What is a Write-Down
BREAKING DOWN Write-Down
Write-downs can have a huge impact on a company’s net income and balance sheet. During the financial crisis, the drop in the market value of assets on the balance sheets of financial institutions forced them to raise capital to meet minimum capital obligations.
Accounts that are most likely to be written down are a company's goodwill, accounts receivable and long-term assets like property, plant and equipment. Write-downs are common in businesses that produce or sell goods have lots of inventory that can become damaged or unsalable. For example, technology and automobile inventories can lose value rapidly, if they go unsold or new updated models replace them.
Property, plant and equipment may become impaired because it has become obsolete, damaged beyond repair or property prices have fallen below the historical cost. In the service sector, companies may write down the value of stores if they no longer serve their purpose and need to be revamped.
Before 2002, goodwill was amortized over 40 years, much the way a piece of equipment might be depreciated over its useful life. But under new generally accepted accounting principles (GAAP) rules for the measurement and disclosure of fair value, goodwill is amortized on a straight-line basis over a period not to exceed 10 years, and must be written down at any time if its value declines — for example, if it turns out that a company has overpaid for an acquisition.
In November 2012, Hewlett-Packard announced a massive $8.8 billion impairment charge to write down a botched acquisition of U.K.-based Autonomy Corporation PLC – which represented a huge loss in shareholder value since the company was worth only a fraction of its earlier estimated value.
Accounting For a Write-Down
Assets are said to be impaired when their net carrying value is greater than the future un-discounted cash flow that these assets can provide or be sold for. Under GAAP, impaired assets must be recognized once it is evident this book value cannot be recovered. Once impaired, the asset can be written down — if the asset remains in use — or classified as an asset for sale, which will be disposed of or abandoned. The disposition decision differs from a write-down because once a company classifies impaired assets as assets for sale or abandonment, they are no longer expected to contribute to ongoing operations. For more on impairment recognition and measurement, read How do businesses determine if an asset may be impaired?
Effects of Write-Downs on Financial Statements and Ratios
A write-down impacts the income statement and the balance sheet. A loss is reported on the income statement — which is not tax deductible unless the affected assets are disposed of — and the asset's carrying value on the balance sheet is written down to fair value.
That said, an impairment usually creates a deferred tax asset on the balance sheet. If the write-down is small, it may be reported as a cost of goods sold (COGS). Otherwise, it is listed as a line item on the income statement, so lenders and investors can assess the impact of devalued assets. In summary:
- The current income statement will include an impairment loss in income before tax from continuing operations, reducing net income.
- On the balance sheet, long-term assets are reduced by the impairment. A deferred-tax asset is created (or if there was a deferred tax liability it is reduced). Shareholders' equity is reduced as a result of the impairment loss included in the income statement.
- Current and future fixed-asset turnover will improve.
- Because shareholders' equity falls, debt-to-equity rises.
- Debt-to-assets will be higher.
- Cash flow based ratios remain unchanged.
- Future net income rises because the lower asset values reduce depreciation expenses.
- The return on assets (ROA) and return on equity (ROE) will both increase.
- Any ratios that evaluated fixed assets and depreciation policy will be distorted.
Big Bath Accounting
Companies often write down assets in quarters or years in which earnings are already disappointing, to get all the bad news out at once – which is known as “taking a bath." A big bath is a way of manipulating a company's income statement to make poor results look even worse, to make future results better.
For example, banks often write down or write off loans when the economy goes into recession and they face rising delinquency and default rates on loans. By writing off the loans in advance of any losses — and creating a loan loss reserve — they can report enhanced earnings if the loan loss provisions turn out to be overly pessimistic when the economy recovers.