[Opinion] New Technical Guide of ICAI on Cash Basis of Accounting

CA. Srinivasan Anand G. – [2024] 159 taxmann.com 382 (Article)

1. About

There are two basis of accounting commonly followed and are acceptable under the Income-Tax Act, 1961:

(a) Accrual Basis of Accounting (also called Mercantile System of accounting)

(b) Cash Basis of Accounting

For companies, it is mandatory under the Companies Act, 2013 to follow the accrual basis of accounting. In case of LLPs, Section 34(1) of the LLP Act, 2008 gives LLPs an option to follow either a mercantile system of accounting or a cash basis of accounting. In the case of sole proprietorships or HUFs or partnership firms, there is no stipulation as to whether they should follow accrual system or cash system. Section 145(1) of the Income-Tax Act, 1961 recognises both accrual as well as cash basis of accounting for the purposes of computing profits and gains from business or profession. Since there is no legal compulsion for non-company entities to follow accrual basis of accounting, it is observed that entities engaged in manufacturing/trading of goods generally follow accrual basis of accounting. It has been observed that some of non-company entities primarily in services sector do follow cash basis of accounting.

While there is ample guidance in accounting standards for non-company entities opting to follow accrual basis of accounting, there is no such comprehensive authoritative guidance on cash basis of accounting. The only authoritative guidance hitherto available on cash basis of accounting was Supreme Court’s decision in CIT v. A. Krishnaswami Mudaliar [1964] 53 ITR 122 (SC) wherein it was observed as under:

“Among Indian businessmen, as elsewhere, there are current two principal systems of bookkeeping. There is, firstly, the cash system in which a record is maintained of actual receipt and actual disbursements, entries being posted when money or money’s worth is actually received, collected or disbursed. There is, secondly, the mercantile system, in which entries are posted in the books of account on the date of the transaction, i.e., on the date on which rights accrue or liabilities are incurred, irrespective of the date of payment. For example, when goods are sold on credit, a receipt entry is posted as of the date of sale, although no cash is received immediately in payment of such goods; and a debit entry is similarly posted when a liability is incurred although payment on account of such liability is not made at the time. There may have to be appropriate variations when this system is adopted by an assessee who carries, on a profession. Whereas under the cash system no account of what are called the outstandings of the business either at the commencement or at the close of the year is taken, according to the mercantile method actual cash receipts during the year and the actual cash outlays during the year are treated in the same way as under the cash system, but to the balance thus arising, there is added the amount of the outstandings not collected at the end of the year and from this is deducted the liabilities incurred or accrued but not discharged at the end of the year. … Again where the cash system is adopted, there is no question of bad debts or outstandings at all, in the case of mercantile system against the book profits some of the bad debts may have to be set off when they are found to be irrecoverable”.

To fill this void of absence of authoritative guidance on cash basis of accounting, ICAI has recently issued the “Technical Guide on Preparation of Financial Statements under Cash basis of Accounting” (hereinafter referred to as “the Technical Guide”).

2. Accrual basis of accounting

Accrual basis of accounting is the method of recording transactions by which revenue, expenses, assets and liabilities are recognised in the accounts in the period in which they accrue. The accrual basis of accounting includes considerations relating to deferral, allocations, depreciation and amortisation. This basis is also referred to as ‘Mercantile Basis/system of Accounting’.

3. Cash basis of accounting

The cash basis of accounting recognizes transactions and events only when cash is received or paid by the entity. Under the cash basis of accounting, transactions are recorded when the related cash receipts or cash payments take place. The revenue is recognised when cash is actually received. Similarly, expenses on acquisition and maintenance of assets used for rendering services as well as for employee remuneration and other items are recorded when the related payments are made. The end product of strict cash basis of accounting (also known as pure cash basis of accounting) is a statement of receipts and payments that classifies cash receipts and cash payments under different heads.

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