 Hello and welcome to this session in which we will discuss net operating loss or known as NOL. What is net operating loss? Well simply put in some years the companies might generate more expenses or we call them deductions for tax language more than revenues or income. So simply put in some years the company might generate revenues of 150,000 and generate expenses or deductions for 250. Well as a result you are at a loss of $100,000. Well what does that mean? It means for this year you don't have to pay taxes but is that it? No. What Congress says to be fair what's going to happen is your business is a continuation. So this is year one. In year two you might have more revenues than expenses. So what happened is this Congress says look your expenses that you took in year one should or your expenses means represented in the loss in the in the loss the loss of 100,000 your access expenses of 100,000 should be used in year two because the company is a continuation otherwise you don't want to lose your deduction. So basically Congress allows you to use the NOL to offset profit in future years. Obviously subject to limitation and the reason I emphasize future years because the rules for NOL has changed recently few times but now we're dealing with 2021 and going forward therefore you can offset your profit in future years. And NOL here for the sake of what we're discussing is the 100,000. So simply put you could use this 100,000. Again no taxes will be paid in the year the NOL is incurred. Obviously you have no gain no taxable income therefore you pay no taxes and the Tax Cuts and Jobs Act of 2017 which is for President Trump permits the carry forward of the net operating loss to offset future taxable income again starting in 2021 because between 2017 to 2020 we had few rules you don't have to worry about them anymore. So bear in mind the Tax Cuts and Jobs Act eliminated any carryback provisions so be careful on the CPA exam there is no carryback provision starting 2021 so it's an easy answer to eliminate. The best way to illustrate this concept is to actually look at an example. Assume that Adam company had has no temporary or permanent differences and what happened Adam incurred net operating loss of 100,000 in year 20x1 and the enacted future tax rate is 20% because when you are looking to compute that future savings from the 100,000 you have to use the future tax rate. Now simply put what's going to happen is this since Adam incurred loss maybe this is year one in Adam's business they did not generate a lot of revenue they had to do a lot of they had to incur a lot of expenses to get the business going that could be the case as a result we have a loss of 100,000. What happened is this you're going to take this 100,000 and multiply it by 20% the future tax rate and here's what we're saying in the future you have a future savings of 20,000 why because you can use those losses to offset your revenues in the future well as a result to represent this you're going to book the third taxed asset of 20,000 and you're going to credit income tax expense loss carry forward of 20,000 so notice what you did is you put an asset on the books and you reduced your income tax expense basically income tax expense credit is the same thing as income tax benefit and this is from the loss carry forward so you have an income tax benefit so what happened on the balance sheet you have an asset called the third taxed asset on the income statement what's going to happen is this you're operating loss is negative 100,000 then you have the income tax benefit of 20,000 your net operating loss becomes negative 80,000 so what happened is is you reduced you reduced your net operating loss from negative 100,000 to negative 80 yes you are still negative nevertheless you are better off reporting negative 80,000 in other words you have a benefit of 20,000 now the question is when are you going to use this benefit and how are you going to use this benefit before we discuss your future use of this benefit I would like to remind you whether you are a student or a CPA candidate and most likely this is how you landed on this recording you must be a student or a CPA candidate I can help you prepare for your CPA exam in addition to your CPA review course I don't replace your CPA review course my resources supplement your CPA review course I also can help you with your accounting courses all my lessons are organized by course chapter I have lectures multiple choice through false my CPA material is aligned with your Becker Roger Wiley gleam so it's very easy to go back and forth between my material and your CPA review course including miles I also give you access to previously released AI CPA questions 1500 of them with detailed solution if you have not connected with me on LinkedIn please do so take a look at my LinkedIn recommendation like this recording just like you found it like it share it with others so it benefit other people connect with me on Instagram Facebook Twitter Reddit and I have a CPA exam support to group on group me please join me another CPA candidate who are preparing for the exam so in future years Adam company is starting with the the third tax asset of 20 000 assume in 20x2 Adam generated taxable income of 80 000 now Adam is profitable prior to the adjustment for NOL carry forward so this is 80 000 before we took that deduction and the tax rate is 20 so what's going to happen is this the taxable income prior to the NOL is 80 000 now there is a limitation on NOL you might be thinking hold on a second I have 100 000 in NOL therefore I can take this 100 000 and eliminate because I have 100 000 and I have taxable income of 80 eliminate the whole 80 000 and make my taxable income go down to zero the new tax cuts and jobs act it could there's a limitation you are you can eliminate up to 80 percent so 80 percent of 80 000 of your taxable income is 64 000 therefore what's going to happen is this you'll be able to deduct from the loss carry forward deduction remember we had you had 100 000 now you used up 64 000 just in case you're wondering what's happening is you used up the credit that credit it's not really a credit because the language the language to say the tax language credit means something else but you used up some of your expenses or some of your losses to be more specific from the prior year you still have losses of 36 000 that you can use in future years then your taxable income becomes 16 000 well taxable income times 20 percent will give you a tax bill of 3200 in year two let's prepare the journal entry for year two starting as always with your income taxes payable how much you have to pay to the IRS 3200 we credit that now what happened is this you used up you remember used up 64 000 used up 64 000 of your deferred taxed assets so used up 64 000 times 20 percent so if we take 64 000 times 0.2 you have to reduce your deferred taxed asset by 12 800 why because you are starting to use those 20 000 now what's left in your deferred taxed 7200 now we book income tax expense which is a plug as I always mentioned in my prior recording it's a plug and income tax expense is your deferred portion plus your current portion therefore is 16 000 now how things are showing on the income statement well on the income statement you have income before taxes of 80 000 then you have income tax expense and I broke it down here by the current portion 3200 but you have to pay now and the third portion the savings that you brought from the prior year your income tax expense is showed as 16 000 80 000 minus 16 000 will give you your 64 000 which is your net income for gap purposes now let's assume let's make this a little bit more interesting that it's more likely than not that Adam will not realize that 20 000 carry forward in future years simply put in simple English we don't expect Adam company to be able to realize to be able to enjoy to use up this deferred taxed asset why not because we expect them to generate losses in the foreseeable future now this rule was little bit more relevant when the carry forward was shorter but now since it's 20 years it's more likely than not not being used but nevertheless you have to learn the rules so what do you have to do if that's the case if it's more likely than not if it's more than 50 percent you remember we talked about the valuation allowance well if that's the case then you have to reduce your deferred taxed asset this account has to be reduced therefore what you do is you debit income tax expense so you eliminate this you see you have here income tax expense credit you'll go back and you'll put your income tax expense debit basically you eliminate this and you credit an account called allowance to reduce the third tax asset to expect to realize realizable value here we're going to assume that you're you're not going to be able to use any of it therefore you're going to have another t account called for short for short it's called this account the allowance but this is the 20 000 that we are having in this account so it's going to happen 20 000 on the balance sheet minus 20 000 allowance you have no deferred taxed asset and on the income statement you have operating losses of 100 000 your income tax benefit is you remember this was a benefit now we went back and we debited the benefit therefore it eliminated this benefit therefore your net loss is 100 000 so this is after you book it you'd say you know what i'm not going to be able to use it and let's assume we were wrong and in 20 x2 adam generated the taxable income of 80 000 prior to the adjustment well again we're going to book the same entry that we booked earlier we we computed this earlier we we have taxable income of 3200 income tax expense was 16 and we reduced our deferred taxed asset by 12 800 now what we have to do too we have to reverse reverse what we did reverse what we did means credit the allowance to reduce the third taxed asset and i'm sorry debit the allowance and credit the income tax expense simply put you have to go back here you have to go back here and the allowance you have to debit the allowance to reverse it so basically what we did is just simply reverse this reverse this notice we did not touch the third taxed asset that's still there what we do is we reduce it by 12 800 as we explained earlier and as a result you still have 7400 in the third taxed asset for future years now the valuation allowance you have to know how does the company come up with this valuation allowance there's what's called negative evidence that we will not realize the savings or there's positive evidence so what are some negative evidence that we're not going to be able to realize the savings well we have a history of prior NOL expired and unused it means we have a history of this so most likely there's a good chance we're always we may not be able to use the NOL if we expect losses in future years some companies expect losses in future years is it for the next 20 years i doubt it but if they do they have to make an adjustment for that if there's any pending circumstances like a lawsuit a major lawsuit or a major technology change or a major patent they're going to take away your business somehow then then you would have negative evidence to suggest you need the valuation positive evidence if you have pending contract or contracts means you're going to be making profit you could look at your sales backlog and based on your sales backlog you're going to be making a profit if you have asset with fair value greater than the basis it means if you're going to sell them you're going to have to pay taxes and if you have strong earning history and this year happened to be a blip just you had an NOL but usually you always have strong earning history so basically if that's the case you don't need a valuation account if that's the case you might need some valuation to do some valuation allowance what should you do now go to farhatlectures.com invest in yourself work multiple choice true false exercises your education is the most important thing it's an asset that stays with you know no one can take it from you take your accounting courses seriously take your CPA preparation seriously good luck study hard and of course stay safe