Let's say SG&A cash expense increases by $10 and we already have 0 taxable income.
For the 3 statements, do we record a NOL under Assets at $10*20% tax rate = +$2 assets or at the before-tax amount of +$10?
My guess: SG&A cash expense +$10. Taxable income is -$10. As a result, net income is -$10. Cash flow: net income is -$10 so total cash is -$10. Balance sheet: cash is -$10, NOL is +$10. No change to L+E.
Is this correct (no change to equity)? Now, what if instead of SG&A it is COGS expense? Assume as usual it's just materials being used (inventory reduction).
My guess: COGS expense +$10. Taxable income is -$10. Net income -$10. Cash flow: net income -$10 and inventory reduction is source +$10 so total cash is $0. BS: Cash is $0, NOL is +$10. Equity +$10?
Is this correct (increased equity)? If so, can someone explain why when we have an expense as non-cash then it accrues to equity whereas a cash expense has no effect on equity? Intuitively why does the nature of the cash vs. non-cash expense result in a different effect to equity? Does the emergence of NOLs (going from operating profit/breakeven to operating loss) play some factor?
Thanks.
A few issues with the above, will take it from the top.
P&L SG&A: +10 Pre-tax income: -10 Taxes: -2 Net Income: -8
CFS Net Income: -8 Increase in Deferred Tax Asset: -2 (to clarify - an NOL is not a balance sheet account, there is a book / tax delta because you are not getting $2 back from the government, becoming a DTA) Total cash: -10
BS Cash: -10 Deferred Tax Asset: +2 Total Assets: -8 Shareholders Equity: -8
Now with it in COGS and a change in inventory:
Income statement: Unchanged
CFS Net Income: -8 Increase in Deferred Tax Asset: -2 Inventory reduction: +10 Total cash: 0
BS: Cash: 0 DTA: +2 Inventory Reduction: -10 Assets: -8 Shareholders Equity: -8
Can you explain why in that first example we have Taxes -2 even when pre-tax income is a negative number? Normally I figured this is how it works but since you have a loss already wouldn't it not be possible to have negative taxes, even in book accounting? Other than that, it makes sense. Thanks.
Sorry if my convention is confusing, -2 for taxes was meant to mean its income from taxes, which is why your loss goes from -10 (pre-tax) to -8. GAAP mutiplies pre-tax income by the effective tax rate, regardless of whether its a positive or negative number.
Ah, I did not know that about GAAP. Thank you for clarifying. So for NOLs even after marking the entry to DTAs we still proceed with Income Taxes as pre-tax * tax rate? In some models I have seen the income taxes line as =MAX(0,pretax*tax rate). I am assuming this is not the technically correct approach then?
You've seen that in models because most finance professional models care about modeling cash flow, and are less focused on proper GAAP. So it adds extra steps to push through tax income, then reverse out the cash impact in the CFS by increasing the DTA.
Super helpful! If we say then had $10 of pretax income the next year, how would the NOL move through the statements when it is rewinding?
I assume carry backs were no longer possible due to reform so it's only carry-forwards. Would you show NOLs impacting pre-tax (taxable) income or would you just run book accounting as usual and then apply DTA adjustments separately?
The latter.
GAAP: $10M pre-tax income $2M taxes $8M Net Income
Tax: $10M pre-tax income Apply $10M NOL from prior year $0M adjusted Pre-tax income $0M taxes
DTA: Reduced by $2M difference
GAAP CFS $8 Net Income +$2M reduction in DTA $10M CFO
Reconciles actual cash experience with no cash taxes paid.
Thanks, you seem like one of the few here who knows accounting very well. Mind if I ask how to treat DTAs when there are also DTLs? Is it common to have both DTA and DTL separate line items on the Balance Sheet or to net them?
An example I would give: suppose you perform a LBO/M&A as a stock purchase and end up with write-ups to PP&E or Intangibles that lack equivalent tax basis step-ups. As a result you'll have some DTLs created as seen from GAAP PPA. Then let's say we have 3 different scenarios.
Scenario 1: Let's say in some year the book/GAAP accounting pre-tax income falls below zero, but tax accounting pre-tax income is still above zero (since the tax basis does not get the step-up, it does not have increased D&A, and therefore has higher taxable income, so higher taxes are obligated relative to the GAAP accounting). - Do you still have a NOL? (Is the NOL determination solely based off of GAAP/book accounting's pre-tax income figure?) Do we still have an associated DTA created? - If the DTA is created, do we net the DTA against the DTL or are they generally treated differently, despite having similar sounding names?
Scenario 2: Let's say now that both GAAP accounting and tax accounting pre-tax incomes are below zero. - Do you still have a NOL? Do we still have an associated DTA created? - If the DTA is created, do we net the DTA against the DTL? It seems that GAAP accounting would still yield some "negative" taxes paid figure. Do the rules for tax accounting also yield a "negative" taxes paid figure? If so, do you still create this "DTL" between these two negative implied tax figures?
Scenario 3: Now suppose both GAAP and tax accounting yield positive pre-tax incomes and now we have NOL to carry-forward from previous years. From what you've said before, I assume we perform the GAAP accounting on Income Statement per usual and then have a section dedicated to reconciling the DTLs and then applying DTAs. Is this correct?
Let me know if these questions make sense. Thanks!
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