Contra Entry: One Person as Debtor and Creditor

Classification of Accounts and the Accounting Equation

Skill: Apply

Stimulus

Question

(a) Using the accounting equation (Assets = Liabilities + Owner's Equity), show the effect of the RM800 contra entry on total assets, total liabilities and owner's equity. Include the figures before and after the contra.

(b) After the contra, state the net balance between Encik Danish and Puan Sofia and classify that balance as an asset or a liability. Justify your answer.

(c) Explain why owner's equity does not change even though the contra entry is made.

Thinking steps

1. Identify the unusual situation: Puan Sofia is at once a debtor (Accounts Receivable) and a creditor (Accounts Payable), so the agreement to offset is a contra entry.
2. Determine the accounts affected and the direction of change: reduce Accounts Receivable (asset) and Accounts Payable (liability) by RM800 each, the smaller of the two balances.
3. Compute each component before the contra using the equation: Assets = Cash + AR + Equipment = RM17,800; Liabilities = AP + Bank loan = RM7,200; Equity = RM17,800 − RM7,200 = RM10,600.
4. Apply the contra and recompute: Assets become RM17,000 and Liabilities become RM6,400; verify Equity stays RM10,600 because no revenue or expense is involved.
5. Find the net balance with Puan Sofia: AR = RM0; AP = RM1,200 − RM800 = RM400. The payable was larger, so the remaining balance is on the liability side.
6. Classify the RM400 balance correctly: because the business still owes money, it is a current liability (Accounts Payable) reported in the Statement of Financial Position.

Model answer

(a) Effect of the contra entry on the accounting equation (Assets = Liabilities + Owner's Equity):

- Accounts Receivable (Puan Sofia) decreases by RM800 → total assets fall by RM800.

- Accounts Payable (Puan Sofia) decreases by RM800 → total liabilities fall by RM800.

- Owner's equity is UNCHANGED because a contra only offsets Puan Sofia's two accounts against each other; it is not a revenue or expense transaction.

Before contra: Assets RM17,800 = Liabilities RM7,200 + Equity RM10,600.

After contra: Assets RM17,000 = Liabilities RM6,400 + Equity RM10,600. The equation stays balanced.

(b) Remaining balance: Puan Sofia's Accounts Receivable becomes RM0, while Accounts Payable = RM1,200 − RM800 = RM400. This RM400 is still owed by Encik Danish to Puan Sofia, so it is classified as a LIABILITY (current liability) and shown under the Owner's Equity and Liabilities section of the Statement of Financial Position.

(c) Total assets fall by RM800 and total liabilities fall by the same RM800, so both sides of the equation decrease by RM800 and remain equal. The contra does not affect profit/loss or equity because no revenue was earned and no expense was incurred.