What is a Contra Liability?
A Contra Liability carries a debit balance rather than a credit balance, which is the opposite of the normal balance carried by liabilities.
Liabilities are typically recorded as a “credit” balance, but contra liabilities carry a “debit” balance, which decreases the associated liability account.
Contra Liabilities Account Definition
A contra account carries a balance — either debit or credit — that offsets the corresponding normal account for that categorization (and thus reduces the corresponding account).
The reason for recognizing a contra liability is to reduce the corresponding account for amounts that cannot be realized or collected, while not adjusting the historical cost.
In doing so, these GAAP reporting standards ensure that the financial statements remain transparent for investors.
- Liability Balance: Usually, a liability features a “credit” balance, which causes the value of the liability account to increase.
- Contra Liability Balance: But in the case of a contra liability, a “debit” balance is carried, decreasing the value of the corresponding liability account.
In spite of its name, contra liabilities function more similarly to assets.
Contra Liability Example – Original Issue Discount (OID)
Compared to contra assets, contra liabilities are less common. Listed below are two examples of contra liabilities:
The first contra liability listed is an original issue discount (OID), a feature of debt financing wherein the issuance price is less than the redemption price.
Suppose a bond is issued at a discounted price – i.e. lower than the redemption price (or the stated “par value”). In such a case, an original issue discount (OID) is created.
The OID is calculated as the difference between the redemption price and the discounted issuance price.
- Original Issue Discount (OID) = Redemption Price – Issuance Price
The three-statement impact of OID is as follows:
- Income Statement: The OID is amortized over the borrowing term of the debt and treated as a form of taxable interest.
- Cash Flow Statement: The OID is amortized across the borrowing term, but treated as a non-cash expense and thus an add-back on the CFS.
- Balance Sheet: On the assets side, cash increases since the OID is an add-back, which is offset by the increase in the debt’s book value, however, the face value of the debt remains constant.
The B/S impact is where the contra liability comes into play, i.e. the historical value of the debt is not impacted by the OID.
In terms of the journal entries, the debit balance in “Discount on Bonds Payable” is subtracted from the credit balance in the “Bonds Payable”.
Contra Liability Example – Financing Fees
In M&A transactions, such as a leveraged buyout (LBO), financing fees are another example of a contra liability.
Financing fees refer to the payments issued to the 3rd parties engaged when arranging debt financing, i.e. the administrative costs charged by the lender, lender legal fees, etc.
The reason financing fees are an example of a contra liability is that the fees – much like interest on the debt – are amortized over the debt borrowing term.
The amortization of the financing fees reduces the pre-tax income (EBT) of the company and the company’s tax burden, i.e. the borrower benefits from these tax savings until the bonds reach maturity.