Reviewing the accounting basics, assets have a debit balance and are reduced by a credit entry; liabilities and owners’ equity accounts, in contrast, have a normal credit balance and are reduced by debits. However, there are some contra accounts that reduce/negate the balance of certain accounts.
The two most common contra-asset accounts are accumulated depreciation and allowance for doubtful accounts. Each of these contra assets are netted against their opposing accounts (Depreciable asset & Accounts Receivable) and are shown on the balance sheet.
- Asset (Equipment, etc. except for Land)/Depreciation Expense - Accumulated Depreciation:
Depreciation expense is calculated in multiple ways such as using the straight line method, MACRS (tax purposes), 200% double declining, 150% declining, and sum of the years digits. For our example we use straight line. The depreciation expense account is an expense item listed on the income statement, while the accumulated depreciation hits the balance sheet reducing the asset.
Ex: Adequate Disclosure buys equipment for $5,000 on January 1st. Estimated useful life is 8 years and there is no salvage value. Record the journal entry to show the purchase on January 1st and depreciation on December 31st.
Accumulated Depreciation is presented on the balance sheet as follows:
- Accounts Receivable/Bad Debts Expense-Allowance for Doubtful Accounts:
Accounts Receivable is displayed and valued on the balance sheet at Net Realizable Value. Net Realizable Value is Accounts Receivable minus Allowance for Uncollectible Accounts. The purpose behind the allowance account is to make sure a company has sufficient funds allocated just in case a customer does not pay or cannot pay. There are three common methods to calculate the allowance for doubtful accounts account: 1) percentage of sales 2) percentage of accounts receivable and 3) the aging schedule of accounts receivable. Bad debts expense hits the income statement and the Allowance for Uncollectible Accounts is shown on the balance sheet reducing accounts receivable.
- Percentage of Sales Method:
Implementing this method requires a debit to the “Bad Debt Expense” account and a credit to “Allowance for Uncollectible Accounts” by multiplying the total sales figure by a percent that the business assumes will be uncollectible in the future. It is important to note that this approach is considered to be the Income Statement approach, since the Sales number is coming from the Income Statement.
Ex: From total revenue of $100,000, Adequate Disclosure estimates that 10% will not be collected.
- Percentage of Accounts Receivable Method:
Using this method requires to calculate the ending balance of Accounts Receivable first and then multiplying it by the percentage that is expected to be uncollectible. It is important to note that this approach is considered to be the Balance sheet approach, since the Accounts Receivable amount is coming off the Balance sheet.
Ex: From total Accounts Receivable of $100,000, Adequate Disclosure estimates that 10% will not be collected.
- Aging of Accounts Receivable Method:
Aging in this case is kind of like depreciation, as the account remains unpaid, the higher the chances the amount will not be collected. As time goes on, the percentage of un-collectability increase therefore it would increase the allowance for uncollectible account.
Ex: Adequate Disclosure requires at the beginning of each accounting period to have an estimated balance of $10,000 in its Allowance for Uncollectible Accounts.
The Allowance for Doubtful Accounts is presented on the balance sheet as follows:
Contra Liabilities
The two most common contra-liability accounts are discounts on Bonds Payable and Premium on Bonds Payable. These two accounts are netted against Bonds Payable.
- Discounts on Bonds Payable:
Bonds issued on a discount require that the stated/nominal/coupon rate is lower than the market rate. Basically meaning that the bonds are issued for less than the face value amount, which would dictate the need for an account such as Discount on Bonds Payable to have a debit balance; reducing the amount in Bonds Payable. Discount on bonds payable decreases the value of the bonds and is subtracted from the bonds payable on the balance sheet.
Ex: Adequate Disclosure, Inc. issues $10,000 five year bonds to Inadequate Disclosure, Inc. with a coupon interest rate of 9% and semiannual interest payments payable on June 30 and Dec. 31, on January 1st when the market interest rate is 12%. The journal entry to record the bond by Adequate Disclosure, Inc. on January 1st of 20X1 is:
Present Value of $1 (6% @ 10 Periods): .55839 (Keep in mind SEMI-ANNUAL)
Present Value of an Ordinary Annuity of $1 (6% @ 10 Periods): 7.36009
Discounts on Bonds Payable are presented on the Balance Sheet as follows:
Here is the discount on the bonds payable amortization table using the effective interest rate method.
- The carrying value multiplied by the semiannual rate results in the interest payment of $556.
- Then subtract the $556 with the semiannual payment of $500 which equals $56.
- Then add the $56 to the beginning carrying value of $9,264 resulting with an ending carrying value of $9,320 for June 30th, 20X1.
- Bonds Issued at a Premium:
Bonds issued on a premium require that the stated/nominal/coupon rate to be higher than the market rate. This means that the bonds are issued for more than the face value amount, requiring an account such as Premium on Bonds Payable to have a credit balance which would increase the amount of the Bonds Payable. Premium on bonds payable increases the value of the bonds and is added from the bonds payable on the balance sheet.
Ex: Adequate Disclosure, Inc. issues $10,000 a 5 year bond to Inadequate Disclosure, Inc. with a coupon interest rate of 14% and semiannual interest payments payable on June 30 and Dec. 31, on January 1st when the market interest rate is 8%. The journal entry to record the bond by Adequate Disclosure, Inc. on January 1st of 20X1 is:
Present Value of $1 (4% @ 10 periods): .67556 (Keep in mind SEMI-ANNUAL)
Present Value of an Ordinary Annuity of $1 (4% @ 10 Periods): 8.1109
Here is the journal entry on the date issuance on Adequate Disclosure’s books:
Premium's on Bonds Payable are presented on the Balance Sheet as follows:
Here is the premium on the bonds payable amortization table using the effective interest rate method.
- The carrying value multiplied by the semiannual rate results in the interest payment of $432.
- Then subtract the $432 with the semiannual payment of $500 which equals $68.
- Then subtract the $68 to the beginning carrying value of $10,811 resulting with an ending carrying value of $10,743 for June 30th, 20X1.
One contra account that reduces the equity balance is Treasury Stock. Treasury stock is the re-purchase of a corporations stock by itself. The main reason behind a corporation buying back its stock is to reduce the amount of outstanding stocks in the market, thereby increasing the price of its own stock; which is a basic financial tactic that corporations use to control the supply of its stock and increase the demand of the stock.
There are two methods for recording the purchase and issuance of Treasury stock; the Cost Method or the Par Value Method. Both methods can be used to determine the total amount of the stock holders equity account. No gain or loss is reported on the income statement.
Under the cost method, the purchase of treasury stocks is recorded at the cost of repurchase or the fair value.
Journal Entry 1: On January 1st Adequate Disclosure issues 1,000 shares with a par of $10 to Inadequate Disclosure, Inc. for $20.
- Common Stock (10 par value x 1,000 shares
- Additional Paid in Capital (Excess of selling price x Shares)
Journal Entry 2: On January 2nd Adequate Disclosure re-purchases 700 shares for $25.
Here is how the Treasury Stock is displayed on the balance sheet using the par value method:
Here is how the Treasury Stock is displayed on the balance sheet using the cost method:
