When a seller learns that one of its business customers has closed suddenly, the seller may conclude that the customer is unlikely ever to pay its outstanding bills. The seller begins the write off by crediting a contra asset account "Allowance for Doubtful Accounts."
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 and write-down are nouns naming actions, and the non-hyphenated phrases write off and write down are verbs for taking that action.
Assets can lose book value or become worthless for a variety of reasons.
One frequent use for the write-off occurs when a seller's accounts receivable assets become non-collectible. 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, the "write-off" creates tax savings for asset owners. These actions 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 hoped-for results. Or write-off can merely refer to an investment of any kind that is now worthless.
Explaining Write Off in Context
Sections below further define, explain, and illustrate write off in context with related terms and concepts from financial accounting and finance, focusing on three themes:
- First, the accounting definitions of Write-Off and Write-Down.
- Second, example transactions that show how Accountants write off bad debt and other losses.
- Third, how and why accountants write down inventory losses.
- What is a write-off?
- How do firms write off bad debt?
- Can a company write-down inventories?
- How do firms write-off other kinds of assets
Sales transactions in business usually 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 some 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 decide to write off the obligation as a bad debt.
- Secondly, the company may choose instead to refer the debt to a collection service or their lawyers for further legal action.
Note that when accountants write off a debt, the customer's obligation to pay remains. 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. They may admit this reality when, for instance, the customer goes out of business, other creditors sue the customer, or the customer challenges the legitimacy of the obligation.
"Bad Debt" Write-Off: Impact on Financial Statements
Specific "bad debt" write-off actions are standard accounting practice for every firm that uses accrual accounting and a double-entry accounting system. Writing of obligations in this way means making two accounting system accounts:
- Firstly, the firm debits the amount of the debt to an account. This account is a non-cash account. "Bad debt expense
- Secondly, the firm credits the same amount to a contra asset account, "Allowance for doubtful accounts."
Writing off the 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
Companies report revenues earned during the period on the Income statement. Note that "earned revenues" include those that are still payable. And, all "earned revenues" 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. Items of this kind appear typically 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 shareholders
- Secondly, as retained earnings
At period end, the firm's Board of Directors decides how to distribute Net Income between "Dividends" and "Retained earnings." A write off impacts Net income, which means that 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.
As a matter of priniiiiple, accountants everywhere try to value assets 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 fall, in turn, meant that the stock 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. This action was necessary to maintain accounting accuracy.
How Do Inventories Lose Value?
In fact, inventories 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 stock. However, theft can also occur as pilferage by shippers, shoplifters, or the company's employees.
This kind of inventory loss is so common and 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." And, inadequate storage and handling conditions can further reduce shelf life. 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 takes 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 hold 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 merely report the loss as part of COGS. When the drop in value is relatively significant, 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 substantial 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, is 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.
Other assets besides "Accounts receivable" and "Inventories" may also be subject to write-off or write-down. These write-downs usually become necessary when assets of various kinds 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 rules specifying the kinds of losses and asset classes that qualify for loss deduction, and the calculation of loss value, appear in the country's tax code. In the United States, for instance, the relevant law is written in 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 disasters