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The post tries to explain the two methods of accounting – mercantile(accrual) and cash.

• Under the mercantile (accrual) method, incomes and expenses are taken into account as and when there arises a “right to receive” or “right to pay”.
• Under the cash method, incomes and expenses are taken into account on actual receipt or payment.

But why are we talking about method of accounting?

#### Why are we talking about the method of accounting?

Suppose I make a Fixed Deposit for Rs 1,00,000 for 3 years at 10% p.a on 1st April 2011 (the financial year 2011-2012 or Assessment year 2012-13) in cumulative option.  This means that the interest rates is calculated on a quarterly basis and the interest is reinvested into the fixed deposit.  Interest from Fixed Deposits is considered as Income from Other Sources and is taxable. Tax or TDS is deducted by the bank if interest income is greater than Rs 10,000 in a financial year as discussed in Fixed Deposits and Tax. The interest in various quarters are given below using Rupeetimes: Calculator on Fixed Deposit.

Quarter Interest after every quarter(Rs) Balance(Rs)
1. 2500.00 102500.00
2. 2562.50 105062.50
3. 2626.56 107689.06
4. 2692.23 110381.29
5. 2759.53 113140.82
6. 2828.52 115969.34
7. 2899.23 118868.58
8. 2971.71 121840.29
9. 3046.01 124886.30
10. 3122.16 128008.45
11. 3200.21 131208.67
90.5625 days. 3253.27 134461.94
Total: Total Interest Earned:   Rs 34461.94 Maturity Value:  Rs 134461.94

So interest in a year is more than 10,000 Rs. So do we account for the interest every year or on maturity at the end of three years? Answering this question requires understanding the method of accounting. Because The scope of income and its taxability always depend upon system of accounting followed by the assessee.

#### Methods of Accounting

There are two methods of accounting, Cash and Mercantile or Accrual method

• Cash Method of Accounting: Under the cash method, incomes and expenses are taken into account on actual receipt or payment. i.e those transactions are considered which physically happen through cash or bank accounts. For example, if you pay your telephone bill on say 15th April 2012, it will be accounted for in the financial year 2012-13 (1-Apr-2012 to 31-Mar-2013) although the bill may be pertaining to the month of March 2012.
• Mercantile or Accrual method: Under this method transactions are considered as and when they are incurred or earned whether they are are received or not. For example:  Salary relating to a particular year is taxable in that year itself irrespective of whether it is actually received or not.

The cash method of accounting effectively postpones (but does not permanently reduce) your tax liability to the year of actual receipt of income, whereas under the mercantile method, the tax on the income has to be paid even if the income has not been received.

#### Income Tax and Method of Accounting

Under the Income Tax Act, as discussed in Income Tax Overview, there are five heads of income

• Salaries,
• Income from house property,
• Income from business or profession,
• Capital gains and
• Income from other sources.

As far as three of these heads of income–salaries, income from house property and capital gains–are concerned, a taxpayer has no option but to follow the mercantile method of accounting. For instance

• Salary relating to a particular year is taxable in that year itself irrespective of whether it is actually received or not
• Rent receivable for house property that has been let out is taxable irrespective of whether it is actually received.
• Capital gains are chargeable to tax in the year in which the asset is transferred, irrespective of whether the sales consideration is actually received.

When it comes to income under the heads ‘Profits and Gains of business or profession’ and ‘Income from other sources’ (like business profits, professional income and investment income other than capital gains), we have the choice of accounting for them on either basis–cash or mercantile. This is specified in Section 145 of the Income-tax Act, 1961. There was yet another accounting system followed by the assessees before the enactment of section 145 in the assessment year 1997-98, called the hybrid system.

With respect to Fixed Deposits Clause 14 of the  The Bank Term Deposit Scheme , 2006 which became effective from 28-07-2006 clearly stipulates a choice for subscriber to pay tax on interest on accrual or receipt basis which states

• Interest on these term deposits shall be liable to tax under the Act on the basis of annual accrual or receipt, depending upon the method of accounting followed by the assessee.
• The tax on such interest shall be deducted in accordance with the provisions of section 194A or Section 195 of the Act.

#### Different Accounting Methods can be used

Can one follow the cash method of accounting for income from some investments, while following the mercantile method for income from others? Quoting from article by Gautam Nayak on livemint(Jul 2010)

Although the Income Tax Act has not defined what exactly constitutes a source of income, the courts have generally taken the view that the term “source” must be understood in its “normal” context as consisting of those items that are treated as one category by the taxpayer. Therefore, each category of investments would generally constitute a separate source of income, and a different method of accounting can be adopted for each such category. For instance, debentures and bonds may constitute one source, company fixed deposits another, bank fixed deposits a third source, and so on. Therefore, it is possible to account for the interest on company deposits on a cash basis, while accounting for interest on bank deposits on an accrual basis.

The method of accounting can differ for each source of income, but within a particular source of income, the method must be the same for all items. This is further clarified by answer to question in eLagaan or taxworry.com Quoting from Should Interest on Tax Saving Term Deposit Be Shown on Receipt or Accrual Basis?

I am a salaried employee. I have made a 5 year tax-saving FD for Rs.30000 and a 3 year FD for Rs.10000 in the financial year 2008-09. I am not any income other than salary and interest. I have following two questions: 1) In respect of FD of 3 years, can I pay tax on interest income in the 3rd year (i.e. cash basis) instead of paying it every year on interest accrued ? 2) In respect of tax-saving FD of 5 yrs, can it be taxed like NSC i.e. interest earned be treated as being reinvested and eligible as deduction u/s 80C ? If not, can this also be taxed on cash basis in the year of receipt of interest income?

The income of interest can be shown on the basis of cash ( receipt  ) or mercantile i.e due basis. But once you selected a particular system of accounting , you can not change . Therefore, it is perfectly alright if for you to pay the tax on the interest on FD for 3 years on maturity only.

But if you follow that rule, you can not choose to pay tax on other fixed deposit on accrual basis. It means that for tax saving funds FDs also , you have to show income and pay tax in the year of receipt of maturity value .

While a one-time change in method of accounting is normally allowed, changes in method of accounting from year to year for income from the same source, just to save taxes, is not.

#### How to choose the accounting method?

You must also examine the nature of income and the deductions available before deciding whether to account for the income on a cash basis or mercantile basis.

Income not guaranteed: If there is a risk of companies defaulting on their interest payment obligations in respect of company fixed deposits (FD) and debentures, it is prudent to account such income on a cash basis so that you do not end up paying tax on income that you do not eventually receive.

Amount of interest: If you decide to use cash accounting method for interest on cumulative deposits i.e you pay tax only on receipt of the interest, then interest paid on maturity will be higher as it is lump sum. Ex: if 50,000 Rs are invested in 3 years then the interest break up after every quarter using using Rupeetimes: Calculator on Fixed Deposit is given below.

Quarter Interest(Rs) Balance(Rs)
1. 1250.00 51250.00
2. 1281.25 52531.25
3. 1313.28 53844.53
4. 1346.11 55190.64
5. 1379.77 56570.41
6. 1414.26 57984.67
7. 1449.62 59434.29
8. 1485.86 60920.14
9. 1523.00 62443.15
10. 1561.08 64004.23
11. 1600.11 65604.33
90.5625 days. 1626.64 67230.97
Total: Total Interest Earn   Rs 17230.97 Ending Balance   Rs 67230.97

Assuming that we started Fixed Deposit on 1 Apr,

• Interest for first year is 5190.64
• Interest for second year is 5729.50
• Interest for third year is 6310.83

Cumulative interest is: 17230.97. So on mercantile basis you will be paying interest on smaller amounts every year(5190.64,5729.50,6310.83) while on cash basis you will be paying in one go for Rs 17230.97.

Interest eligible for deduction under 80C: However, where the interest on such deposits is eligible for a deduction under section 80C, such as National Saving certificates(NSC), it may be beneficial to follow the mercantile method and claim the deduction each year, rather than allow the interest to accumulate and be offered to tax on maturity under the cash method.

Tax Deducted at Source or TDS:If you follow the cash method of accounting, one important aspect to remember is that the tax credit for the tax deducted at source on such income will be available only in the year in which such income is offered to tax, though, the tax would generally be deducted by the payer on an accrual basis each year. Therefore, you need to ensure that the tax deduction certificates (irrespective of the year in which they were issued) are matched with the income offered to tax in the relevant year. Now with TDS information available in Form 26AS it’s easier to find TDS. You might get letter from Income tax office for TDS not matching as in case of Mr Sharma.

Mr Sharma had opened a Fixed Deposit in a bank for 5 years. He got Form 16A from the bank in which TDS was deducted for his Fixed Deposit but this was not reflected in Form 26AS. In July 2011  he filed his return including TDS from bank deposit. In Sep 2011 he got the letter from Income Tax saying his TDS claim does not match Form 26AS and he needs to pay balance amount of Rs 3310. To avoid hassle in Oct 2011 Mr Sharma paid the amount. In Jan 2012 Form 26AS got updated with TDS from the bank account(Mr Sharma went multiple times to bank to get it done). Now Mr Sharma doesn’t know whether to ask for refund extra tax paid or not!

Premature Closure or Withdrawal: Investment such as fixed deposit can be closed before the original term of the FD. As discussed in Overview of Fixed Deposits

In the event of the Fixed Deposit being closed before completing the original term of the deposit, interest will be paid at the rate applicable on the date of deposit, for the period for which the deposit has remained with the Bank. In case of premature withdrawal the deposit may be subject to penal rate of interest as prescribed by the Bank on the date of deposit. RBI has left it to banks to decide whether they want to impose any penalty on premature closure of fixed deposits.

So in such case actual tax would be different from accrued tax.

#### Summary or Bottom Line

Even if system of accounting is ignored and also TDS provisions are set aside, it is always prudent to present interest income on annual accrual. This also will not burden you with extra tax in the year of its maturity. Please ensure that TDS matches with the Form 26AS.

Reference: Livemint:The correct method of accounting(Jul 2010), Taxmann: Accrual of Income

Related articles:

Which method of accounting- Cash or Mercantile do you use? Why did you choose that method? Which method do you think makes sense to use? Any case related to method of accounting that you can share?

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