Explain how a deferred tax debit balance can arise in an entity and the criteria for its recognition of an asset?

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 A deferred tax debit balance arises when a company has overpaid taxes or when the tax expense recognized in the financial statements is greater than the tax paid or payable. This occurs due to temporary differences between the accounting treatment of income, expenses, and taxes. Deferred tax assets and liabilities arise as a result of these temporary differences, with the deferred tax debit balance representing a deferred tax asset.

How a Deferred Tax Debit Balance Can Arise:

A deferred tax debit balance typically arises from the following scenarios:

  1. Temporary Differences:

    • Temporary differences occur when there are discrepancies between the accounting and tax treatment of certain items, leading to differences in the amount of income or expense recognized in the financial statements and the tax returns. These temporary differences reverse over time, resulting in either a future tax benefit (deferred tax asset) or a future tax liability (deferred tax liability).

  2. Taxable Income vs. Accounting Income:

    • Depreciation: One common example of a temporary difference is when the depreciation expense recognized for tax purposes is higher than the depreciation recognized for accounting purposes. This leads to a higher taxable income in the future, creating a deferred tax asset (deferred tax debit balance).
    • Provisions and allowances: If a company sets up a provision (e.g., for bad debts) that is not deductible for tax purposes until it is realized, this creates a temporary difference, resulting in a deferred tax asset.

  3. Carryforward of Losses:

    • A deferred tax asset can also arise when a company has carryforward tax losses or unused tax credits. The entity can use these losses to offset future taxable income, resulting in a future tax benefit, which is recognized as a deferred tax asset.

  4. Changes in Tax Rates or Laws:

    • A change in tax laws or rates can also create deferred tax assets or liabilities. If tax rates are expected to decrease, the company might recognize a deferred tax asset if it anticipates paying less tax in the future.

Criteria for Recognition of a Deferred Tax Asset (Deferred Tax Debit Balance):

According to IAS 12: Income Taxes, a deferred tax asset (or debit balance) is recognized when it is probable that there will be future taxable profits against which the deductible temporary differences, tax losses, or tax credits can be utilized. The recognition criteria include:

  1. Probable Future Taxable Income:

    • There must be a reasonable expectation that the company will generate sufficient taxable profits in the future to utilize the deferred tax asset. If future taxable income is unlikely, then the asset should not be recognized, or it should be reduced.

  2. Timing of Reversal of Temporary Differences:

    • A deferred tax asset arises when there are deductible temporary differences (i.e., differences between accounting and tax values of assets or liabilities that result in lower taxes in the future). The recognition depends on the expected reversal of these differences over time.

  3. Tax Planning Strategies:

    • Management must assess the company’s tax planning strategies to determine if the deferred tax asset is likely to be realized. For example, the company could sell assets to generate taxable income, or it may plan to carry forward losses to future periods.

  4. Limitations on Recognition:

    • The recognition of a deferred tax asset is limited to the amount that is expected to be realized. This means that if the company has not demonstrated a reasonable expectation of future taxable income, the deferred tax asset may not be recognized or could be written down.

  5. Reassessment of Deferred Tax Asset:

    • Deferred tax assets must be reassessed at each reporting date to ensure that it is still probable that future taxable profits will be available to offset the asset. If circumstances change and it becomes unlikely that the asset will be utilized, the deferred tax asset may be reduced or derecognized.

Example:

Suppose a company has recognized a tax deduction for depreciation on an asset for tax purposes that is higher than the depreciation recognized in the financial statements. As a result, the company has paid less tax in the current period, but it will have to pay more tax in future periods when the depreciation for tax purposes decreases. This creates a deferred tax asset because the company will receive future tax relief when the tax depreciation difference reverses. The deferred tax debit balance reflects this future benefit.

Similarly, if a company has tax losses that can be carried forward to offset future taxable income, it can recognize a deferred tax asset based on these carryforward losses, assuming it is probable that the company will generate taxable profits in the future to utilize the losses.

Conclusion:

A deferred tax debit balance arises due to deductible temporary differences, tax loss carryforwards, or other tax-related circumstances that create future tax benefits. The recognition of a deferred tax asset depends on the likelihood of future taxable income, tax planning strategies, and the expected reversal of temporary differences. If there is insufficient evidence that the asset will be realized, it may not be recognized, or its carrying amount may be adjusted.

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