Accounting and decision making

A business buys assets and using those assets to convert less valuable input into more valuable output.

A business can do one of three things with any given asset:

  1. Continue the business as-is and making profit at the usual rate, but allowing assets to run down without replacing them
  2. Buying more assets in order to grow / be able to convert more input to output each day, or to maintain the current asset level
  3. Selling assets

When you compare options 1 and 2, what you want to understand is how much it would cost you to grow your business or to replace the assets that are degrading away. This is often approximated with the book value of your assets, and that approximation can be improved by adjusting for inflation and otherwise actually thinking about how much you can buy new assets for (the asking price). You compare this to the gross margin you get from utilizing the assets, or the ROA (return on assets), and that is in turn compared to the cost of capital.

If ROA is very low, you then think about selling the asset, and are comparing options 1 and 3. Instead of considering the replacement value of the asset you now consider the sale value (the bid price) of the asset–if the margin divided by the sale value is lower than the cost of capital, you would choose to sell the asset.

Considering all this, then, what is the difference between an unprofitable company posting a low return on assets compared to posting a write-down? (In the former, you are using a large denominator with a small numerator, while in the latter you are incurring a one-time loss followed by a higher profit level.)

The difference comes in when you consider what use those book values would be put to in the future. The book value’s primary function is as a proxy to replacement or sale value, and so if the assets in question can be bought for less they should be written down, and if they can be sold for more money they should be revalued upwards.

For example, a company that finds out it had overpaid 50% for some machinery it bought should write down that machinery, because that then gives the right signal with regard to whether it should expand or not, i.e., it should show off its ability to use cheaper fixed capital input to generate a given level of gross margin.

Writedowns are used to calibrate decision making and there is a definite correct way to do them!

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