No, this has nothing to do with the Iran-Contra affair.
Now that I have thoroughly dated myself, let’s get into contra accounts.
What is a contra, and what do I need to know? I’m glad you asked.
Contra accounts are a standard accounting practice. Here is the basic definition:
A contra account is used in a general ledger to reduce the value of a related account when the two are netted together. A contra account's natural balance is the opposite of the associated account. If a debit is the natural balance recorded in the related account, the contra account records a credit.
Some basic examples of contra accounts are bad debt and depreciation. Bad debt is uncollectible revenue, which offsets a doubtful receivable. Depreciation is an offset of the value of PP&E (Property, Plant, and Equipment).
Who cares? You should!
Commercial and industrial (C&I) lenders come across contra accounts more than we would like to admit. Many businesses will barter or exchange goods and services. These exchanges can and do lead to contra accounts.
I’ll use an example of my next-door neighbor. We borrow each other’s tools on a regular basis. Say I borrow his table saw and he borrows my wrench set. Which has more value...the table saw or the wrench set? A good table saw is much more expensive than a socket set. As a result, if we had to square up with cash for the tools borrowed, I would owe him the value of the table saw minus the value of my socket set.
Still don’t understand why it matters if the contra is showing on the books?
Nuanced Contra Accounts
Here’s where it gets interesting. Not all contra accounts are as obvious as bad debt or depreciation. Take my example above with my neighbor. If we apply accounting rules and assign value to the tools borrowed, technically speaking, we both have an account receivable (AR) and an account payable (AP) to each other for the equipment/tools borrowed.
Yes, I’m taking a little liberty here, but the concept is the same. The AR to my neighbor is offset by the AP. In the end, the value of both our receivables is lower. My receivable to my neighbor is completely wiped out by the offset payable due to the value of the saw.
When a company has both receivables and payables to the same business or individual, the value of one or the other is reduced. In a default situation, the amounts are offset, and the receivable value is lower or nonexistent.
As in my tools example, the individual or company could end up owing more to the other business when the debtor is also a vendor. Therefore, it’s vitally important that lenders ask for and receive both payables and receivables. The contra to many receivables is right in front of us, but often missed as we don’t compare the two ledgers to look for offsetting amounts.
Another instance of this is related companies. It’s not unusual for an owner to have multiple entities that do business together. In a distressed situation, is the owner going to pay back the receivable due from one of his companies to the next? Highly unlikely. That’s why we don’t lend to the related entity.
Lenders should always compare AR and AP and look for contra/offsetting dollar amounts to the same company, individual, or related entity to ensure the value of receivables we’re lending against is accurate. Without a review of contra accounts, the institution may find itself significantly under collateralized should the company default on its credit facility.