Chapter 3 of 6 · 10 min

Write-downs and impairments

Marking an asset down: a non-cash charge whose cash effect depends entirely on tax.

By the end of this chapter you can

Walk an inventory write-down through the three statements
Explain why a goodwill impairment moves no cash at all
Work out the size of a write-down from the change in cash
Say what a write-down tells you about the business

The intuition

A clothing retailer has $1 million of winter coats in its warehouse. Winter ends early, and the coats will now only sell for $600,000. The retailer does not wait until it sells them: it writes the inventory down by $400,000 today, because the balance sheet should not claim the coats are worth more than they are.

No cash moved: the coats were paid for months ago. The write-down is an admission, recorded as an expense. Whether it affects cash at all comes down to one question: does the tax authority let you deduct it?

The key idea

A write-down is a non-cash charge. If it is tax-deductible, cash rises by the tax saved, just like depreciation. If it is not, cash does not move and net income takes the full hit.

Why it works

Balance sheet. The asset (inventory, goodwill, a factory) falls by the charge, W.
Income statement. The same W runs through as an expense. An inventory write-down usually sits in cost of goods sold, so EBITDA falls too; impairments of goodwill and other long-lived assets sit below EBITDA.
Tax. An inventory write-down is generally deductible: tax falls by W × t and net income falls by W × (1 − t). A goodwill impairment generally is not: tax does not move and net income falls by the full W.
Cash flow statement. Start from net income and add back the non-cash charge, W. What remains is the tax saving: W × t for a deductible charge, zero otherwise.
Balancing. Assets fall by W, partly offset by any extra cash. Retained earnings fall by the drop in net income. The two always match.

$40 charge at a 25% tax rate

Inventory write-down (deductible): net income	−30
Inventory write-down: change in cash	+10
Inventory write-down: total assets (−40 inventory, +10 cash)	−30
Goodwill impairment (not deductible): net income	−40
Goodwill impairment: change in cash	0
Goodwill impairment: total assets	−40

In both cases retained earnings fall by exactly the drop in net income, so the balance sheet balances.

The formulas

Tax shield = W × t (only if deductible, otherwise 0)

The one way a non-cash charge can touch cash.

Δ Net income = −W + shield

−W × (1 − t) if deductible; the full −W if not.

Δ Cash = Δ net income + W = shield

Add the non-cash charge back and only the tax saving is left.

Δ Asset = −W

The asset is marked down by the full charge.

Δ Total assets = shield − W = Δ equity

More cash (perhaps), less asset; retained earnings match.

Worked example

A full walk-through. Check whether the charge is deductible before you touch the tax line.

Drawing the numbers…

See it move

Same company. Switch between a deductible inventory write-down and a goodwill impairment, and change the size of the charge and the tax rate.

Drawing the numbers…

Try this

Switch to goodwill. The tax line and cash stop moving, and net income falls by the whole charge.
Switch back to inventory. Net income falls by less, and cash rises by exactly the amount net income improved.
Raise the tax rate with inventory selected: the write-down hurts net income less and adds more cash. With goodwill selected, the tax rate changes nothing.
Try both switches: the balance check stays green either way.

Run it backwards

Same company, reversed: the only clue is that cash went up. How big was the write-down?

Drawing the numbers…

A write-down uses no cash, so the only cash that moved is the tax saved: W × t. Divide the change in cash by the tax rate to get W.

This only works because the write-down was deductible. A goodwill impairment leaves cash untouched, so cash tells you nothing about its size.

Traps

Saying cash falls by the size of the write-down.

Nothing was paid. The asset was bought long ago; the write-down only records that it is worth less.

Taking a tax deduction on a goodwill impairment.

Goodwill impairments are generally not deductible, so there is no tax saving: net income falls by the full charge and cash is unchanged.

Forgetting the asset on the balance sheet.

The asset falls by the full charge. Pair it with any change in cash, then match against retained earnings.

Assuming no write-down touches EBITDA.

An inventory write-down usually runs through cost of goods sold, above EBITDA. A goodwill impairment sits below it.

Dismissing the charge because it is non-cash.

It tells you something went wrong: demand fell, products became obsolete, or an acquisition was overpaid. Ask what it means for future cash flows.

Say it in the interview

The interviewer asks

“A company writes down $40 of inventory at a 25% tax rate. Walk me through the three statements.”

Say yours out loud first, then compare.

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4

Drawing your questions…

Remember

Write-down: asset −W, expense +W.
Deductible: net income −W × (1 − t), cash +W × t.
Goodwill impairment: usually not deductible, so net income −W and cash unchanged.
Retained earnings match the change in total assets: it balances.