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Write-Off, Asset and Bad Debt Write Down
Definition, Meaning Explained, Examples

 

When a seller learns that one of its customers is bankrupt or closed, the seller may decide that the customer is unlikely ever to pay its outstanding bills. The seller can write off an uncollectable receivable by debiting a non cash expense account "Bad Debt Expense" while at the same time crediting a contra asset account "Allowance for Doubtful Accounts."

Firms sometimes have to admit—formally and publicly—that certain assets have lost value.

What is a Write-Off?

Write-off is an accounting term referring to an action whereby the book value of an asset is declared to be 0.  A write-down also lowers asset book value, but it does not take the value to 0. In either case, the loss enters the accounting system as an expense.

Write-off is a noun naming the action and the non-hyphenated phrase write off is a verb for taking that action.

Assets can lose book value or become worthless for a variety of reasons.

One common use for the write-off occurs when a seller's accounts receivable assets become non collectable. In that case, the seller writes off the debt by registering a Bad debt expense

A write-off (or write-down) is also called for when inventory assets lose some or all of their value. Note that inventory can lose value through obsolescence, changes in market demand, damage, spoilage, or theft.

Purpose of the Write Off

In any case, accounting write-offs serve two purposes:

  • Firstly, write-offs support accounting accuracy objectives
  • Secondly, write-offs create a tax savings for asset owners. Write-offs reduce tax liability by creating (non cash) expenses that result in lower reported income.

Broader Meaning of Write Off

Note by the way that the term is also used informally and more broadly to mean "worthless." In this sense, "write-off" might refer to a project, initiative, or program that is abandoned, or stopped, because it is not expected to deliver results that were hoped for. Or write-off can simply refer to an investment of any kind that is now regarded as worthless.

Explaining Write Off in Context

Sections below further define, explain, and illustrate write off. Note especially that the term appears in context with related terms and concepts from the fields of financial accounting and finance.


 

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How do Firms Write Off Bad Debt?

Sales transactions in business normally include payment timing provisions, such as "Net 30 from receipt of invoice." An invoice with this annotation means that payment is due no later than 30 days from invoice receipt. When a customer is late in paying, however, most companies continue to carry the obligation under "Accounts receivable" for a period of time. During this time, they use various means to encourage the customer to pay (see Bad Debt). 

The Decision to Write Off a Bad Debt

Most firms, however, also have a specified cutoff period which may be something like 30, 60, 90, or 120 days, beyond which the firms must choose between two possible actions:

  • Firstly, the company may choose to write off the obligation as bad debt.
  • Secondly, the company may choose instead to refer the debt to a collection service or to their lawyers for further legal action.

Note that writing off the debt by the accountants does not remove the customer's obligation to pay. Writing off the debt serves only to improve the company's accuracy in accounting.  

Firms may also decide to write off a bad debt when it becomes clear for other reasons that the customer will never pay. This can occur when the customer goes out of business, or is sued by other creditors, or simply challenges the legitimacy of the obligation.

Bad Debt Write-Off: Impact on Financial Statements

Certain bad debt write-off actions are standard accounting practice for every firm that uses accrual accounting and a double-entry accounting system. Writing off debt in this way means making two accounting system accounts:

  • Firstly, the firm debits the amount of the debt to an account, Bad debt expense. This is a non cash expenses account.
  • Secondly, the firm credits the same amount to a contra asset account, Allowance for doubtful accounts.

Writing off debt in this way therefore directly impacts two accounting system accounts: Bad debt expense and Allowance for doubtful accounts. Changes in these accounts, in turn, involve other accounts and the firm's financial reports as follows:

Income Statement Impact

Firms report revenues earned during the period on the Income statement. And, earned revenues include those that are still payable. These are carried in a Balance sheet Current assets account, Accounts receivable. This account is itself is not an Income statement line item, but its balance is part of the Income statement item Total net sales Revenues.

When the period includes a bad debt write off, however, the Income statement does include the Bad debt expense balance as a line item. This normally appears under Operating expenses, below the Gross profit line. As a result, Bad debt expense from a write off lowers Operating profit and bottom line Net income.

Balance Sheet Impact

A bad debt write-off adds to the Balance sheet account, Allowance for doubtful accounts. And this, in turn, is subtracted from the Balance sheet Current assets category Accounts receivable. The result appears as Net Accounts receivable. The write off, in other words means that Net Accounts receivable is less than Accounts receivable.  

Statement of Changes in Financial Position (Cash Flow Statement)

Bad debt expense also appears as a non cash expense item on the Statement of changes in financial position (Cash flow statement). Bad debt expense from a write off is subtracted from Sales Revenues, lowering Total Sources of Cash.

Statement of Retained Earnings

Net income (Net profit) from the Income statement impacts the Statement of retained earnings in two ways.

  • Firstly, as dividends paid to share holders.
  • Secondly, as retained earnings.

At period end, the firm's Board of Directors decides how to distribute Net Income between dividends and retained earnings. Because write off impacts Net income, therefore, the action also lowers dividends and retained earnings on the Statement of retained earnings.

For more on these transactions, and examples, see the article Allowance for Doubtful Accounts.

How Do Firms Write Down Inventories?

It is an accounting principle everywhere that assets are to be valued accurately and realistically. In December 2012, however, Research in Motion (RIM) of Canada recognized that the realizable market value of its Blackberry Playbook inventory had fallen well below the company's COGS (Cost of Goods Sold). This, in turn, meant that the inventory would never earn revenues enough to cover its original Balance sheet value. Consequently, RIM took a $485 million write-down on the total book value of the unsold devices. The write-down was necessary to maintain accounting accuracy.

How Do Inventories Lose Value?

In fact, inventory of various kinds can lose value due to quite a few different factors. Inventory write-downs may be necessary, when:

Inventory Market Value Decreases

Market value may be driven lower by lack of customer demand or aggressive pricing by competitors.

Inventory is Stolen

Burglary in the warehouse or shop can result in stolen inventory. However, theft can also result from pilferage by shippers, shoplifters, or the company's own employees.
This kind of inventory loss is so common, and so immune to complete eradication, that many companies call such losses leakage or shrinkage and then regularly report an inventory write-down under one of these names.

Inventory Suffers Damage or Spoilage

Perishable goods such as vegetables, fruits, or cut flowers, for instance, have by nature a short "shelf life." This can be further reduced by inadequate storage and handling. Disasters or accidents can also drastically destroy or lower value.

Items Become Obsolete or Out of Date

Many consumer technology products can command high market prices for a few months at most. Designer fashion clothing commands a high market value only for a relatively short "season" of a few weeks or several months at most. Printed magazines and other dated publications may have high value for no more than a few days.

Accounting for inventory write-down

When inventory loss due to one of these causes is relatively small, the firm can simply report the loss as part of COGS. When the loss is relatively large, however, as in the case of RIM's 2012 write down, the loss impacts the company's other Balance sheet and Income statement accounts.

With a relatively large inventory write-down:

  • The firm credits a Balance sheet asset account, such as Finished goods inventory. A credit transaction lowers the value of an asset account.
  • Simultaneously, the firm debits an Income statement expense account. The firm could carry, for instance, an expense account for this purpose called "Inventory shrinkage." The expense item in any case appears as an operating expense.

The ultimate impact of these transactions, of course, are to (1) reduce Net income on the Income statement, and (2) Reduce the value of the total asset base on the Balance sheet.
For more on inventory accounting, including inventory write-downs, see the article Inventory and Inventory Management.

Writing Off Other Kinds of Assets

Other assets besides "Accounts receivable" and "Inventories" may also be subject to write-off or write-down. This occurs usually when they become worthless or nonproductive. In these cases, a write-off or write-down also means reporting two simultaneous and equal transactions:

  • Firstly, as a debit (increase) to an Income statement expense account.
  • Secondly, as a credit (decrease) to an asset account.

The laws specifying the kinds of losses and kinds of assets that qualify for loss deduction, and the calculation of loss value, appear in the country's tax code. In the United States, for instance, this is Internal Revenue Code Section 65.

Generally, the kinds of losses that qualify for writing off in this way include:

  • Ownership of stock shares that become worthless.
  • Theft or vandalism for Property, plant and Equipment or other Capital assets.
  • Casualty or catastrophe such as fire, flooding or other natural disaster.

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