Definition
The financial accounting term loss carryforward refers to an income-averaging provision that allows a company to apply a net operating loss to taxable income for up to 20 years in the future. When a net operating loss occurs, an income-averaging provision of the tax law allows companies to carry the amount forward for up to 20 years, thereby lowering the amount of income taxes payable in the future.
Explanation
Also known as a NOL, a net operating loss occurs when a company's taxable expenses are in excess of its taxable revenue. Since companies are required to pay income taxes when profitable, the tax law provides some relief when operating at a loss. There are two methods a business can use to recapture a portion of their previously paid income taxes: a loss carryback or loss carryforward.
With a loss carryforward, the business applies the net operating loss to future tax years. In practice, companies will carry a loss forward when a NOL is not fully absorbed using the carryback approach. Since a carryforward affects future tax years, the effect is to provide future tax savings.
When a company experiences a NOL, its ability to generate future earnings may be uncertain. For this reason, the tax benefit (deferred tax asset) associated with a loss carryforward is based on the expected profitability of the business in the future. If the company is not expected to generate enough future profits to consume all of the carryforward loss, the company must establish a valuation allowance account to reduce this carrying value since the balance sheet should reflect the anticipated future benefit from the carryforward.
Example
In the current tax year, Company A suffered a net operating loss of $5,000,000, and has not generated enough profits in the past to absorb all of the net operating loss. The company will be using a combination of a carryback and carryforward approach to maximize the NOL's tax benefit.
Company A's taxable income in the preceding two years is shown in the table below:
Taxable Income | Tax Rate | Income Taxes Payable | |
Year 1 | $2,500,000 | 40% | $1,000,000 |
Year 2 | $2,000,000 | 40% | $800,000 |
The tax refund generated by the carryback would be calculated as:
Year 1 | Year 2 | |
Taxable Income | $2,500,000 | $2,000,000 |
Less: Carryback | $2,500,000 | $2,000,000 |
Taxable Income After Carryback | $0 | $0 |
Tax Rate | 40% | 40% |
Income Taxes Payable | $0 | $0 |
Taxes Paid | $1,000,000 | $800,000 |
Rebate | $1,000,000 | $800,000 |
The total tax benefit derived from the NOL is $5,000,000 x 40%, or $2,000,000. However, the carryback is only able to provide $1,000,000 + $800,000, or $1,800,000 of the benefit; so a carryforward is needed to capture the remaining benefit. The journal entry to record this transaction would be:
Debit | Credit | |
Income Tax Refund Receivable | $1,800,000 | |
Deferred Income Tax Asset | $200,000 | |
Refund of Income Taxes From Loss Carryback | $1,800,000 | |
Refund of Income Taxes From Loss Carryforward | $200,000 |
Company A's management team is not certain they're going to be able to turn the company around and generate future profits. For this reason, the accounting department created a valuation account for the carryforward:
Debit | Credit | |
Benefit Due to Loss Carryforward | $200,000 | |
Allowance to Reduce Deferred Tax Asset to Expected Value | $200,000 |
Company A's management team undertook a cost cutting effort that lowered the company's expenses and generated a profit of $2,000,000 the following year; thereby absorbing the remaining tax benefit derived from the net operating loss.
Taxable Income | $2,000,000 |
Tax Rate | 40% |
Income Taxes Payable | $800,000 |
Less: Benefit from Carryforward | $200,000 |
Income Taxes Payable | $600,000 |
The journal entries to account for this transaction include:
Debit | Credit | |
Income Tax Expense | $800,000 | |
Income Taxes Payable | $600,000 | |
Deferred Tax Asset | $200,000 |
Finally, the valuation account needs to be eliminated from the company's books:
Debit | Credit | |
Allowance to Reduce Deferred Tax Asset to Expected Value | $200,000 | |
Benefit Due to Loss Carryforward | $200,000 |
Related Terms
Deferred income tax is the accounting term used to describe situations where the income tax expense and the income tax payable are not the same. Deferred income taxes are listed on the balance sheet as a liability.
Moneyzine EditorJanuary 15th, 2024- The financial accounting term net operating loss refers to accounting periods or tax years in which the tax-deductible expenses of a company are in excess of their taxable revenues. When a net operating loss occurs, the tax law contains an income averaging provision that allows a company to carry the amount back to the preceding two years, or carry it forward for up to 20 years.Moneyzine EditorSeptember 20th, 2023
The financial accounting term loss carryback refers to an income-averaging provision that allows a company to apply a net operating loss to the preceding two years. When a net operating loss occurs, an income-averaging provision of the tax law allows companies to carry the amount back two years and receive an immediate tax rebate.Moneyzine EditorJanuary 24th, 2024
