You owe them, they owe you, but neither of you have any money how do you get paid and how do you record the payments?

One of your customers also supplies goods to you so therefore he is both a customer and a supplier to you. You owe him money and he owes you money, but you don’t have very much cash and would like to minimise the amount you wish to pay him. So how do you do this?

Example:

You owe your supplier ABC Products €1,000

ABC Products also buys goods from you and so is a customer. They owe you €900.

Normally what would happen is that you send them a cheque for €1,000 and they send you a cheque for €900. Sometimes the term “Swapping Cheques” is used, you both get your money at the same time. The problem with swapping cheques is that there may not be enough money in your bank account to honour your cheque to your supplier. When you lodge the cheque from them for €900 in your bank account, the cheque may not yet actually be cleared and the money on that cheque may not yet be available for you to spend. So when the cheque you wrote to ABC Products for €1,000 hits your bank account, the bank will dishonour the cheque (bounce it) as the cheque for €900 has not yet been cleared and is not in the funds available to meet any cheques you have written.

This may also be the same situation for your supplier ABC Products. They may have their own cashflow problems and are relying on your cheque to ensure that their cheque is honoured by the bank.

So how do we overcome this? The answer is by using “Contra’s”.

Contra’s are transactions where only the difference between what we owe ABC Products and what ABC Products owes us is paid. In this case, if we pay ABC Products €100 and contra the €900 they owe us against what we owe them, this will settle their account with us and our account with them. Effectively the net difference will have been paid over by a cheque.

How it is done using your accounts software.

A.  Your accounts software has a contra option

If your accounts software has a contra option then find out how it works and use it. If your accounts software does not have a contra option then there are two options (B & C) listed below on how you can perform contra’s.

B. Your software has Sales Journals and Purchase Journal options

1. In the Nominal ledger set up a contra account in the balance sheet in the current liabilities section.

2. In the Sales ledger, where ABC Products owes us €900, enter a Sales Journal for €900 and use the nominal ledger code for contra account as set up in 1 above. This will reduce the amount owed to us by ABC Products to zero and put a value of €900 in the contra nominal ledger account.

3. In the Purchase Ledger where we owe ABC Products €1000 enter a Purchase Journal for €900 and use the nominal ledger code for contra account as set up in step 1 above. This will reduce the amount we owe ABC Products to €100 and reduce the nominal ledger code balance for contra to zero.

4. Enter a payment for €100 to be entered into ABC Products account in the Purchases Ledger. The ABC Products supplier account will now have a zero balance.

In this entire transaction only €100 of money actually changed hands. But all liabilities from and to ABC Products are now paid up.

C.  Your software has no Sales Journals or Purchase Journal options

In this case you will have to use credit notes to replace journals. In order not to upset your VAT analysis you need to use a VAT code that will not appear on your VAT return reports.

1. In the Nominal ledger set up a contra account in the in the current liabilities section of the balance sheet nominal codes.

2. In the Sales ledger, where ABC Products owes us €900, enter a Sales Credit for €900 (do not charge VAT) and use the nominal ledger code for contra account as set up in 1 above. This will reduce the amount owed to us by ABC Products to zero and put a value of €900 credit in the contra nominal ledger account.

3. In the Purchase Ledger where we owe ABC Products €1000 enter a Purchase Credit Note (do not charge VAT) for €900 and use the nominal ledger code for contra account as set up in step 1 above. This will reduce the amount we owe ABC Products to €100 and reduce the nominal ledger code balance for contra from €900 to €0.

4. Enter a payment for €100 to be entered into ABC Products account in the Purchases Ledger. The ABC Products supplier account will now have a zero balance.

In this entire transaction only €100 of money actually changed hands. But all liabilities from and to ABC Products are now paid up.

What we have learned here is that a contra can be used to clear off debts and reduce the amount of money needed to pay the debts. This only works where a customer of yours is also a supplier to you. Contra’s can also be used where you get paid in something that is not actually money but could be stock product items. The same principle applies of using a contra to contra the customer’s account and contra the stock account value in the case where you are paid by stock. This can happen when a company is going out of business because of lack of cash so all it has to handover are stock product items.

(c) HelpForBookkeepers 2009