In a report, layering on that additional context can be easy, but in a general ledger, you have few options for conveying nuance and subtlety. Namely, within a ledger, each account is intended to contain transactions and balances of a similar type only. But sometimes, dissimilar transactions are important to consider together within a ledger.

When a company sells its products or services to customers on credit, the company records the amount sold in its accounts receivable account. Typically, a company fails to collect all of the money owed by customers making purchases on credit. Asset accounts always maintain a debit balance, so anytime that you increase the value of an asset, such as when you deposit customer payments or invoice a customer, that asset account is debited or increased. Likewise, when you pay a bill, your cash account is reduced (credited) because you’re lowering the balance.

An example of recording a contra asset

This balance is used to offset the value of the asset being depreciated, so as of September 1, your $8,000 asset now has a book value of $7,866.67. Writing off your obsolete inventory in this manner allows you to expense the cost of the obsolete inventory while also decreasing your current inventory balance using the contra asset account. Allowance for doubtful accounts (ADA) is a contra asset account used to create an allowance for customers who are not expected to pay the money owed for purchased goods or services.

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