Accounts in any business hold important information regarding different aspects of the entity and its operations. And to keep the information relevant and reliable these accounts needs to be updated to record all such transactions that relates to particular account. For example, funds deposited in the bank account and withdrawn are recorded in the Bank account.
However, some accounts are of that significance that we cannot adjust it for everything. Even if the transaction relates directly to a particular account as we fear that we will loose track of important information. But in order to prepare financial statements complete and with true and fair view we cannot just ignore the transactions that we do not want to adjust in a specific account. So, what we do is that we maintain another account in which we will record the transactions. Usually these additional accounts that we maintain are retrograde (opposite in nature) to the normal accounts. That’s why we call them Contra Accounts.
As the name suggests Contra account is any account which is opposite in nature with respect to a certain account i.e. its balance is opposite to the balance of an account against which contra account is maintained.
For example: Drawings account which is a contra-equity account. In this account we maintain the records of all such transactions which does relate to owner’s equity and should be recorded in Capital account but instead of adjusting Capital account we record such transactions separately. Because if such transactions will be recorded in capital account straight then by looking at the new closing balance of capital account we will never understand how much amount was initially invested in business. Therefore, we record all such transactions that will cause reduction in equity under Drawings account. And as we hold such items in this account the balance of Drawings account is also opposite to the balance of Capital account. And that is the reason we deduct the balance in Drawings account from the balance of Capital account. So, the reporting (financial statements) will never be affected as after deducting drawings balance from capital balance we will get the same amount that we would have get if the transactions were adjusted straight in Capital account. And also the important information in Capital account is preserved.
Contra accounts can be categorized as following:
- Contra-equity accounts
- Contra-asset accounts
- Contra-revenue accounts
- Contra-expense accounts
Most of us are already familiar with contra accounts but might have not discussed them with this name. Here are some examples of contra accounts according to different categories:
- Accumulated Depreciation account for the respective asset account which is contra-asset account.
- Discount allowed and received accounts for Sales or Purchases respectively.
- Sales Returns account which is maintained against Sales account is basically contra-revenue account.
- Purchases Returns account which is maintained against Purchases account is contra-expense account.
- Provision for Doubtful Debts account is a contra account maintained against Receivables accounts and is deducted from total Receivables to report net Receivables in Statement of Financial Position and is contra-asset account.