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Confusion on add-backs for NOLs and other non-cash items

Ray’s question:

I learned to add back Net Operating Losses listed on 1040, Page One, Line 21 because they are non-cash. I just moved to a new bank and they say not to add it back. Why the difference?

Linda says:

Add-backs for NOLs, depreciation and other noncash items cause confusion because it depends on where you start with your cash flow calculation. I see this most often with depreciation on business returns. Let me explain.

Definition of NOL

This comes right off of page 1-11 of our manual, TAX RETURN ANALYSIS: Essentials and 1040 Review. The Net Operating Loss (NOL) is the carry forward of losses related to business, work, casualty or theft. NOLs may be pass-thoughs from a partnership or S corporation. They can be carried forward 15-20 years.

They are always noncash and in a 1040 are found on Page One, Line 21.

A statement showing the year it came from, how much was used each year and what is left is required.

If there is remaining NOL to carry forward, this may be a compensating factor. To the extent the borrower has an NOL, they are not paying taxes on some of their otherwise taxable income.

Add it back or not?

At your previous bank, your company used the AGI method for converting taxable income to cash flow available to pay debt and the owners. Since AGI was reduced by the noncash NOL, you added it back.

At your new bank, from your description, I believe you use the Schedule Analysis Method. You start with a blank worksheet and add the cash flow items that are continuing. When you get to Line 21, Other Income, you would add it if you believed it to be recurring cash flow. But if it is an NOL, under the Schedule Analysis Method, you will leave it out.

Adding it back when you use the AGI method has the same impact as leaving it out when you use the Schedule Analysis Method.

Mistakes with Depreciation Add-Backs

Depreciation and any other noncash expense or loss should only be added back if it has reduced a number you are using in your cash flow analysis. Thus, adding back depreciation on a Schedule C makes sense if you have included either AGI or the full Schedule C expenses in your analysis. Ditto for depreciation on page one of an 1120, 1065 or 1120S.

Where lenders and analysts sometimes get into trouble is when they spot depreciation on Schedule M-1 of a business return. Most lenders to small- and medium-size businesses who use the tax return instead of financial statements start with taxable income for the cash flow analysis. Depreciation listed on the M-1 is either depreciation on the books but not on the return (in which case it has not reduced your bottom line) or it is depreciation on the return but not on the books (in which case you already have added it back).

Here is the rule for noncash add-backs

I chuckle as I write this. Some of you like my sometimes long-winded explanations and some of you have learned to skip to the end of the post where I will often come right out and tell you what to do.

Add back noncash expenses or losses that have impacted a number you are including in your cash flow calculation. If it has not reduced your numbers yet, skip it. But you may need to explain why you did.

Free resource to clear up the confusion

If the add-backs and other adjustments to get from taxable income to recurring cash flow are a source of confusion for you or anyone on your team, you are in luck. One of the free demo modules on our self-study online training site covers it! Click here to access the 30-minute-or-less module on Green Legos, Six Ns and a Map to Tax Return Analysis.

More help with Depreciation and/or the M-1s

If I lost you in that M-1 explanation, click through to www.LendersOnlineTraining.com. Navigate to the Tax Return Analysis modules and select Depreciation in the “Fundamentals” section and any or all of the modules in the “Business Returns” section. You can purchase individual modules as needed or the entire list of Tax Return and Financial Statement Analysis topics.

About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.