Method of Accounting: How far relevant for computing Business Income (PGBP)
- Blog|Income Tax|
- 9 Min Read
- By Taxmann
- Last Updated on 22 April, 2022
Authored by – Himanshi Lodha
1. Methods of Accounting
Method of accounting means a method where the income, expenses, liabilities and assets of every business are recorded in the books of account over an accounting period.
There are two types of accounting methods:
|1.||Cash method: It is a method where only cash inflows and outflows are recorded. This accounting is mostly followed by small concerns and professionals who deal mostly with cash.|
|2.||Mercantile method: It is also known as accrual method of accounting. In this method not only cash inflows and outflows but also receivables (assets) and payables (liabilities) are recorded. This is the widely used system of accounting by many business organizations.|
2. Let’s understand both the methods with an example:
MIID coaching center imparts training to students. In the month of February 2017 to 10 students took admission for learning tally course for a fess of Rs 3500 per month. Out of 10 students only 7 students paid cash and the total amount which was received by the coaching center was just 24,500.
|♦||If coaching center follows cash method only the fess received from seven students i.e. Rs 24,500 should be recorded as sales for the month of Feb. and the rest amount i.e. Rs 10,500 as fees received in march. It won’t create any asset for the month of Feb.|
|♦||If MIID coaching center follows mercantile method then not only the fees received by 7 students i.e. Rs 24,500 but also the fees which shall be receivable from the rest of the three students i.e. Rs 10,500 shall also be recorded as asset in the month of Feb.|
3. Provisions for Computing Business Income (PGBP)
1.1. Section 145 – Methods of Accounting
This section deals with Method of Accounting. This accounting method is applicable on the taxes which is paid by the individuals. It is further been divided into three sub-sections which are as follows:
♦ Section 145(1)-
|HEADS OF INCOME||SYSTEM OF ACCOUNTING|
|(1) Profits and gains of business or profession (PGBP)
(2) Income from other sources
|It can be computed on the basis of either “Cash or Mercantile” system of accounting at the option of the assessee.|
(4) House Property
(5) Capital Gains
|Method of accounting plays no role. These incomes are taxable as per specific rules applicable to them.|
|1.||Ishita and Kunal, both are running a grocery store in the same locality, following mercantile and cash system of accounting respectively. Hence, their computation of income will be taxed under the head PGBP.|
|2.||Mahaveer the owner of the house has rented the house to Ritu (who teaches Yoga) for Rs. 20,000 per month. He is regularly maintaining the books of account in order to record his rental income and has followed the cash system of accounting. According to the interpretation of section 145(1) his income will be taxed under the head of “House Property” provided under sections 22 to 27. Here, the method of accounting holds no relevance with respect to house property.|
Few assessee use a hybrid form of accounting, i.e. both the Cash Method and the Mercantile Method, to compute their income, which basically gives inaccurate income. Presently, the assessors are no longer permitted to use the mixed system. Either the cash system or the mercantile method must be used. The assessee must remain consistent while choosing the said method.
♦ Section 145(2)- In this clause the Central Government has been empowered to notify ICDS i.e. “Income Computation and Disclosure Standards” to be followed by the assessee. This is applicable only to those who are following mercantile system of accounting. Individuals and Hindu undivided households are excluded from getting their accounts credited under section 44AB. The notification of ICDS must be published in the Official Gazette from time to time.
The central government recently released the 10 new ICDS which will be applicable from 2017-2018 Assessment year. ICDS will not be applicable for maintenance of books of account but shall be relevant for computation of total income and disclosure of information in the return.
The 10 ICDS are as follows: –
|I||Disclosure of Accounting Policy|
|II||Valuation of Inventories|
|V||Tangible Fixed Assets|
|VI||Effects of changes in Foreign Exchange Rates|
|X||Provisions, Contingent Liabilities & Contingent Assets|
♦ Section 145(3)– According to this clause, the following three circumstances assessing officer (AO) may (or may not) take up the case and complete the assessment in the manner provided in section 1441 i.e. Best Judgement Assessment:
|(1)||If assessing officer is not pleased with the completeness or correctness of the Books of Accounts and documents of the assessee;|
|(2)||If assessee did not follow the correct accounting procedure on a daily basis;|
|(3)||ICDS notified by Central Government under section 145(2) may have not been followed by the assessee for computation of income.|
If there are any discrepancies in the books of accounts, the assessing officer has the power to reject it. These are as follows:
|•||If the method of accounting is improperly followed.|
|•||If the accounts were not produced for authentication.|
|•||If no records are produced.|
|•||If the accounts were defective.|
|•||If stock register was not maintained.|
If the assessing officer rejected the books of account because he was not satisfied with the accuracy of the accounts which were produced by the assessee, then the AO must make the best decision possible, taking into account all of the factors set out in Section 145 of the Income Tax Act of 1961.
1.2. Section 154(A) – Methods of Accounting in Certain Cases
Section 145A and section 145B was added by Finance Act of 2018 with effect from assessment year 2017-2018 by replacing the earlier provision of section 145A(a) of the act and in addition the proposed sections give legislative backing to some ICDS provisions.
Section 145A is only applicable for calculating income under the head “profit and gains from business or profession”. Simply meaning, that the new provision has no effect on the maintenance of books of accounts or the accounting methods that are commonly used under section 145 of the Act.
This section is sub-divided into 4 clauses: –
Clause (i) – According to ICDS, inventory should be valued at “lower of actual cost or net realizable value (NRV)”is mandatory. The word “inventory” has not been defined in the Act, so in order to dodge needless lawsuits, refer definition at paragraph 2(1)(a) of ICDS II. Here the assessee cannot exercise discretion to value the inventory.
NRV is calculated using market value of asset minus the cost needed for sale of that asset like transportation or production cost etc.
- Market value of asset = Rs. 50,000/-
- Transportation cost = Rs 5,000/-
- Production cost = Rs 2,000/-
- Advertising cost = Rs 3,000/-
- Then, NRV = 50,000 – (5,000+2,000+3,000) = 40,000/-
Clause (ii)–This clause basically means that if tax, duty, cess or fee are actually paid or incurred by the assessee in the purchase, sale of goods or services and also inventory then while evaluation of the same the assessee is under obligation to include the amount of tax, duty, cess or fee irrespective of method of accounting.
Section 145 of the Act will remain in effect as a whole and will not be superseded by proposed Section 145A. (ii).
Clause (iii)and Clause (iv)– The word, ‘Securities’ mentioned in both the clauses has not been defined in this act but the same can be looked in ICDS-VIII which explains the term securities. It is explicit from both the clauses that securities valuation is compulsory and not optional.
Distinctions between clauses (iii) and (iv) is explained in the following table.
|Particulars||Section 145A(iii)||Section 145A(iv)|
|1. Types of securities||This clause refers to the following two categories of securities:
(1) Securities that are not listed on a recognised stock exchange.
(2) Securities that are listed but not quoted on a “recognised stock exchange” on the basis of time to time.
|It is a residuary clause covering all securities which are not included in clause (iii).|
|2. Valuation in compliance with the ICDS notified under section 145(2).||Must be valued on the basis of actual cost.||Must be valued on the basis of actual cost or net realisable value. Hence their comparison of securities shall be made category-wise.|
1.3. Section 145(B) – Taxability of Certain Income
It starts with a non-obstante clause, hence has an overriding effect on the provisions of s.145.It states that the, “Interest on the compensation” or “enhanced compensation” received by the assessee is considered to be the income of the previous year under which it was received.2
Subsidies (or grants, cash incentives, duty drawbacks, waivers, concessions, or reimbursements) as stated in section 2(24)(xviii)4, are considered to be “income in the previous year in which they are received, if they have not been charged to income tax in any previous year. “5
1. Chamber of Tax Consultants V. Union of India . (2017)
The writ petition was filed in the high court of Delhi by the petitioner. The petitioner challenged the section 145(2) of the income tax Act which notify us to follow the ICDS, empowered by the central government for computing the income chargeable using mercantile system of accounting under the head “Profit and gains of business or profession” or “income from other sources”. The petitioner challenged the notification no. 87/2016 and circular no. 10/2017 demanding to follow 10 ICDS.
Is part of ICDS which override the laws as mentioned in judicial precedents are need to be struck down or not?
The Delhi High Court held the updated ICDS and its specific provisions and also CBDT for issuing clarification as to be ultra vires the Act. And the section 145(2) has been read down by restricting the central government powers to only notify if the provisions made do not contradict the judicial precedents. The court also held that, under Articles 141 and 1447 of the Constitution, when there is a binding judicial precedent, the executive cannot supersede it unless the Act is amended by way of a validation statute.
As ICDS is mandatory to follow it was no longer possible for an Assessee to measure taxable income in accordance with the Act, as elucidated by Supreme Court and High Court judgments. Also many provisions in the ICDS were in conflict with the act or judicial precedents which in result becomes prevailing over the judicial precedents. So, accordingly there is a need to resist the powers of central government in notifying the ICDS in such a way that no override situation occurs. The decision taken by Delhi High Court to read down the section 145(2) of the Act is in accordance with the constitution. Further, CBDT clarified that in the event of a conflict between the provisions of the ICDS and the Act, the provisions of the act will take precedence.
2. Hercules Pigment Industry V. ITO
The assessee is in business of manufacturing and marketing of pigments and following inclusive method of accounting. The excise duty paid or received were taken into unutilized CENVAT credit (UCC) account by assessee. During assessment the AO disallowed the unutilized CENVAT of Rs. 1.39 million under the section 145A of the Act. On appeal the order of AO was confirmed by the CIT(A) although relief of Rs. 0.339 million was allowed to the assessee. The aggrieved assessee is in appeal before tribunal.
Is the profit determined by the assessee for the stated assessment year is applicable irrespective of inclusive or exclusive method of accounting followed?
Appeal of the assessee was dismissed as the assessee doesn’t carefully followed the provisions of section 145A of the income tax Act for valuation to determine correct taxable value.
The UCC account maintained by the assessee is a measure of excise liability on removal of goods but it does not represent the unutilized credit available on the goods that were held as stock in trade. So, the UCC account cannot be taken as correct measure of excise duty on inventories. Therefore, to determine the correct profit the assessee needs to make a correct profit and loss statement including the excise duty in opening stock, closing stock and purchases in a way that the CENVAT credit in integrated within it.
3. ACIT V. Origin Express (I) North (P.) LTD.
The assessee is a private company involved in the business of share trading. Nil return of Income filed by assessee on 15.11.2007. AO dissatisfied on the return filed and called assessee several times but no one responded and in the end of month, the AR of the assessee appeared and filed balance sheet and profit and loss on account and requested for adjournment. In the absence of books of account, the AO rejected the same by assuming that accounts are not complete and unrealizable by invoking the provisions of section 145 (3) and determined the total income to be Rs. 28,67,101/- by several disallowance. The aggrieved assessee appeals before the CIT(A), the commissioner nullified all the disallowances by the AO. Feeling unfair of the decision of the CIT(A), the revenue made an appeal in the tribunal.
Whether rejection of books of account by the AO was justified or not under 145(3)?
After the Revenue’s appeal, the Tribunal overturned the CIT(A)’s Order which was in the favour of the assessee and gave the decision in the favour of AO. The reason being was that the assessee failed to submit the required particulars even after asking for multiple times by the AO. Furthermore the assessee was unable to give proper justification regarding non-production of books of accounts. Hence, the order by the AO was restored.
As no books of account were produced by the assessee and the same was asked several times by AO but the assessee did not respond. In concern of rejection of books of account, the assessee replied that the account was maintained by the employee who left when business was shut down and so the accounts are not traceable. Not producing books under this situation is not agreeable. Further replying, assessee said that due to fire in the company’s office on 18.06.2007 most of the accounts were destroyed. The facts raised by assessee in absence of “production of books of accounts” were peculiar, so it is justified to reject books of account u/s 145 (3).
Accounting – Meaning and its Basic Concepts
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