This is an example of a non-cash charge. When an asset that is still carried at some value on the balance sheet is determined to be worthless, the company reduces that value to $0 and takes a charge on the income statement. The charge is found below the operating profit line and is often called an unusual or extraordinary item.
Depending on the size of the write-off, the result can be a major reduction in net income in the period in which the writedown occurs. At times, it can even turn a net profit into a loss.
The effect on the balance sheet is a little less obvious. It reduces the "carrying" value or book value of the asset, which has the effect of lowering equity and affects such ratios such as debt-to-equity. This can also trigger debt covenants.
At times, a company will push this charge into a single year or quarter and pool it with other non-cash charges, "take a bath" with the intention of wiping the slate clean, so to speak. This also has the effect of making the following year's comparison artificially very good.
This type of charge can be an indicator of problems with inventory management. If inventory is determined to be non-salable, then management misjudged on what could be sold how quickly. Technology companies, such as Cisco can run into this problem as the pace of change can be faster than sales. Or economic conditions can change and the company is caught with a bunch of worthless inventory.
One way to sniff this out is to pay attention to levels of raw materials, goods in progress, and finished goods, which are the various components of inventory. These numbers are reported in the footnotes to the financial statements, especially the annual report. A build-up of finished goods represents a future slow down in sales or increased levels of obsolete inventory.
Recent Mentions on Fool.com
- Here?s the Single Biggest Itemized Tax Deduction
- 4 Uncommon Tax Deductions You May Be Overlooking
- These 3 Low-Priced Stocks Could Help You Beat an Overvalued Market
- How the Home-Office Deduction Works With the Mortgage-Interest Deduction
- Forget the Costco Loss -- AmEx Has This Advantage its Big Rivals Can't Beat
- Best Tax Tips for 2015