What is a contra account?

A contra account is an account used to accumulate information separate from, but related to, a specific account. For example, rather than crediting a capital asset directly for accumulated amortization, we use a contra asset account, Accumulated Amortization, to do so. See other FAQ’s for the reasoning for this practice. Contra accounts have an opposite normal balance to the account it relates to. You can have a contra asset account (normal credit balance), a contra liability account (normal debit balance), a contra revenue account (normal debit balance); or a contra expense account (normal credit balance). Examples of contra asset accounts include Accumulated Amortization (contra to Capital Assets) and Allowance for Doubtful Accounts (contra to Accounts Receivable). An example of a contra liability account is Discount on Bonds Payable (contra to Bonds Payable). An example of a contra revenue account is Sales Returns and Allowances (contra to Sales). An example of a contra expense account is Purchase Returns and Allowances (contra to Purchases).

What is meant by the accrual basis of accounting and how does it differ from the cash basis of accounting?

The accrual basis of accounting recognizes revenues when earned normally when goods or services are delivered. The recognition of expenses occurs in the period in which the related revenue was generated matching costs and benefits.
The accrual basis of accounting recognizes revenues as they are earned and expenses as incurred, regardless of when cash receipts and cash payments occur. The cash basis of accounting recognizes revenues when cash is received and expenses when cash is paid.

I would like to know why the Capital asset account cannot be credited for the value of the expense. Why it is necessary to have an accumulated amortization account set up as a contra account?

Students should not credit accumulated amortization directly to a capital asset account. Instead, the amortization should be credited to a contra asset account, Accumulated Amortization. The reason that the contra account, Accumulated Amortization, is used to accumulate the amortization expense on a capital asset is twofold. First, we don’t want to mix actual numbers with estimates. The cost value recorded as a capital asset is a real number. It represents the original cost of the asset. The amortization is an estimate. While estimates are required in accounting, it is best to indicate clearly that they are estimates and not mix them with other numbers. Second, in order to provide the most useful information for the reader, we must disclose both the capital asset figure and the amount of the accumulated amortization. If we net the two, we cannot determine how much longer the capital asset is likely going to be able to produce revenue or other benefits for the company. For example, if you see only a net book value of $100,000 on the statements, you don’t know if the capital asset is brand new at a cost of $100,000 with no accumulated amortization (and therefore many more years of useful life) or if it is a capital asset that originally cost $1 million that is nearly fully amortized.

The concept of matching is interesting. Does this mean that even if I have paid for something such as inventory, I can’t claim it as an expense until I have sold it and recognized the revenue from the sale?

Yes. Accountants try to provide users with a measure of profit by subtracting all of the related expenses from the revenue earned in a period. We call this profit net earnings. It is important to include only those expenses that are related to the earned revenue so that there is consistency in the measurement of profit. Internal managers need to know that they are earning enough revenue to cover all of the related expenses. The implementation of the matching principle helps them make that determination.

What are adjusting entries?

Don’t underestimate this topic! It is a concept/principle necessary for understanding accounting. In order to measure properly the period’s earnings and to bring related asset and liability accounts to correct balances for the financial statement, adjusting entries are needed. At the end of the accounting period, any transactions (such as errors, omissions, corrections) that have not been recognized and recorded (due to whatever causes!) must be recorded. Recording these entries is called adjusting entries. Adjusting entries are journalized and usually done at the end of the accounting period. Some examples are: amortization, interest that is owed on loans, office supplies that have been used, wages that have not been paid, but you have incurred, etc. Adjusting entries can be divided into four categories:

  1. Prepaid expenses

  2. Unearned revenues

  3. Accrued revenues

  4. Accrued expenses