The process of determining taxable profits from business or profession is inseparably tied to the method of accounting adopted by the assessee. Accounting does not merely serve as a record‑keeping exercise; it is the very foundation upon which income, expenditure, assets, and liabilities are recognized and measured. The Indian Income Tax Act recognizes this centrality and provides specific guidance under Section 145 regarding acceptable methods of accounting for the purposes of taxation.
This article examines the methods of accounting, their application in computing business income, and the statutory framework that governs them. By analyzing statutory provisions, judicial decisions, and practical examples, it aims to present a comprehensive picture of how accounting methods shape taxable income under the head of profits and gains of business or profession.
Understanding Methods of Accounting
Accounting methods determine the timing and manner in which income and expenses are recognized. Broadly, two methods are legally recognized in India: the cash system of accounting and the mercantile system of accounting. Each system has unique features and consequences for the computation of taxable income.
Cash System of Accounting
Under the cash system, income is recognized only when it is actually received, and expenditure is recorded only when it is actually paid. This approach is straightforward and easy to follow, particularly for small businesses or professionals dealing mainly in cash transactions.
For example, if a trader sells goods worth ₹50,000 in January but receives payment in February, the income will be recognized in February under the cash system. Similarly, if expenses are incurred in January but paid in March, they will only be accounted for in March.
While the cash system is simple, it does not reflect the true financial position of a business. Outstanding liabilities and receivables remain unrecorded until settlement occurs, which can distort the picture of profits or losses during a given accounting period.
Mercantile System of Accounting
The mercantile system, also referred to as the accrual basis of accounting, recognizes income when it is earned and expenses when they are incurred, regardless of the actual timing of receipt or payment. This method presents a more accurate picture of the financial performance and position of a business, which is why it is the preferred system for most organized businesses and corporations.
For instance, if services worth ₹35,000 are rendered in February and only ₹24,500 is received while ₹10,500 remains outstanding, the entire ₹35,000 will be recognized as income for February under the mercantile system. Likewise, expenses incurred but not yet paid will also be recorded.
The mercantile system requires more detailed record‑keeping and monitoring of receivables, payables, and accruals. However, its ability to present a fair and consistent picture of financial results makes it the standard for taxation and corporate reporting.
Illustrative Example
Consider the case of a coaching institute offering computer training. In February, ten students enrolled for ₹3,500 each, generating a total fee of ₹35,000. Out of this, only seven students make payment, amounting to ₹24,500, while fees from three students totaling ₹10,500 remain unpaid.
Under the cash system, the institute will record only ₹24,500 in February, with the unpaid ₹10,500 being recorded only upon actual receipt. Under the mercantile system, both the received and receivable portions are recognized, making the income for February ₹35,000.
This example demonstrates how different accounting systems lead to different recognition of income, directly affecting tax liability for that period.
Statutory Recognition under Section 145
The Income Tax Act formalizes the role of accounting methods through Section 145, which governs the computation of income under the heads of profits and gains of business or profession and income from other sources.
Section 145(1): Choice of System
Sub‑section (1) explicitly provides that income chargeable under these two heads shall be computed in accordance with either the cash or mercantile system of accounting, whichever is regularly employed by the assessee. Hybrid or mixed systems, where a taxpayer selectively applies both methods, are not permitted.
The freedom to choose between cash and mercantile systems is a significant right available to taxpayers. However, once a system is adopted, it must be followed consistently. Changing the system without justification could lead to rejection of accounts by the Assessing Officer.
It is also important to note that Section 145 does not extend to all heads of income. Income from salaries, income from house property, and income from capital gains are governed by specific provisions, and the taxpayer’s accounting method has no impact on them. For instance, a landlord following the cash system cannot delay recognition of rental income; it will still be taxed in accordance with provisions under the head of house property.
Section 145(2): Income Computation and Disclosure Standards
Recognizing the need for uniformity and to minimize ambiguities, the legislature empowered the Central Government to notify Income Computation and Disclosure Standards (ICDS) under Section 145(2). These standards are applicable only to taxpayers who follow the mercantile system.
The ICDS are not intended for preparation of financial statements but solely for computation of taxable income. They override conventional accounting practices where differences arise, ensuring consistency and clarity in tax reporting. Ten ICDS have been notified, covering areas such as disclosure of accounting policies, valuation of inventories, construction contracts, revenue recognition, treatment of tangible fixed assets, effects of foreign exchange, government grants, securities, borrowing costs, and provisions or contingent liabilities.
For example, under ICDS on revenue recognition, income from certain transactions may need to be recognized earlier than under traditional accounting standards, directly impacting the timing of taxability.
Section 145(3): Power of the Assessing Officer
While taxpayers have the right to choose an accounting method, this choice is subject to scrutiny. Section 145(3) grants power to the Assessing Officer to reject books of account and make a best judgment assessment under Section 144 if the following conditions exist:
- The accounts are incomplete or inaccurate
- The method of accounting has not been regularly followed
- The provisions of ICDS have not been complied with
- Essential records such as stock registers are missing
This provision ensures that accounting methods are not misused to evade taxes and that the income reported reflects a fair picture of the business.
Judicial Approach and Case Studies
The courts have often been called upon to interpret the scope and implications of accounting methods under Section 145.
Chamber of Tax Consultants v. Union of India (2017)
This landmark case dealt with the validity of ICDS provisions that appeared to override established judicial precedents. The Delhi High Court held that where ICDS conflicts with the Income Tax Act or judicial decisions, it would be ultra vires. The judgment reinforced the principle that statutory provisions and judicial rulings prevail over administrative notifications, ensuring taxpayer protection.
Hercules Pigment Industry v. ITO
The issue in this case was whether inclusive or exclusive methods of accounting for excise duty could impact computation of taxable profits. The court held that excise duty must be included in the valuation of closing stock, and income should be computed accordingly. The case highlights how statutory requirements under Section 145A influence accounting practices regardless of the assessee’s preferred method.
ACIT v. Origin Express (I) North (P.) Ltd.
In this case, the assessee failed to produce books of account despite repeated notices from the Assessing Officer. Consequently, the AO rejected the accounts under Section 145(3) and proceeded with a best judgment assessment. The appellate tribunal upheld the AO’s decision, emphasizing the importance of maintaining and producing proper records.
These cases underline the judiciary’s approach in ensuring that accounting methods are not misused and that statutory provisions retain their supremacy.
Importance of Consistency in Accounting
Consistency is a cornerstone of accounting for tax purposes. Once a taxpayer adopts a system, it must be employed regularly. Shifting from cash to mercantile or vice versa merely to manipulate tax liability is not permissible. Consistency ensures comparability over time, facilitates transparency, and allows tax authorities to assess income more effectively.
For example, if a grocery store owner adopts the cash system in one year and shifts to the mercantile system in the next, the timing of income recognition could be altered, creating distortions. Such practices may attract rejection of accounts by the Assessing Officer.
Practical Implications for Businesses and Professionals
The method of accounting chosen has several practical implications beyond taxation. For professionals such as doctors, lawyers, or consultants, the cash system may appear simpler as it aligns with cash flow. However, it may not truly represent the extent of services rendered where significant receivables exist.
For organized businesses and corporations, the mercantile system is more suitable as it reflects a realistic financial position. It is also aligned with statutory audit requirements, financing needs, and global accounting practices. Moreover, compliance with ICDS under the mercantile system ensures that income computation is standardized for tax purposes.
Section 145A: Method of Accounting in Certain Cases
Section 145A was inserted to address specific situations where uniformity in valuation and income recognition was necessary. It lays down rules for inventory valuation, inclusion of taxes and duties, and treatment of securities held as stock in trade.
Purpose of Section 145A
The rationale behind introducing Section 145A was to ensure that income could not be manipulated by adopting different methods of accounting for valuation of stock or by excluding statutory levies from cost and sales figures. Prior to this provision, there were divergent practices across businesses regarding whether taxes like excise duty, service tax, or VAT should be included in valuation. Section 145A created a level playing field by prescribing uniform treatment.
Inventory Valuation
One of the central features of Section 145A is the requirement that inventory must be valued at cost or net realizable value, whichever is lower. This aligns with the principle of prudence in accounting, where anticipated losses are recognized but anticipated profits are not.
For instance, consider a manufacturer who holds closing stock with a market value of ₹50,000. The costs directly attributable to this stock include transport expenses of ₹5,000, production costs of ₹2,000, and advertisement costs of ₹3,000. The net realizable value in this case would be ₹50,000 minus the attributable costs, which amounts to ₹40,000. If the cost of production of the inventory is higher than ₹40,000, the closing stock must be valued at ₹40,000, ensuring the profit is not overstated. This rule prevents inflated valuations and ensures a conservative recognition of income.
Inclusion of Taxes and Duties
Section 145A also provides that while valuing purchases, sales, and inventory, taxes, duties, cess, or fees actually paid or incurred to bring the goods to their present location and condition must be included, irrespective of the method of accounting.
For example, if a trader purchases goods for ₹100,000 and pays GST of ₹18,000, the total cost considered for valuation purposes must be ₹118,000. Similarly, when such goods form part of inventory, their value must reflect the gross figure including taxes. This rule ensures that statutory levies are not excluded to artificially reduce or increase profit margins.
Treatment of Securities
The valuation of securities held as stock in trade is another area governed by Section 145A. The provision distinguishes between different types of securities:
- Unlisted securities or listed securities not quoted on a recognized stock exchange at the valuation date must be valued at actual cost.
- All other securities must be valued at cost or net realizable value, whichever is lower, and such valuation should be made on a category‑wise basis rather than scrip‑wise.
This distinction prevents selective valuation practices that could otherwise be used to manipulate income by recognizing losses while deferring gains.
For banks, financial institutions, and certain other businesses where securities form a major part of inventory, valuation must also conform to the guidelines issued by the Reserve Bank of India. In such cases, securities are generally valued at lower cost or net realizable value as per regulatory norms.
Practical Example of Securities Valuation
Suppose a trader holds the following securities at the end of the accounting year:
- Listed and quoted securities: Cost ₹200,000, market value ₹180,000
- Unlisted securities: Cost ₹100,000
- Listed but not quoted securities: Cost ₹50,000
According to Section 145A, the unlisted securities and listed but not quoted securities must be valued at actual cost, that is ₹100,000 and ₹50,000 respectively. The listed and quoted securities must be valued category‑wise at the lower of cost or market value.
Since the market value of ₹180,000 is lower than cost, they will be recorded at ₹180,000. The total closing stock of securities will therefore amount to ₹330,000. This uniform method reduces scope for subjective adjustments and manipulation in the computation of income.
Section 145B: Taxability of Certain Income
Section 145B complements the earlier provisions by specifically prescribing the timing of recognition for certain categories of income. It overrides the general principles of accounting methods where necessary, ensuring that income is taxed in a consistent manner across all taxpayers.
Interest on Compensation or Enhanced Compensation
When compensation is received in connection with compulsory acquisition of land or property, there is often litigation regarding enhancement of the amount. The timing of taxability of such enhanced compensation was a matter of dispute until Section 145B clarified it.
The provision states that interest on compensation or enhanced compensation shall be taxed in the year of receipt, regardless of the method of accounting followed by the assessee. This ensures uniformity and prevents uncertainty that could arise if recognition depended on accrual principles under the mercantile system.
Escalation Claims and Export Incentives
Another area addressed by Section 145B is the taxability of escalation claims and export incentives. These are to be recognized as income in the year in which there is reasonable certainty of their realization.
For instance, a construction company may lodge an escalation claim with its client due to increased input costs. Until there is reasonable certainty that the claim will be accepted, the amount cannot be treated as income. Once certainty arises, the entire claim becomes taxable in that year.
Similarly, export incentives like duty drawback or other government schemes must be recognized in the year when their realization becomes reasonably certain, ensuring consistency in reporting across taxpayers.
Subsidies, Grants, and Other Incentives
Section 145B also provides that subsidies, grants, duty drawbacks, incentives, waivers, concessions, or reimbursements are taxable in the year of receipt, unless they were already taxed earlier on accrual basis.
For example, if a manufacturing unit receives a government subsidy for promoting renewable energy, the subsidy becomes taxable in the year it is received. Even if the sanction of subsidy was known earlier, the taxability arises on actual receipt unless the amount was previously included in income. This rule aligns taxation with actual benefit received, ensuring that income recognition is not unduly postponed.
Judicial Approach to Sections 145A and 145B
The judiciary has had to interpret the application of these provisions in several cases, ensuring clarity on their implementation.
Chamber of Tax Consultants v. Union of India
While the primary issue in this case was about the validity of ICDS, the judgment indirectly impacted Section 145A because ICDS also deals with inventory valuation, revenue recognition, and government grants. The Delhi High Court held that if ICDS provisions conflict with the Act, the Act will prevail. This ensures that Section 145A and 145B are interpreted strictly within the framework of the Act, rather than being overridden by administrative instructions.
Hercules Pigment Industry v. ITO
In this case, the assessee had adopted a method of excluding excise duty while valuing inventory. The court held that profit must be computed by including excise duty in the valuation of closing stock, aligning with the requirements of Section 145A. This case established the principle that inclusive treatment of duties and taxes in valuation is mandatory, and alternative methods cannot be used to reduce tax liability.
ACIT v. Origin Express (I) North (P.) Ltd.
Though this case primarily involved rejection of accounts under Section 145(3), it is also relevant to Section 145A and 145B because non‑maintenance of accurate stock registers or failure to comply with prescribed valuation methods can lead to rejection of books. The ruling emphasized the necessity of following statutory valuation rules to ensure acceptance of accounts.
Broader Implications for Businesses
Standardization of Practices
Sections 145A and 145B bring standardization to critical areas of income computation. Without these provisions, taxpayers could adopt divergent methods, leading to inconsistent recognition of income and consequent disputes with tax authorities.
Impact on Profit Margins
The requirement to include taxes and duties in valuation affects reported profit margins. For example, earlier practices of excluding excise duty from closing stock valuations often resulted in understated income. The inclusion mandated by Section 145A ensures that such understatement is corrected.
Certainty in Timing of Income
Section 145B removes ambiguity in recognizing compensation, subsidies, or export incentives. By prescribing a clear timing of recognition, it prevents prolonged disputes on whether such income should be taxed on accrual or receipt basis.
Compliance and Documentation
The provisions also place responsibility on businesses to maintain detailed documentation, especially for valuation of inventory and securities. Stock registers, purchase records including taxes, and evidence of subsidies or claims become essential for accurate reporting and for avoiding rejection of accounts.
Section 145(3): Power of Assessing Officer to Reject Books
Scope of Section 145(3)
Section 145(3) empowers the AO to disregard the books of accounts and make a best judgment assessment if:
- The accounts are not complete or are inaccurate.
- The accounting system employed is not in accordance with the notified standards or statutory provisions.
- The assessee fails to maintain or produce books of accounts and supporting documents, such as stock registers.
The purpose is not to punish the assessee but to protect the integrity of income computation by ensuring it is based on authentic and reliable records.
Grounds for Rejection of Accounts
The AO cannot reject books arbitrarily; there must be reasonable grounds supported by evidence. Some typical grounds include:
- Failure to maintain quantitative details of stock, making it impossible to verify the correctness of gross profit.
- Non‑compliance with provisions of Section 145A regarding inclusion of taxes and duties in valuation.
- Ignoring ICDS provisions in computation of taxable income.
- Contradictions between reported turnover and other records, such as VAT returns, GST filings, or third‑party confirmations.
- Failure to produce books despite repeated notices from the AO.
Effect of Rejection of Accounts
Once the accounts are rejected, the AO proceeds under Section 144 to make a best judgment assessment. This involves estimating income based on available information, comparable cases, industry averages, or other reasonable bases. While the AO has discretion, such estimation must not be arbitrary and should be guided by principles of fairness and reasonableness.
Best Judgment Assessment under Section 144
Meaning and Nature
A best judgment assessment refers to the computation of taxable income by the AO on the basis of his judgment when reliable accounts are not available. It does not mean absolute discretion but rather an informed estimate using available material. Courts have consistently held that while exactitude may not be possible, the assessment must be rational, honest, and not vindictive.
Procedure Followed
Before making a best judgment assessment, the AO typically:
- Reviews available records such as purchase invoices, sales bills, bank statements, and third‑party confirmations.
- Consider comparable cases in the same industry to estimate gross profit or net profit margins.
- Applies past performance of the assessee as a guide to present estimation.
- Ensures the assessee is given an opportunity of being heard.
This procedure ensures compliance with the principles of natural justice.
Illustration of Best Judgment Assessment
Suppose an assessee reports gross receipts of ₹50,00,000 but fails to maintain stock registers or furnish purchase invoices. Past records show that the assessee’s gross profit ratio was consistently around 20 percent. Industry averages also indicate a gross profit of 18–22 percent. The AO may reasonably apply a 20 percent margin and assess income at ₹10,00,000, disregarding the figures in the books.
Such an estimate balances fairness with practicality, ensuring that the absence of proper accounts does not lead to revenue loss.
Case Law Analysis
ACIT v. Origin Express (I) North (P.) Ltd.
In this case, the assessee failed to produce books of accounts despite repeated opportunities. The AO rejected the accounts under Section 145(3) and proceeded to make a best judgment assessment. The tribunal upheld the AO’s action, emphasizing that production of books is essential for verification and their non‑production justifies rejection.
This decision illustrates the importance of cooperation with the tax authorities and the consequences of non‑compliance.
Hercules Pigment Industry v. ITO
The issue here was whether inclusive or exclusive methods of accounting for excise duty impacted income computation under Section 145A. The court ruled that profits must be computed by including excise duty in stock valuation, in line with Section 145A. The attempt by the assessee to exclude duties was held invalid, and the AO’s rejection of accounts was justified.
This case demonstrates how non‑compliance with statutory provisions on valuation can lead to rejection of accounts and reassessment.
Chamber of Tax Consultants v. Union of India
Although primarily related to ICDS, this case clarified that provisions of the Act take precedence over administrative standards. If an assessee ignores statutory requirements under Sections 145A or 145B and relies on ICDS provisions, the AO may reject the accounts.
However, in case of conflict between ICDS and the Act, the Act prevails. This decision reaffirmed judicial supremacy in interpreting income tax law.
Other Judicial Pronouncements
Courts have consistently held that rejection of accounts cannot be mechanical. For example, in certain cases where minor defects were found but overall reliability was intact, rejection was held unjustified. On the other hand, where absence of stock records made it impossible to verify results, rejection was upheld. The principle is that the AO’s power must be exercised judiciously, not arbitrarily.
Interplay of Method of Accounting with Judicial Precedents
Importance of Consistency
Judicial precedents stress the importance of consistency in the method of accounting. An assessee cannot switch between cash and mercantile systems at will to obtain tax advantage. Once a method is adopted, it must be followed year after year unless there is a genuine change, and the AO must be satisfied that the new method reflects true income.
Prudence and Fairness
Courts have often invoked the principle of prudence in income recognition. For instance, anticipated losses are allowed to be recognized but anticipated profits are not. This aligns with the requirement of valuing stock at lower cost or net realizable value under Section 145A. The judicial approach ensures that taxable income is not overstated, protecting both taxpayers and the integrity of revenue collection.
ICDS and Judicial Oversight
While ICDS was introduced to bring standardization, its application has sometimes conflicted with established judicial principles. Courts have clarified that ICDS cannot override the Act or binding precedents. This ensures that statutory provisions like Section 145A and 145B are applied harmoniously without undermining settled law.
Safeguards Against Arbitrary Assessments
The judiciary has also acted as a safeguard against arbitrary best judgment assessments. For example, courts have held that while estimation is permissible, it must be based on material evidence and past records, not on conjectures. This prevents misuse of Section 144 and Section 145(3) powers by ensuring accountability.
Practical Implications for Businesses
Need for Proper Documentation
The cases discussed highlight the importance of maintaining complete and accurate records. Businesses must ensure that books of accounts, stock registers, and supporting documents are up to date. Failure to do so can invite rejection of accounts and income estimation, which may not always be favorable to the assessee.
Compliance with Valuation Rules
Businesses must carefully follow the valuation rules under Section 145A, especially with regard to inclusion of taxes and duties. Deviations can lead to adjustments by the AO, affecting reported profits and potentially resulting in litigation.
Anticipation of Income Recognition
With Section 145B clarifying the timing of income recognition for subsidies, compensation, and incentives, businesses must be prepared to report such income promptly in the year of receipt or certainty. Proper planning and documentation are essential to avoid disputes.
Risk of Best Judgment Assessment
Assessees must be aware that failure to maintain reliable accounts exposes them to the risk of best judgment assessment. Such assessments often rely on industry averages or past performance, which may not reflect actual business conditions, leading to higher tax liability.
Sector‑Specific Applications
Manufacturing Sector
For manufacturers, the requirement to value closing stock including excise duty and GST under Section 145A is particularly significant. Accurate inventory valuation impacts not only profits but also tax liability. Failure to maintain stock records often leads to rejection of accounts in this sector.
Trading Sector
Traders frequently deal with large volumes of goods and fluctuating prices. Proper valuation and documentation are crucial. Inconsistent gross profit ratios or unexplained differences in turnover between books and GST returns often trigger rejection of accounts.
Banking and Financial Sector
Banks and financial institutions holding securities as stock in trade must comply with valuation norms under Section 145A while also following RBI guidelines. Any mismatch can invite adjustments by the AO. Given the significance of securities in their balance sheets, compliance in this area is critical.
Export‑Oriented Businesses
Exporters often rely on incentives like duty drawbacks, subsidies, or MEIS/SEIS benefits. Under Section 145B, such incentives become taxable when there is reasonable certainty of realization. Exporters must ensure proper recognition of such income and maintain relevant documentation to avoid disputes.
Conclusion
The method of accounting plays a pivotal role in the framework of income computation under the head of Profits and Gains of Business or Profession. By providing the option to adopt either the cash system or the mercantile system, the law respects the diversity of business models and professional practices. At the same time, it ensures uniformity, discipline, and transparency by mandating consistency in whichever method is chosen.
With the insertion of Sections 145A and 145B, and the introduction of Income Computation and Disclosure Standards, the legislature has strengthened the foundation of accounting for taxation purposes. These provisions standardize the treatment of inventory valuation, inclusion of taxes and duties, recognition of subsidies and incentives, and the timing of income recognition. This framework reduces the scope for arbitrary practices, minimizes manipulation, and aligns tax computation more closely with economic reality.
The authority granted to the Assessing Officer under Section 145(3) ensures that incomplete or inaccurate accounts do not escape scrutiny. By empowering the tax authorities to reject unreliable books and proceed with best judgment assessments, the law balances taxpayer autonomy with revenue protection. However, judicial oversight acts as a crucial safeguard against arbitrary use of these powers, emphasizing that assessments must always be fair, reasonable, and guided by material evidence.
Judicial pronouncements have consistently reinforced the principle that statutory provisions take precedence over administrative guidelines, and that consistency, prudence, and transparency form the backbone of tax accounting. At the same time, courts have clarified that anticipated losses may be recognized while anticipated profits cannot, reflecting the conservative approach that protects both the assessee and the tax system.
From a practical perspective, businesses must maintain complete and accurate records, comply with valuation rules, and recognize income in accordance with statutory provisions. Sector‑specific implications further highlight the importance of compliance, particularly for manufacturers, traders, exporters, and financial institutions. Non‑compliance not only risks rejection of accounts but also invites income estimation that may significantly increase tax liability.
In essence, the method of accounting is not merely a technical choice but a determinant of tax liability, financial reporting credibility, and legal compliance. It integrates statutory mandates, administrative standards, and judicial interpretations into a coherent framework. For businesses and professionals, careful adherence to these principles ensures not only compliance with the law but also trustworthiness in financial reporting and predictability in tax obligations.