Loss Carryforward

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 taxesnet operating loss, loss carryback