Write off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.
Write-Off happens when the recorded book value of an asset is reduced to zero. Usually, this happens when the assets of the business cannot be liquidated and are of no further use to the business or have no market value.
It can be defined as the process of removing an asset or liability from the accounting books and financial statements of a company. For example, this might happen when inventory becomes obsolete or there is no particular use of a fixed asset. Generally, it is done by moving a part of or all of the balance in an asset account to an expense account. It varies with the types of assets.
It usually occurs once and is not spread over various periods. A tax write-off is the reduction of taxable income. In retail companies, the common write-offs are damaged goods and in industrial companies, it happens when a productive asset gets damaged and is beyond repair.
Why Write-Off is done in Accounting?
It happens mainly because of two reasons.
- It helps with tax savings options for asset owners. Actions like these reduce tax liability by creating expenses that are non-cash in nature which ultimately results in lower reported income.
- It supports the objectives of accounting accuracy.
- Bad Debt – Bad Debt can happen when a business client owes money to the company but is unable to pay back the invoice amount since the client has been declared bankrupt. The amount of debt that could not be collected is taken as a loss and the company writes it off on its tax return.
- Asset Write-Offs – This happens when a company removes an account. In this case, the asset’s value has gone down to zero and that is the reason for writing off the asset from the accounting records.
- Accounts Receivables – In the situation, accounting receivable not being collected, it is usually offset against the allowance for doubtful accounts i.e. contra account.
- Inventory – In case of obsolete inventory, this can either be charged directly to the cost of goods sold or offset against the reserve for inventory which is obsolete (contra account).
- Advanced Pay – When a pay advance given to an employee cannot be collected then it is charged to compensation expenses.
How Write-Off is Applicable for Banks
A bank is in the business of lending money to individuals or companies. In an ideal situation, banks expect to get back the money that they lend to other organizations, for the expansion of their business. But there are situations where the organizations fail to generate income from their operations, ends up making losses and defaulting on their loan payments.
That is why banks maintain the provision for bad debt. For banks loans are there primary assets and source of future revenue. If the bank is not able to collect a loan or there is minimal chance of the collection of a loan a then it affects the financial statements of a bank and will result in diverting resources from other productive assets.
As a result of loans that have a high probability of getting defaulted, banks use write-offs for those loans from their balance sheet.
Let us understand with the help of an example of how a bank reports a loan in its financial statements and maintains the provision for the bad debt. Suppose a bank lends $100,000 to an organization and have 5% provision for bad debt against that loan. Once the bank lends the loan it will report $5000 as expenses in its financial statements. The remaining $95,000 will be reported as assets in the balance sheet.
If the default amount is more the provision made by the bank, then the bank will write-off that amount from receivables and will also report additional expenses. For example, if the default amount says $10,000, $5000 more than the provision for the bad debt. Then the bank will report an additional $5,000 as the expense and will also remove the entire amount.
When the bank removes the non-performing asset from its books, it receives the tax deduction for the loan amount. Moreover, even the loan is written off, the bank has the option to pursue the loan and generate some revenue from that bank. The banks also avail the option of selling the defaulted loans to third-party agencies to recover those loans from the customers.
Banks around the world are still under pressure due to the subprime crisis that affected the banking system. The customers took the loan for their house in lieu of mortgaging the house and could not return the loan. These loans needed to be written off form their balance sheet and as a result, put a lot of pressure in the financial health of the bank. The similar situation has happened in India as well where banks mainly public sector banks have lend money to organizations which have defaulted their loan payments. This situation resulted in writing off the loans from the balance sheet, resulting in shrinking of the book value of the banks.
Whenever a company has to write-off asset faces its impact on the future flow of revenue, as the asset can no longer generate any source of revenue for the company. But in spite of that, a company needs to write-off asset which is no longer in use for the company, as it helps the company to become cleaner and also avoid the situation of that asset using resources of another productive asset.
This has been a guide to what are Write-Offs, its examples, accounting and why they are done. Here we discuss write-offs in banks along with practical examples. You may learn more about accounting from the following articles –