Hello, I'm Professor Bryan Bushee, and welcome back. In this video, I'm going to teach you a surefire way to avoid paying taxes. All you have to do is not make any money. Just have taxable losses, which will then provide NOL carryforwards, valuation allowances and all this fun stuff. [LAUGH] You'd probably rather pay taxes. Let's get started. So sometimes, we have to create a valuation allowance for deferred tax assets. Remember, deferred tax assets represent future tax savings, a reduction in future cash outflows, and this is, in fact, the definition of an asset that we used much earlier in the course. But companies can only realize those tax savings, those reduction in future cash outflows, if they're profitable. The deferred tax asset would then reduce taxes paid if you're profitable, but it won't produce a refund if the company does not have to pay taxes. When does a company not have to pay taxes? Companies don't have to pay taxes when they have negative taxable income. So, to use a deferred tax asset, a company must have positive taxable income and positive income tax payable in the future. Because then it can use the deferred tax asset to reduce that income tax payable and get the benefit of the tax savings. So companies can only report a deferred tax asset if it's more likely than not the firm will be profitable enough in the future to take advantage of the tax savings. So the tax savings will only benefit the company, only be reduction of future cash outflows, if the company thinks it will be profitable enough in the future to be able to offset their ga, their profits with these deferred tax assets. So, if it is not more likely than not that a company will get to use these tax savings, they have to reduce the deferred tax asset using something called the valuation allowance. It's going to be a contra asset and it's going to work just like allowance for doubtful accounts. And that's a good way to think about this where, in the case of receivables, we have accounts receivable as how much that we hope to collect. We reduce it by an allowance for doubtful accounts to how much we expect to collect, taking out the customers that we're not going to collect from. In this case, a deferred tax asset is how many tax savings we hope to collect. We subtract the valuation allowance, which are the ones that we don't think we'll get because we won't be profitable. And we're left with a net deferred tax asset which will be how much tax savings we actually expect to collect in the future. >> Not more likely than not? Here is a suggestion. Why not say greater than 50% or less than 50%? We can do without the double not sentences. >> I totally agree. I've always hated the phrase more likely than not because then you have to say not more likely than not. I, yeah. I mean accounts just are not straightforward in these things. It's like when we had other than temporary instead of the word permanent. So, I'm duty-bound to use more likely than not, but you can think of it as greater than 50% or less than 50%. Now that we've introduced the subject of tax losses, it's probably a good time to talk about net operating losses, or NOLs. So, net operating loss occurs in a year when taxable income is negative, so when you have a loss for tax purposes. Federal tax law in the U.S. allows taxpayers to use an NOL to offset the profits of prior and future years. Now, most countries in the world have similar laws with NOLs. The only thing that might differ is the number of periods that we're going to talk about, but pretty much every country has something similar in terms of allowing you to use net operating losses to offset profits in other years. So first, you can carry the NOL back two years and receive refunds for any income taxes that you've already paid. So let's say this year you have a $500,000 taxable loss, so you lose $500,000 for tax purposes. Let's say over the last two years, the prior two years, you would had $100,000 of tax profits. What you can do is use part of those NOLs to get a refund on the taxes that you paid for that $100,000 the prior two years. So the IRS will send you a check to refund you for those prior taxes paid. Any loss remaining after the two-year carryback can then be carried forward for up to twenty years to offset future taxable income. So in our example, we only used $100,000 of our $500,000 NOL. Now we have $400,000 of NOL that we can carry forward up to 20 years to offset future taxable income. That means that in the next 20 years, the first $400,000 of taxable income we earn will be tax-free because we'll be able to use that NOL to zero out that income and we won't have to pay taxes until we have more than $400,000 of taxable income in the future. We're going to create a deferred tax asset to represent the amount of tax savings due to these NOL carryforwards. >> What do you mean by carry a loss forward 20 years? I prefer to forget my losses and carry forward with my head held high. Now you are saying I have to carry a loss around with me for two decades? What a downer! >> Well, don't think of it as carrying around a loss for the next 20 years. Think about it as carrying around a get-out-of-taxes-free card, which allows you to get out of paying some taxes anytime in the next 20 years. That's a much happier thought. So let's take a look at an example of how these net operating loss carryforwards work and we'll also bring in valuation allowances as part of the example as well. So in 2011, Noll International Incorporated experienced an $80,000 net operating loss, so it had negative taxable income, in its U.S. subsidiary. And it had $150,000 net operating loss in its Liechtenstein subsidiary. Noll didn't pay any taxes in 09 or 2010 in either jurisdiction, so it can't carry the loss back to get a refund. Noll expects that it is more likely than not to be able to use the NOL carryforwards in 2014 in both countries so that means we get to recognize a deferred tax asset. The U.S. tax rate's expected to be 35%, so the U.S. related deferred tax asset will be $80,000 of NOL times 35% equals $28,000 of deferred tax assets. That $28,000 represents the expected tax savings in the future because what'll happen is the U.S. subsidiary will return a profitability. The first $80,000 of profits in the U.S. will be offset by the NOL. So we won't have to pay taxes on that 80,000, which will save us $28,000 in taxes. In Liechtenstein, the tax rate is expected to be 15%. The Liechtenstein deferred tax asset then will be $150,000, which is the amount of the NOL carryforwards times the 15% tax rate equals $22,500. Again, the logic here is that the next $150,000 of taxable income in Liechtenstein will be offset by these NOL carryforwards, basically zeroed out, saving us $22,500 in taxes in the future. So, the journal entry, and I will not put up the pause sign, I'll just, I'll just do this with us together, we're going to debit a deferred tax asset for $50,500. So that's adding together the two deferred tax assets from the two countries. So that represents the future expected tax savings. And then we're going to credit income tax expense for 50,500. Why? Well, it, there's no cash involved, so we can't credit cash. It doesn't affect the income tax payable we owe the government now, so really, the only place to recognize this is a negative expense. Sort of an unexpected gain of having these losses is that you can expect to have these future tax savings. >> Where is Liechtenstein? And do companies really have to keep track of this on a country-by-country basis? My brother Abishek is a lawyer. I bet he could find a way to transfer the losses to another country so they wouldn't have to wait. >> Well, Liechtenstein is right next to Switzerland. Do, do you know where Switzerland is? Well feel free to pause the video. You're on electronic device, can google Lichtenstein and you can look at where it is. But anyway Vienna does raise a good point that there are potential ways to get out of this through creative tax lawyering and income shifting. I mean there's restrictions on moving losses across jurisdictions. So if you have a loss in Lichtenstein, you can't use that loss to offset income in Sweden. But there are creative things that you can do to try to shift income from Sweden into Lichtenstein or, or at least I've heard. But, but all those things are beyond the scope of scope of the course. In fact, forget I even talked about those things and just go back to trying to find Lichtenstein. Now let's bring in the valuation allowance piece. So in June of 2012, Noll is preparing its quarterly reports and has serious doubts about the future profitability of its Liechtenstein subsidiary. Noll decides that it is not more likely than not. >> Less than 50%. Thank you. >> yeah, so Noll decides that there's a less than 50% chance that it'll be able to use its NOL carryforwards in Liechtenstein before they expire. Recall that the deferred tax asset in Liechtenstein was $22,500. So we have to create a valuation allowance to reflect the fact that we don't expect to be able to collect those tax savings. So what we're going to do is debit income tax expense 22,500 and credit valuation allowance for 22,500. The valuation allowance is going to be a contra asset that offsets the deferred tax asset to bring it down to what we expect to get in tax savings. The analogy to this, again, is debit bad debt expense, credit allowance for doubtful accounts for situations where we don't expect to collect from customers. Here's a situation where we don't expect to be able to collect from the tax authority because we won't have enough profits to be able to get the tax savings. So the way this'll look in the footnotes is under the deferred tax assets section, there's going to be a deferred tax asset for NOL carryforwards of 50,500. This is how much we're entitled to collect in future tax savings. Then we're going to subtract the valuation allowance, which is how much we expect to not be able to collect to get a net deferred tax asset number, which are the tax savings that we expect to be able to collect in the future. And again, the, it's completely analogous to gross accounts receivable less allowance for doubtful accounts, gives you net accounts receivable. Same Idea. >> I understand. So, a valuation allowance is a permanent write off of the deferred tax asset. It has been used up as an expense now, correct? >> No. It is not a permanent write down. If circumstances change and you think that you might be able to use those NOL carryforwards in Liechtenstein in the future, you can undo this entry. Reverse it, basically get rid of the expense, get rid of the valuation allowance, and restore the full value of the deferred tax asset to the balance sheet. Continuing on with the example, in December of 2012, Noll is putting together its annual report. And now it's very optimistic about the future profitability of its Liechtenstein subsidiary. In fact, Noll decides that it's now more likely than not, I mean greater than 50% that it will be able to use the NOL carryforwards in Liechtenstein by 2014. So, what Noll has to do now is undo the valuation allowance. They don't need it anymore. So the journal entry here has debit valuation allowance to get rid of the contra asset, to zero it out because we don't need it any more. And to balance this out, we credit income tax expense 22,500. Note that this journal entry will increase net income by 22,500. >> Let me get this straight. All the company has to do is say that it is now optimistic about the future, and it can create a negative expense, or, I should say, a gain? >> You simply cannot trust those Liechtensteiners! >> Yes, I completely agree. Not about the not trusting Liechtensteiners. I, I completely trust Liechtensteiners. No, I agree that this is a journal entry that you want to keep an eye out for because there is a lot of potential for abuse. If a company was just short of an earnings target, all it would have to do is say that circumstances have changed in one of its subsidiaries, where now they think they will be able to use these deferred tax assets. So they do this jenture, this journal entry to reverse out the valuation allowance, create a negative expense and voila, an extra 22,000 of net income. So, if you ever do see one of these journal entries, you want to be a little skeptical and you want to see if you can find any other information to indicate that it's legitimate. Otherwise, it could just be last chance earnings management. And just continuing on with this, there actually is some academic research that finds managers use these reversals of valuation allowance as a way to manage earnings. So where can I find out all this cool information about valu, valuation allowances? Well, in the footnote disclosures, of course, and that's what we're going to look at in the next video. See you then. >> See you next video!