Net Operating Losses and Deferred Tax Assets

Overview of Net Operating Losses (NOL)

• Definition: A Net Operating Loss (NOL) occurs when a company has negative taxable income on its tax return. In such instances, the company is not required to pay income taxes for that specific year.
• Tax Benefit and Deferred Tax Assets (DTA): While taxes are not paid in the loss year, the loss remains useful for accounting and tax purposes. It creates a Deferred Tax Asset because the company can use the loss to offset taxable income in future years, thereby reducing future tax liabilities when the company returns to profitability.

Statutory Regulations and Carryforward Rules

• Current Rules (Post-Reform):
  • Carryback: Companies are no longer permitted to carry losses backward to previous tax years (no carryback).
  • Carryforward: Losses can now be carried forward indefinitely. They do not expire and can be utilized until the entire loss amount is exhausted.
  • Utilization Limitation: Companies are limited to offsetting a maximum of $80\%$ of their taxable income with NOL carryforwards in any given single year.
• Historical Context and Exceptions:
  • The rules changed roughly six years ago. Prior to this change, the standard rule was a 2-year carryback and a 20-year carryforward limit.
  • Industry Exceptions: The "old rules" (2-year carryback, 20-year carryforward) still apply specifically to:
    • Property and casualty insurance companies.
    • Certain farm businesses.
  • It is critical for accounting professionals to be aware of these exceptions if they work for or represent clients in the insurance or agricultural sectors.

Accounting for NOL in the Loss Year: Initial Recognition

• Case Study: American Laminating Corporation:
  • Total Net Operating Loss: $-120,000,000$.
  • Pre-tax Income: The company reports a loss rather than positive pre-tax income.
  • Tax Rate: $25\%$.
• Calculating the Deferred Tax Asset:
  • To determine the tax benefit, multiply the total loss by the tax rate:
  • $120,000,000 \times 25\% = 30,000,000$
  • This $30,000,000$ represents the tax dollars the company expects to save in the future, establishing the ending balance for the Deferred Tax Asset (DTA) for the loss year.
• Income Tax Payable:
  • In the year of the loss, the income tax payable is always $0$.
• Journal Entry Procedure:
  • A debit is made to the Deferred Tax Asset to establish the account.
  • A credit is made to Income Tax Expense (or occasionally labeled as "Income Tax Benefit").
  • Crediting an expense account is unusual and typically only seen during closing entries or in this specific context where a loss provides a future benefit.
• Impact on the Income Statement:
  • The loss is presented net of the tax benefit.
  • Operating Loss before Tax: $-120,000,000$
  • Income Tax Benefit: $30,000,000$
  • Net Loss: $-90,000,000$

Accounting for NOL Utilization in Future Periods

• Case Study Continuation: American Laminating Corporation (Year 2022):
  • Positive Income: The company earns $100,000,000$ in the subsequent year.
  • Applying the 80% Offset Limit:
    • The tax code limits the look-back offset to $80\%$ of current income.
    • $100,000,000 \times 80\% = 80,000,000$
    • Even though the company has a $120,000,000$ loss available, it can only use $80,000,000$ of it this year.
  • Calculating Taxable Income:
    • $100,000,000 \text{ (Current Income)} - 80,000,000 \text{ (NOL usage)} = 20,000,000 \text{ (Taxable Income)}$
  • Step 1: Calculate Income Tax Payable:
    • $20,000,000 \times 25\% = 5,000,000$
  • Step 2: Determine Ending DTA Balance:
    • Original NOL: $120,000,000$
    • NOL Used: $80,000,000$
    • Remaining NOL: $40,000,000$
    • Ending DTA Balance: $40,000,000 \times 25\% = 10,000,000$
  • Step 3: Calculate the Change in DTA:
    • Beginning DTA: $30,000,000$
    • Ending DTA: $10,000,000$
    • Decrease (Credit) to DTA: $20,000,000$
• Verification of Income Tax Expense (Check Figure):
  • Income tax expense can be calculated by applying the tax rate to the current pre-tax income:
  • $100,000,000 \times 25\% = 25,000,000$
  • Alternatively, it can be confirmed by summing the tax payable and the change in DTA: $5,000,000 \text{ (Payable)} + 20,000,000 \text{ (DTA Change)} = 25,000,000$.

Summary Journal Entry for NOL Utilization

• Debit: Income Tax Expense: $25,000,000$
• Credit: Income Tax Payable: $5,000,000$
• Credit: Deferred Tax Asset: $20,000,000$
• Note: This entry records the current tax liability while simultaneously reducing the Deferred Tax Asset to reflect the portion of the tax benefit that has been consumed during the period. The company saved $20,000,000$ in actual cash outflow (paying $5,000,000$ instead of $25,000,000$) due to the prior year's loss.