In accounting, a valuation account is used to adjust the value of an asset or liability account. A valuation account is considered a “contra account,” meaning it is paired with an associated account but has the opposite normal balance. The purpose of a valuation account is to show the net carrying value of an asset or liability on the balance sheet.
Common Types of Valuation Accounts
- Allowance for Doubtful Accounts: This is a contra-asset account used to reduce accounts receivable to their expected collectible amounts, representing what the company estimates it might not collect from customers.
- Accumulated Depreciation: This is another contra-asset account that shows the total depreciation taken on a company’s assets. It reduces the gross value of assets to get to their net book value.
- Discount on Bonds Payable: This is a contra-liability account that reduces the value of bonds payable to their carrying or book value. This usually happens when bonds are issued for less than their face value.
- Accumulated Amortization: This is a contra-asset account used to reduce the value of intangible assets like patents or copyrights.
- Unrealized Gains or Losses: These accounts are often used in the valuation of investment securities that can fluctuate in market value.
- Deferred Tax Assets/Liabilities: These accounts are used to reconcile differences between tax accounting rules and the accounting methods used in the financial statements.
Example of Valuation Account
Let’s consider a fictional business, “XYZ Electronics,” to illustrate how a valuation account works in a real-world accounting scenario. We’ll focus on the Accounts Receivable and its corresponding valuation account, the Allowance for Doubtful Accounts.
Scenario: Year-End Accounting at XYZ Electronics
XYZ Electronics has sold various electronic goods to customers on credit, accumulating Accounts Receivable of $100,000 by the end of the year. Based on past experience and current economic conditions, XYZ estimates that 5% of the receivables are likely to be uncollectible.
Step 1: Recording the Accounts Receivable
At the point of sale on credit, the Accounts Receivable would have been recorded as follows:
- Journal Entry for Sales on Credit:
- Debit: Accounts Receivable $100,000
- Credit: Sales Revenue $100,000
Step 2: Estimating Uncollectible Amount
XYZ Electronics estimates that 5% of the Accounts Receivable or $5,000 ($100,000 * 5%) is likely to be uncollectible.
Step 3: Recording the Valuation Account (Allowance for Doubtful Accounts)
To account for the estimated uncollectible amount, XYZ makes the following journal entry:
- Journal Entry for Allowance for Doubtful Accounts:
- Debit: Bad Debt Expense $5,000
- Credit: Allowance for Doubtful Accounts $5,000
Step 4: Reporting on the Balance Sheet
On the balance sheet, the Accounts Receivable and its corresponding valuation account would appear like this:
- Accounts Receivable: $100,000
- Less: Allowance for Doubtful Accounts: $5,000
- Net Accounts Receivable: $95,000
In this example, the valuation account (Allowance for Doubtful Accounts) helps present a more accurate and conservative picture of XYZ Electronics’ financial condition. Instead of showing the full $100,000 as collectible, the use of a valuation account indicates that only $95,000 is expected to be collected, taking into account potential defaults.
By using the valuation account, XYZ Electronics is adhering to the accounting principle of conservatism, preparing for potential losses and presenting a less optimistic but more realistic view of its financial health.