What is a Net Operating Loss?

Carol Francois

A net operating loss occurs when a firm's tax deductible expenses are more than the taxable revenue for the taxable year. In this situation, the business does not pay any taxes, as they have more expenses than income. Business taxes are still calculated, but the value of the tax credit cannot be used to receive a tax refund, as these types of payments are not issued to businesses.

Man climbing a rope
Man climbing a rope

When a business has a net operating loss, the tax credit calculated can be carried forward or back to other taxable years and used to reduce the amount of tax owed. The assumption is that the business will be profitable in a different tax year. The tax credit should be applied in that period to properly recognize the true revenue of the firm over the period.

The carry forward provision for net operating loss allows a firm to apply the tax credit to any of the seven years directly after the year of the loss. The purpose of this rule is to smooth out the tax liabilities over the business cycle, which can create profitable years and loss years. The carry forward provision has no frequency limitation on it, allowing firms the flexibility to make any business adjustments as necessary.

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Net operating loss carry back is a generally accepted accounting principle that allows the company to apply net operating loss values to the previous year’s income in order to reduce tax payment. The net operating loss carry back can only be applied to the previous three years of taxable income that occurred before the net operating loss reporting year. The loss can be applied to multiple years, should the value exceed the income from one year.

Most countries have a very similar method of carrying forward or back the tax liabilities that occur when a business has a net operating loss. The number of years may vary slightly, but the rules are provided on the annual tax reporting forms. Businesses usually hire accounting services firms to complete the tax returns, and these firms would be very familiar with these requirements.

A net operating loss has other impacts on the business, aside from tax liabilities. If a firm has more expenses than revenue, they have lost money in this year. Take the time to review your financial statements and monthly reports to determine the root cause of the loss. Losses can be attributed to poor sales, increased expenses or mismanagement of resources.

Different causes require different steps to address and correct. Determine if the net operating loss is a result of timing. Make a list of the orders and sales for the next period. A net operating loss can occur when the equipment is purchased for a job that does not start until the next period.

Look at the expenses incurred in the year and determine what can be done to reduce expenses and increase sales. Too much inventory or equipment purchases can tie up cash flow and cause an increase in expenses for the period. Poor sales in a particular period require additional effort and resources to correct.

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