NOLs on Three Statements
Hey - I was reading the M&I 400, and one of the questions they asked was: "How do NOLs affect a company's 3 statements?". The answer they gave was that you should "create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you book the difference as an increase to the Deferred Tax Liability on the Balance Sheet."
I'm slightly confused as to why they reference DTLs in the answer and not DTAs (I thought NOLs corresponded with DTAs). I'm also confused about why they are adding the difference between Taxable Income based on NOLs and what you pay in taxes w/o NOLs. Shouldn't we just be adding the difference between what we pay in taxes with and without NOLs to deferred taxes?? Maybe I'm missing something here. Would greatly appreciate any help - thanks!
You got it right.
Did you get an answer for this? Would be curious since I'm also confused on this question.
NOLs are a GAAP metric, and therefore reduce taxable income on a book basis. DTLs come into place because a difference arises between book taxes and cash taxes, as you alluded to previously. Therefore, when calculating book taxes your basis (pre-tax income) is going to be lower because the NOLs have been applied vs cash taxes where the basis is higher due to no NOLs reducing pre-tax income. Since the IRS doesn’t give a fuck about NOLs a DTL arises because of the difference in basis (book vs cash). At some point down the line (no pun intended), a special payment will likely need to be made to the IRS to bring taxes back in line
Hey, thanks for the response. Could you also help me understand whether NOLs create DTLs or DTAs? The M&I 400 guide says that NOLs create DTLs, but I also see a lot about how it creates DTAs instead. I'm not sure how to interpret this.
Also, there's another line that says that the quick way to do this is to reduce taxable income by NOL, apply the tax rate, and "subtract that new Tax number from the old Pretax Income number (which should stay the same)." Why would you reduce taxable income by NOL and subtract the new tax number---won't this double count the effect of NOL? And what are the things that should stay the same?
Here is how it works. Assume in year 1 company generates a $100 NOL and has a 20% tax rate. In year two, company generates $40 of taxable income before NOLs. To be super clear, the below is ONLY going to focus on the tax impacts related to the NOL creation and utilization, NOTHING else will be considered.
Year 1
IS: NOL creates deferred tax benefit of $20 ($100 NOL x tax rate). Net income goes up by $20
BS: DTA of $20 is created and $20 of net income increases retained earnings. NOLs always create DTAs, never DTLs.
CF: Start with net income of $20. Then reverse $20 as the deferred tax benefit is non-cash. Zero impact to cash.
Year 2
IS: $8 of DTA will be reversed ($40 x tax rate), which creates deferred tax expense. Using the NOL also saves $8 of current tax expense (this years tax bill). These two impacts net out to zero. No impact to net income. This is counter intuitive to many; point is that you recognize entire benefit of the future taxes you will save from an NOL in the year you generate it, not when you use it. Counter to what was said in another comment, IRS absolutely cares about NOLs, you can carry them forward to offset future taxable income — so getting them right matters.
BS: DTA reduced by $8 and taxes payable reduced by $8 for the use of the NOL. Said differently, you used some of the tax benefit, so need to reverse the DTA, and you saved on this years taxes, so can also reduce liability to taxing authority.
CF: Start with net income of zero. The reversal of the DTA and decrease in taxes payable will be shown in cash flows from operations but will net to zero.
As an aside, I’ve worked in both IB and PE and not a single deal professional I’ve worked with can explain the above. Point is, I understand desire to get this stuff, but recommend you master the real needle movers first. Some unsolicited advice :)
Hope that helps.
Thank you for sharing.
Would you mind me clarifying: For Year 1, what is the rationale behind classifying NOL as non-cash expense reversal rather than a DTA increase under cashflow operations. The net change in cash is the same but just wanted to understand the classification of line item.
What the line item is actually doing is reversing a deferred tax benefit (reduction to the income tax expense line) out of net income.
I’m less sensitive to what it’s called, but if you know what the line item truly represents you can choose the verbiage in a way that makes sense. I’d lean toward calling it deferred tax expense / benefit because there can be changes in the deferred tax balance sheet accounts that don’t hit the P&L (e.g., purchase accounting), and thus don’t need to be removed from net income.
Suscipit voluptatem ut rerum velit dolore. Debitis quis qui voluptas id eos eum. Sequi qui quia voluptas ut et. Expedita praesentium sit et.
Minus qui ad ipsam et sit aut quos. Ratione unde inventore aliquid natus quod velit. Dolores voluptas qui qui necessitatibus facilis perferendis.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...