CPA Exam (FAR): Net Operating Loss - YouTube

“Net Operating Loss.” ♫ Mystery Sound ♫

Sounds like bad news, right?

Well, it does have a bright side. ♫ Heavenly Sound ♫

If you don’t have income, then you don’t pay tax.

And on top of not paying tax in the year of loss,

a net operating loss gets carried forward to reduce future taxable income.

?! You heard right.

Net operating losses get carried forward and offset future taxable income.

Remember, if it reduces taxable income later,

it’s a future tax savings.

A deferred tax asset.

So, here’s the shortcut.

Net operating losses are ALWAYS deferred tax assets.

Let’s see how this works with an example.

Transition: Net Operating Loss FAR: Income Taxes

The prompt reads: Apple has a net operating loss in year 1 of $100,000

and taxable income of 40,000 in year 2

and 80,000 in year 3.

The tax rate for all years is 21%.

Provide the journal entries for years 1, 2 and 3.

First, let’s line up the information so it’s easier to see.

Put the years on one side.

And the amounts on the other.

“Net operating LOSS” sounds bad.

But here’s the bright side.

We don’t pay tax in the year of loss.

And net operating losses get carried forward and offset future taxable income.

Meaning, we carryforward year 1’s negative 100,000

to reduce taxable income and the tax paid in year 2.

Negative 100,000 is big enough to cover all 40,000 of taxable income and then some.

Can the net operating loss reduce taxable income to zero?

Nope.

Net operating losses only cover up to 80% of taxable income in any one year.

40,000

Times 80%

Equals

32,000.

That’s the 80% limit in year 2.

Now, we used 32,000 of the net operating loss.

How much is left?

Negative 100,000

Plus 32,000

Equals

Negative 68,000.

Which carries forward to year 3.

Can we use the entire 68,000 net operating loss to reduce year 3’s taxable income?

Nope.

Net operating losses only cover up to 80% of taxable income in any one year.

80,000

Times 80%

Equals

64,000.

That’s the 80% limit.

We just used 64,000 of the net operating loss.

How much is left?

Negative 68,000

Plus 64,000

Equals

Negative 4,000.

Which carries forward to future years.

Let’s take a step back and look at our calculations.

Notice, net operating losses only get carried forward.

And they get carried forward forever.

Also, net operating losses only reduce future taxable income.

Based on what we learned about temporary differences, We know, items that reduce later taxable income

create a tax savings.

A deferred tax asset.

So, net operating losses are always deferred tax assets.

Lastly, use of a net operating loss is limited to 80% of taxable income in any one year.

So, NOLs carry forward only.

Always DTA.

And 80% limit.

That’s it!

Let’s do the journal entries at December 31, Y1.

So far, we learned there are 2 basic entries for tax.

First for current. Second for deferred.

Let’s start with the first entry for current income tax expense.

Calculated as taxable income times the tax rate.

In year 1, taxable income is negative 100,000.

We’re calculating current income tax expense.

Here, there’s no income.

Plug in zero.

Remember, we have a progressive tax system.

The more taxable income you have, the more you pay.

If you have zero or a net operating loss, there’s nothing to tax.

And anything times zero is

Zero!

So, our first entry for current is nothing.

You can’t have tax expense if you don’t have taxable income.

Let’s do the second entry for deferred.

Remember, the shortcut.

Net operating loss always a deferred tax asset.

How much is it for?

We have a net operating loss of 100,000.

Is that what we’re going to record?

No way!

We want the tax amount.

We gotta multiply by the tax rate.

100,000

Times 21%

Equals

21,000.

Deferred tax asset.

Asset increasing.

Debit.

What’s the other side of the entry?

It’s a credit for 21,000.

Where’s it going?

Income Tax Expense.

Take note.

Income tax expense shows up in every basic tax entry.

The first entry for current, we have income tax expense.

The second entry for deferred, we have income tax expense.

And in the next video you’ll see, the third journal entry for the allowance,

we have income tax expense.

So, if you have an income tax question on FAR and you draw a blank on the account,

see if plugging in income tax expense makes sense.

First year done.

Let’s do the entries for December 31, year 2.

For tax, we have two basic entries.

First for current. Second for deferred.

Starting with the first entry for current income tax expense.

Calculated as taxable income times the tax rate.

In year 2, taxable income is 40,000.

Times 21%

Equals

8,400.

Let’s plug that into the journal entry.

Income tax expense increasing.

That’s a Debit. 8,400.

What’s the other side of the entry?

Normally, it would be a credit to Income Tax Payable.

But in year 2, are we going to pay the IRS 8,400?

What’s different about year 2?

We have a net operating loss from year 1.

Which reduces taxable income and the tax paid in year 2.

Year 1’s net operating loss of 100,000

is big enough to cover all 40,000 of taxable income and then some.

Can the net operating loss reduce tax payable to zero?

Nope.

Remember the 80% limit.

Net operating losses only cover up to 80% of taxable income in any one year.

For year 2, we said it covers 32,000.

Do we just plug 32,000 into the journal entry?

No way!

We want the tax amount.

We gotta multiply by the tax rate.

32,000

Times 21%

Equals

6,720.

That’s the 80% limit.

What account do we use?

[Thinking]

Deferred tax asset.

We now use the deferred tax asset and make use of those future tax savings from last year

Deferred tax asset getting used.

Credit.

Do our debits equal our credits?

We have a difference and it’s on the credit side.

It’s the difference between 8,400

and 6,720.

Which equals

1,680.

What’s this for?

This is the remaining 20% that we still have to pay.

Income Tax Payable.

Let’s look at our entry.

The income tax expense for current is the same every time.

It’s just taxable income times the tax rate.

The only thing that does change is that instead of a payable to the IRS for the full

tax expense we use the deferred tax asset.

Before we move on, let’s calculate the deferred tax balance.

Year 1, 21,000 debit.

Year 2, 6,720 credit.

Equals

14,280.

Let’s do the second entry for deferred.

Are there any new deferred items in year 2?

Nope.

Were there any tax rate changes where we need to adjust our existing deferred

tax balances?

Nope.

Then it’s blank.

Nothing new and no changes means no entry.

Let’s do the journal entries for December 31, year 3.

For tax, we have two basic journal entries.

First for current. Second for deferred.

Starting with the first entry for current income tax expense.

Calculated as taxable income times the tax rate.

In year 3, taxable income is 80,000.

Times 21%

Equals

16,800.

Let’s plug that into our journal entry.

Income tax expense increasing.

Debit. 16,800.

What’s the other side of the entry?

Normally, it would be a credit to Income Tax Payable.

But in year 3, do we pay the IRS 16,800?

What’s different about year 3?

We have a net operating loss balance from year 2.

Which reduces taxable income and the tax paid in year 3.

Can we use the whole balance of 68,000?

Nope.

Net operating losses only cover up to 80% of taxable income in any one year.

For year 3, we said it covers 64,000.

Do we plug this 64,000 into our journal entry?

No way!

We want the tax amount.

We gotta multiply by the tax rate.

64,000

Times 21%

Equals

13,440.

That’s our 80% limit.

What account do we use?

The deferred tax asset.

Deferred tax asset getting used.

Credit.

Do our debits equal our credits?

We have a difference and it’s on the credit side.

It’s the difference between 16,800

and 13,440

which equals

3,360.

What’s this for?

This is the remaining 20% that we still have to pay.

Income Tax Payable.

Let’s look at our entry.

The income tax expense for our current entry is the same every time.

It’s just taxable income times the tax rate.

The only thing that does change is that instead of a payable to the IRS for the full

tax expense, we use the deferred tax asset.

Before we move on, note the deferred tax balance.

Year 2, ending balance 14,280 debit.

Year 3, 13,440 credit.

Equals

840 debit.

Let’s do our second entry for deferred.

Are there any new deferred items in year 3?

Nope.

Were there any tax rate changes where we need to adjust our existing deferred

tax balances?

Nope.

Then it’s blank.

Nothing new and no changes means no entry.

Transition: Net Operating Loss FAR: Income Taxes

Just to summarize, For net operating losses,

Carry forward only.

Always a deferred tax asset.

And 80% limit.

Next up, we’ll review what happens when we think we won’t use the deferred tax asset.

You want to be sure to rack up these points on the exam.

So, don’t go away.

I’m Liz Cho, with Test Prep, In a Snap!