Method of accounting refers to the process through which income, expenses, assets, and liabilities are recorded in the books of accounts of a business during a specific accounting period. It plays a vital role in determining the tax liability under the head Profits and Gains of Business or Profession. The method adopted directly influences the timing and recognition of income and expenses, which ultimately affects the computation of taxable business income.
Cash Method of Accounting
The cash method of accounting is a straightforward approach where transactions are recorded only when actual cash is received or paid. Income is recognized when it is received in cash, and expenses are recorded when they are paid. This method does not account for receivables or payables. Therefore, any income earned but not received in cash within the accounting year is not recorded as income for that year. Similarly, liabilities incurred but not paid in cash are not considered expenses. This system is generally preferred by small businesses and professionals who primarily deal in cash and do not have complex financial structures.
Mercantile Method of Accounting
The mercantile method, also known as the accrual method, is based on the concept of matching revenue and expenses to the accounting period in which they occur, irrespective of when the actual cash transaction takes place. Income is recorded when it is earned and not necessarily when received. Likewise, expenses are recorded when they are incurred, regardless of whether payment has been made. This system provides a more accurate picture of a business’s financial performance and position as it includes all receivables and payables. It is the most widely accepted method of accounting, particularly among larger organizations.
Illustrative Example of Both Methods
To understand the difference between cash and mercantile methods of accounting, consider the case of MIID Coaching Center, which provides training services. In February 2017, ten students enrolled for a Tally course, each paying a monthly fee of Rs. 3500. However, only seven students paid the fees in February, amounting to Rs. 24,500, while three students paid later.
If MIID Coaching Center follows the cash method, it would record only Rs. 24,500 as income for February, as only this amount was actually received during the month. The remaining Rs. 10,500 received in March would be recorded in that month’s books. On the other hand, if the center follows the mercantile method, it would record the entire Rs. 35,000 in February, recognizing Rs. 10,500 as receivables in the balance sheet. This illustrates how the choice of method impacts the computation of income.
Section 145 of the Income Tax Act
Section 145 of the Income Tax Act provides the statutory basis for the method of accounting to be followed by taxpayers for computing income under the head Profits and Gains of Business or Profession and Income from Other Sources. This section has been divided into three subsections, each dealing with different aspects of accounting methods.
Section 145(1)
This subsection permits an assessee to compute income under the heads Profits and Gains of Business or Profession and Income from Other Sources, either based on the cash system or the mercantile system of accounting. The choice is left to the assessee. However, once a method is chosen, it must be followed consistently year after year. In contrast, for income under the heads Salaries, House Property, and Capital Gains, the method of accounting is not relevant as these are governed by specific provisions in the Act. For example, rental income from a house property is taxed under sections 22 to 27, and the method of accounting followed by the assessee does not impact its taxation.
Consistency in Method of Accounting
The assessee needs to follow the chosen method consistently. Changing methods without a valid reason may lead to inaccurate or misleading financial statements and could result in scrutiny from tax authorities. In earlier times, some assessees used a mixed or hybrid method, applying the cash system to certain items and the mercantile system to others. However, this practice is no longer permitted. The assessee must adopt either the cash system or the mercantile system for the entire computation process and apply it uniformly.
Section 145(2) and ICDS
Section 145(2) empowers the Central Government to notify Income Computation and Disclosure Standards (ICDS) to be followed by assessees who adopt the mercantile method of accounting. These standards are aimed at ensuring consistency and clarity in the computation of income. The standards notified by the government do not apply to the maintenance of books of account but are specifically intended for the computation of income and disclosure in the return. It is important to note that these standards apply only to assessees following the mercantile system. Individuals and Hindu Undivided Families (HUFs) not subject to tax audit under section 44AB are generally excluded.
List of Notified ICDS
The Central Government has notified ten ICDS applicable from the assessment year 2017-2018 onwards. These standards cover various aspects of income computation and are as follows..
ICDS I relates to the Disclosure of Accounting Policies
ICDS II deals with the Valuation of Inventories
ICDS III covers Construction Contracts
ICDS IV addresses Revenue Recognition
ICDS V pertains to Tangible Fixed Assets
ICDS VI involves the Effects of Changes in Foreign Exchange Rates
ICDS VII refers to Government Grants
ICDS VIII relates to Securities
ICDS IX deals with Borrowing Costs
ICDS X covers Provisions, Contingent Liabilities, and Contingent Assets
These standards provide guidelines on specific accounting treatments to be adopted while computing taxable income, particularly where the provisions in the Act are silent or ambiguous.
Section 145(3) and Rejection of Books of Accounts
According to Section 145(3), the Assessing Officer may reject the books of account submitted by an assessee under certain conditions. If the officer is not satisfied with the correctness or completeness of the accounts, or if the accounting method has not been regularly followed, or if the ICDS are not followed by an assessee using the mercantile method, the officer is empowered to reject the accounts and proceed with best judgment assessment under section 144.
Common grounds for such rejection include improper maintenance of accounts, failure to produce books for verification, maintaining defective records, or failure to maintain essential documents like a stock register. When the Assessing Officer finds that the books do not reflect a true and fair view of the financial transactions, the books can be rejected, and income can be assessed based on estimates or external evidence.
Importance of Proper Accounting Practices
Proper accounting practices are essential for the accurate computation of taxable income. A methodically maintained set of books offers transparency and helps in avoiding legal disputes. It ensures compliance with statutory requirements and minimizes the risk of penalties and assessments based on best judgment by tax authorities. Businesses must ensure that the chosen method of accounting is followed consistently and aligns with the applicable provisions of the Income Tax Act and ICDS, wherever required.
Inventory Valuation Under Section 145A
The first and foremost clause under Section 145A requires that inventories be valued at the lower of actual cost or net realizable value by ICDS II. While the Act does not define the term inventory, the definition provided under ICDS II is referred to for clarity and uniformity. The concept of net realizable value is used to reflect the actual value that a business can expect to realize from selling its inventory, minus the cost necessary to bring it to market.
For instance, if a business has goods with a market value of Rs. 50,000, but incurs Rs. 5,000 in transportation costs, Rs. 2,000 in production costs, and Rs. 3,000 in advertising costs to sell those goods, then the net realizable value would be Rs. 40,000. If the actual cost is higher than the NRV, the lower NRV will be adopted for inventory valuation.
Inclusion of Taxes, Duties, and Cess in Valuation
Section 145A also requires the inclusion of taxes, duties, cesses, or fees paid or incurred by the assessee on the purchase or sale of goods or services or inventory. This inclusion is mandatory, regardless of the method of accounting followed. The objective is to ensure that the computation of income under the Income Tax Act is reflective of the actual cost to the assessee, including all statutory levies.
This provision overrides the traditional treatment in financial accounting, where input taxes such as GST are often excluded from the cost of inventory if they are eligible for credit. However, for income tax, such amounts must be added back while computing the value of inventory and cost of goods sold.
Securities Valuation Under Section 145A
Section 145A contains clauses specifically dealing with the valuation of securities. The word securities is not defined in the Income Act, but is explained in ICDS VIII. Clauses (iii) and (iv) under this section lay out distinct treatment for different types of securities.
Clause (iii) applies to securities that are not listed on a recognized stock exchange or are listed but not quoted with regularity. Such securities must be valued at actual cost.
Clause (iv) acts as a residuary provision, covering all other securities not covered under clause (iii). These securities are required to be valued at either cost or net realizable value, whichever is lower. This method ensures that the valuation is reflective of the possible market realization and avoids overstatement of income.
When it comes to financial institutions and scheduled banks, the Reserve Bank of India’s guidelines must also be considered. In such cases, inventories or securities held should be valued in line with those guidelines, adopting the lower of cost or net realizable value approach.
Practical Implications of Section 145A
The provisions of Section 145A necessitate a change in the way businesses compute their income for tax purposes. While the statutory books may follow standard accounting principles, the computation for tax must comply with these specific guidelines. This creates a dual approach: one for statutory reporting and the other for tax reporting.
For example, in the context of excise duty or GST, even if the credit is available, the value of inventory for income tax must include the amount of tax, creating a temporary difference between accounting and tax profit. This may also result in deferred tax calculations under the Income Tax Act.
Businesses must ensure that their inventory and securities valuations are correctly aligned with these provisions, failing which they may face disallowances or adjustments during assessment proceedings.
Section 145B and Taxability of Certain Income
Section 145B was introduced to provide clarity on the taxability of specific types of income that were previously subject to varied interpretations. It begins with a non-obstante clause, indicating that it overrides other provisions of Section 145 in case of conflict.
This section specifically deals with interest on compensation or enhanced compensation, escalation claims under contracts, and government subsidies and grants.
Interest on Enhanced Compensation
According to Section 145B, interest received on compensation or enhanced compensation is taxable in the year in which it is received, irrespective of the method of accounting followed. This provision settles the ambiguity that previously existed regarding the year in which such income should be taxed. By treating such interest income as taxable in the year of receipt, the law simplifies its treatment and ensures consistency.
Escalation Claims and Export Incentives
Section 145B also covers escalation claims arising from contractual arrangements and export incentives. These incomes are chargeable to tax only in the year in which the right to receive them is established with reasonable certainty. This approach is based on the principle of prudence, ensuring that income is not recorded prematurely.
The concept of reasonable certainty acts as a safeguard against including income that may later prove unrealizable. It aligns with the Supreme Court’s interpretations on accrual and recognition of income, providing a legislative backing to such judicial pronouncements.
Subsidies, Grants, and Reimbursements
Subsidies, cash incentives, waivers, reimbursements, and similar receipts are to be taxed in the year in which they are received if they have not already been taxed in any previous year. This provision ensures that such incomes are not indefinitely deferred or excluded from tax liability.
The scope of this provision includes various forms of government support under Section 2(24)(xviii) of the Income Tax Act. Such receipts are considered income and are to be included in the total income for the relevant assessment year, subject to the condition that they were not taxed in earlier years.
Relevance of Section 145B
Section 145B was introduced to remove any uncertainty about the timing of taxation for certain types of income that are not recurring or routine in nature. By clearly specifying when such income is to be recognized for tax purposes, the section aids in eliminating litigation and interpretational issues.
For example, if a business receives a subsidy from the government in the previous year but had not included it in its books due to a lack of clarity, the new provision ensures that such income must be taxed in the year of receipt, provided it has not been taxed previously.
Effect on Method of Accounting
While Section 145 allows for flexibility in choosing the method of accounting, Sections 145A and 145B introduce mandatory requirements for income recognition and valuation, irrespective of the method adopted. This means that even if a business follows the cash basis of accounting, certain incomes such as interest on compensation, and subsidies,, must be accounted for on a receipt basis.
This reinforces the idea that the method of accounting cannot be used to defer or manipulate the recognition of certain types of income. The legislative intent is to ensure that all income is brought to tax at the appropriate time, and in a manner consistent with the economic reality of the transaction.
Importance of Judicial Interpretation in Taxation
The Income Tax Act lays down statutory provisions for computing income under various heads, but their interpretation often requires clarity through judicial rulings. The judiciary plays a crucial role in resolving conflicts between the statute, its notifications,, such as ICDS, and established accounting principles. Judicial precedents ensure that tax law is applied in a manner that respects constitutional rights and promotes fairness. Several cases have influenced the interpretation and implementation of accounting methods and tax computation under Sections 145, 145A, and 145B.
Chamber of Tax Consultants v. Union of India
This landmark case was filed before the Delhi High Court challenging the constitutionality of Section 145(2), which empowers the Central Government to notify Income Computation and Disclosure Standards. The petitioners argued that the ICDS overrode existing judicial precedents and the Income Tax Act’s provisions.
The Delhi High Court ruled that the power given to the Central Government under Section 145(2) to notify ICDS could not override settled judicial interpretations. If there was a conflict between ICDS and Supreme Court or High Court decisions, the judicial precedents would prevail. The court read down Section 145(2) and emphasized that the executive branch cannot overturn or supersede court rulings unless Parliament enacts a validating statute.
The judgment highlighted that ICDS must align with the principles laid down by courts. It also reinforced the constitutional mandate that judicial decisions are binding under Articles 141 and 144, and no notification can override them. The decision provided relief to assessees who faced ambiguity and unfair tax liabilities due to conflicting ICDS provisions.
Impact of the Chamber of Tax Consultants Case
This case clarified that the Income Computation and Disclosure Standards cannot override judicial interpretations. It maintained the balance of power between the legislative, executive, and judicial branches and ensured that tax computation adhered to established legal principles. It also prompted the Central Board of Direct Taxes to issue clarifications stating that, in case of a conflict, the provisions of the Act would prevail over ICDS.
The case has practical relevance for businesses as it allows them to rely on well-settled judicial decisions instead of being compelled to follow potentially conflicting standards issued by the executive. It also sets limits on administrative overreach and strengthens the legal framework governing tax compliance.
Hercules Pigment Industry v. Income Tax Officer
This case involved a dispute regarding the valuation of inventory in compliance with Section 145A. The assessee was engaged in manufacturing pigments and was maintaining an inclusive method of accounting. The dispute arose over the treatment of excise duty and unutilized CENVAT credit.
The Assessing Officer disallowed Rs. 1.39 million on account of unutilized CENVAT credit, claiming non-compliance with Section 145A. The Commissioner of Income Tax (Appeals) partially upheld the AO’s view but granted partial relief. On further appeal, the tribunal confirmed the disallowance, ruling that the assessee had failed to correctly follow Section 145A’s provisions.
The tribunal observed that the assessee’s CENVAT records did not reflect excise duty in the valuation of inventory. It concluded that the CENVAT account could not be considered a proper representation of excise duty paid on goods held in inventory. The failure to include excise duty in the valuation of opening stock, purchases, and closing stock led to inaccurate profit computation.
Significance of the Hercules Pigment Industry Case
This case underscores the mandatory nature of compliance with Section 145A, particularly in valuing inventory. It demonstrates how failure to include excise duty in the valuation of inventory as required under tax law can result in rejection of accounts and disallowance of expenses. The case illustrates the distinction between financial reporting and tax computation, where tax law requires certain adjustments regardless of general accounting practices.
The decision emphasizes that accurate profit computation under income tax requires adherence to tax-specific valuation norms, especially when it comes to duties and taxes. This has broad implications for manufacturers and businesses involved in trading, where duties and levies are significant components of cost.
Assistant Commissioner of Income Tax v. Origin Express India North Private Limited
In this case, the assessee was engaged in the business of share trading and filed a nil return. The Assessing Officer was dissatisfied with the return and issued notices requesting the production of books of account. Despite repeated requests, the assessee failed to comply. Eventually, the Assessing Officer invoked Section 145(3), rejected the books, and completed the assessment using best judgment under Section 144. The total income was computed at Rs. 28,67,101.
The assessee appealed to the Commissioner of Income Tax (Appeals), who reversed the Assessing Officer’s decision and nullified the disallowances. The revenue, dissatisfied with the CIT(A)’s decision, appealed to the Income Tax Appellate Tribunal.
The tribunal ruled in favor of the revenue. It found that the assessee’s failure to produce books of account, even after several opportunities, justified the rejection of accounts under Section 145(3). The explanation that the employee responsible for accounting had left, or that a fire had destroyed the records, was not sufficient without supporting evidence.
Lessons from the Origin Express Case
This case demonstrates that the maintenance and production of proper books of account are essential under the Income Tax Act. If the Assessing Officer finds the records to be incomplete, untraceable, or defective, he is empowered to reject the books and compute income using his best judgment.
It also shows the importance of documentary evidence to support any claim for non-availability of records. Mere oral submissions or vague excuses are not acceptable. This case serves as a warning to taxpayers that laxity in maintaining records or non-compliance with notices from tax authorities can lead to unfavorable assessments and increased tax liabilities.
Interplay Between Sections 145(3) and 144
Section 145(3) allows the Assessing Officer to reject the books of account if they are not complete or if the method of accounting has not been followed regularly. Once the books are rejected under this provision, Section 144 comes into play, allowing the AO to proceed with a best judgment assessment.
This approach is not punitive but procedural. It is meant to protect the revenue in cases where the books do not give a true and fair view of the business. It places a responsibility on taxpayers to maintain accurate, verifiable, and consistent records to avoid assessment based on estimation.
Practical Implications for Businesses
The method of accounting chosen by a business—whether mercantile or cash—has wide-ranging implications on how income is computed and recognized. Under the mercantile system, income and expenses are recorded when they are earned or incurred, regardless of when actual payment happens. This has a direct impact on the timing of taxable income.
For instance, sales made on credit are taxable in the year they accrue, even if payment is received in the next financial year. Similarly, expenses are allowable when incurred, even if paid later. This allows for a more accurate reflection of business performance but requires robust accounting controls.
In contrast, the cash system records transactions only when money is received or paid. While simpler, it may not reflect the true financial position of the business. It also limits the applicability of certain deductions or tax planning opportunities, which depend on accrual concepts.
Industry-Specific Considerations
The choice and application of accounting methodsalso depend on the nature of the industry. For example, contractors, manufacturers, and traders typically use the mercantile system due to its comprehensive tracking capabilities. In contrast, small service providers or individual professionals may opt for the cash system, especially if their income does not exceed the threshold requiring an audit.
Furthermore, ICDS has specific provisions for certain industries. Construction contracts, real estate transactions, and revenue recognition in such sectors have special treatment under notified standards. Businesses must therefore ensure they apply relevant ICDS provisions to maintain compliance and accurate tax reporting.
Audit Considerations
Section 44AB of the Income Tax Act mandates an audit for businesses with turnover exceeding the prescribed limits. The audit process involves verifying the consistency and correctness of the method of accounting, including compliance with ICDS. Auditors must certify that income has been computed according to the regularly followed accounting method and that deviations, if any, are disclosed.
Discrepancies in method of accounting, irregular adoption, or non-disclosure of changes can attract audit qualifications and scrutiny. The tax auditor must also reconcile profits as per books with profits as per return, especially where ICDS adjustments are involved.
The Form 3CD (tax audit report) specifically requires disclosures related to accounting methods, ICDS compliance, valuation of inventory, recognition of income, and treatment of taxes. Proper documentation and internal controls are critical to satisfy audit requirements and avoid litigation.
Role of Consistency in the Method of Accounting
Consistency is a core principle in accounting and tax law. The method adopted by the assessee in a previous year must be followed in subsequent years unless there is a valid reason for change. Section 145 mandates that any change in the method of accounting must be disclosed and its impact on profits must be quantified.
Inconsistent application of accounting methods can distort taxable income and raise red flags during assessments. It may also invite rejection of books under Section 145(3). Therefore, a business must not only choose an appropriate method but must also apply it consistently year after year.
If a business chooses to change its method—for example, shifting from cash to mercantile—proper justification must be provided, such as alignment with accounting standards or business restructuring. Additionally, transitional adjustments must be made to avoid double taxation or omission of income.
Transitional Provisions and ICDS Implementation
When the ICDS was introduced, it required certain transitional adjustments, especially in revenue recognition, inventory valuation, and treatment of construction contracts. These adjustments had to be incorporated in the computation of income to ensure that prior year items were correctly brought into tax in the year of transition.
Businesses were also required to disclose these transitional impacts in their financial and tax statements. This included one-time income or expense recognition due to changes in treatment mandated by ICDS.
The transitional period posed challenges for businesses in aligning their financial systems and ensuring compliance. However, it also provided opportunities to streamline accounting and enhance transparency in tax reporting.
Consequences of Non-Compliance
Failure to follow a consistent and acceptable method of accounting can have significant consequences. These include:
- Rejection of accounts under Section 145(3): This empowers the Assessing Officer to disregard the books and use best judgment for assessing income.
- Additional tax liability: Misstatement or improper recording of income and expenses can lead to higher tax assessments.
- Penalties and interest: Inaccurate computation of income or failure to comply with ICDS can attract penalties under Section 271(1)(c) and interest under Sections 234A/B/C.
- Litigation and scrutiny: Persistent non-compliance increases the risk of audits, notices, and prolonged litigation.
To mitigate these risks, businesses must ensure robust accounting policies, periodic internal audits, professional tax advice, and continuous monitoring of regulatory updates.
Summary of Key Takeaways
- Section 145 mandates that income under the head “Profits and Gains of Business or Profession” must be computed using either the cash or mercantile system, consistently followed.
- Section 145A deals with specific inclusions and valuation adjustments, especially relating to duties, taxes, and inventory.
- Section 145B clarifies the timing of income recognition, including interest on compensation and subsidies.
- ICDS are binding for tax computation, but cannot override the Income Tax Act or judicial rulings.
- Judicial decisions such as Chamber of Tax Consultants and Hercules Pigment Industry have clarified the limits of executive notifications and reinforced the role of judicial interpretation.
- Consistency and accuracy in accounting methods are crucial to ensure fair tax assessments and avoid disputes.
- Audit requirements and disclosures in Form 3CD demand full transparency in the adoption and application of accounting methods.
- Transition and compliance with ICDS requires adjustments, documentation, and coordination between accounting and tax departments.
Conclusion
The method of accounting is not merely a technical formality but a foundational pillar in computing business income under the Income Tax Act. It affects how income and expenses are recorded, how profits are computed, and how taxes are paid. Sections 145, 145A, and 145B along with ICDS and judicial interpretations form a structured yet evolving framework that guides this process.
Businesses must treat the method of accounting as a strategic tool for compliance, efficiency, and financial integrity. With regulatory expectations rising and tax authorities becoming increasingly data-driven, maintaining consistency, transparency, and accuracy in accounting practices is more important than ever. The relevance of the method of accounting, thus, is both foundational and functional in the domain of taxation and beyond.