Question on NOLs

Hi guys,

I have a question on Net Operating Losses (NOLs) that has been stumping me for awhile, so was hoping to get some help on this.

Assuming

• EBT: Year 1 $100, Year 2 -$200, Year 3 $300

• Tax: 40%

• NOL: Starting balance $150

I understand that in Y1, the following happens:

• IS: PBT $100, Net income $60 (40% tax)

• Use $100 NOL (from the $150 balance), so NOL-adjusted net income is $0 (and remaining NOL balance is $50). The $100 use of NOL reduces DTA by $40 (tax rate x NOL used)

• CF: Net income $60 + Change in DTA $40 = $100

• BS: Cash +$100, DTA -$40 = $60. Retained earning +$60

I get a little confused when it comes to Y2 - which of the following scenarios is correct?

Scenario 1

• IS: PBT -$200, Net income $0 (no tax)

• Create $200 NOL (so balance is now $50 + $200 = $250). DTA increases by $80 (tax rate x NOL created)

• CF: Net income -$200 - $80 change in DTA = -$280

• BS: Cash -$280, DTA  +$80 = -$200. Retained earning -$200

Scenario 2

• IS: PBT -$200, Net income -$120 (40% positive tax)

• Create $200 NOL (so balance is now $50 + $200 = $250). DTA increases by $80 (tax rate x NOL created)

• CF: Net income -$120 - $80 change in DTA = -$200

• BS: Cash -$200, DTA  +$80 = -$120. Retained earning -$120

Between Scenario 1 and 2, Scenario 1 seems more logical to be (i.e. PBT = net income) but I struggle a bit with the concept that your cash position decreases by $280 when your PBT was -$200.

Thanks!