Methods Of Accounting Accrual Cash: The post attempts to explain the two methods of accounting – cash and mercantile (accrual).
- Under the cash method of accounting, the incomes and expenses are taken under consideration on the actual receipt of payment.
- Under the mercantile or accrual method of accounting, incomes and expenses are taken into consideration as and when there arises a “right to receive” or “right to pay”.
- Accrual accounting implies the revenue and expenses are recognized and recorded when they occur, while cash basis accounting indicates these line items aren’t documented until cash exchanges hands.
- Cash-based accounting is more straightforward. However, accrual accounting portrays a more accurate view of a company’s health by including the accounts payable and accounts receivable.
- The accrual or mercantile method is the most commonly used, especially by publicly traded companies, as it smooths out earnings over time.
But why are we talking about the methods of accounting? Let’s discuss.
Why are We Discussing The Methods Of Accounting?
Suppose one makes a Fixed Deposit of Rs 1,00,000 for three years at the rate of 10% p.a on 1st April 2011 (the financial year 2011-2012 or the Assessment year 2012-13) in the cumulative option.
This implies that the interest rates are going to be calculated each quarter, and the interest is then reinvested into the fixed deposit. Interest from the Fixed Deposits are considered as Income from Other different Sources and is taxable.
The bank deducts tax or TDS if the interest income is more significant than Rs 10,000 in a financial year. The interest in various quarters is given below using Rupee times.
Calculator on Fixed Deposit
| Quarter | Interest after every quarter (in Rs) | Balance (in 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: Rs 34461.94 | Maturity Amount: Rs 134461.94 |
So, the interest in a year is more than Rs. 10,000. So, the question arises do we account for the interest each year or on maturity at the end of the three years? To answer this question, a proper understanding of the methods of accounting is required.
This is because the scope of Income and its taxability always depending upon a system of accounting that is followed by the assessee.
Various Methods of Accounting
There are two different methods of accounting, Cash and Mercantile or Accrual method.
Cash Basis Of Accounting
Under the cash basis of accounting, transactions are recorded when the actual cash is received or paid. It implies that the Income is recognised when the cash is accepted, and the expenses are recognised when the money is spent.
It does not really matter whether the money paid or received belongs to the current, past, or future year. Hence, there is no scope for recording the credit transactions. This basis of accounting is also referred to as the Receipts basis of accounting.
Accrual Basis Of Accounting
The accrual basis of accounting is also known as the Mercantile basis of accounting. It is the system where the transactions are recorded when they arise. It does not really matter whether the cash is received or paid or not. It implies that the incomes are recorded in the books of the accounts when earned, irrespective of whether it is received or accrued.
The cash method of accounting productively postpones (but does not permanently reduce) your tax liability to the year of actual receipt of Income. In contrast, under the mercantile method, the tax on the income has to be paid even if the Income has not been received.
EXAMPLE: Rent accrued is Rs. 1,000. (earned but not received)
Similarly, expenses are recorded in books of accounts when they are incurred; it does not matter whether the cash is paid or outstanding.
This system is most widely used and followed by each business organisation.
Hybrid or Mixed Basis of Accounting
This can be considered as a third method. Not the typical kind. Accountants have tried to merge the advantages of the two systems (cash and accrual) and have come up with the mixed or hybrid basis of accounting.
In this method, both cash basis and accrual basis are followed. Incomes are recorded on a cash basis, whereas expenses are taken on an accrual basis. The net income is discovered by matching the costs on an accrual basis with income on a cash basis.
This is the most conservative basis of accounting because all possible expenses relating to the period, whether paid or not, are considered. In contrast, payment only received in cash is taken into consideration. This method is followed by professionals like Doctors, Lawyers, and CAs but not commonly used.
Difference Between The Cash And Mercantile System Of Accounting
| Basis of Differentiation | Cash System of Accounting | Mercantile (Accrual) System of Accounting |
| Record of Transactions | It records only the cash transactions. | It records cash along with credit transactions. |
| Record of Incomes | Only those incomes are recorded that are made in cash. | All the incomes are recorded whether the money is accepted for the same or not. |
| Record of Expenses | Only those expenses are recorded, which are paid in cash. | All the costs are recorded whether money has been paid for the same or not. |
| No adjustments in regards to Outstanding expenses, Accrued Income, Income received in advance, and prepaid expenses are passed. | All adjustments regarding Outstanding expenses, Accrued Income, Income received in advance, and prepaid expenses are passed. | |
| Capital and Revenue items | This system doesn’t differentiate between capital and revenue items. | This system differentiates between capital and revenue items. |
| Legal Recognition | This system is not recognised by the Companies Act, 2013 and Income Tax Authorities. | This system is recognised by the Companies Act, 2013 and the Income Tax Authorities. |
| Ascertainment of the Accurate Profit or Loss | This basis doesn’t provide a correct view of profit or loss as this does not make a complete record of cash or credit transactions. | This basis offers an accurate view of profit or loss because this produces an entire record of cash or credit transactions. |
| Non-cash Items | It doesn’t record the non-cash items like depreciation etc. | It makes the record of the non-cash things like depreciation etc. |
| Suitability | This method is suitable for professional people such as lawyers, doctors etc. | This method has been adopted by the business houses which are involved in the Trading as well as Manufacturing business. |
| Period | It records all the incomes which are received and expenses paid in cash related to current, past, or future year. | It records the incomes and expenses associated with the current year only. |
| Simple and Easy | This method of accounting is simple and easy to adopt and apply. | This basis of accounting includes all the technicalities of accounts and hence is challenging to use. |
| Evidence in Court | The records maintained as per this system cannot be accepted as a piece of evidence in the court of law. | The records maintained as per this system are accepted as evidence in the court of law. |
Income Tax and Method of Accounting
Under the Income Tax Act, there have been five heads of Income stated
- Salaries,
- Income from business or profession,
- Income from house property,
- Income from other sources and
- Capital gains
As far as the three of these heads of Income–salaries, capital gains and Income from house property–are concerned, a taxpayer has no option but to follow the mercantile (accrual) method of accounting. For instance
- Salary relating to a specific year is taxable in that year itself irrespective of whether it has been received or not
- Rent receivable for a house property that has been let out is taxable regardless of whether it is received.
- Capital gains are chargeable to the tax in the year in which the asset is transferred, regardless of whether the sales consideration is received.
When talking about Income under the heads of ‘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 option to choose to account for them on either the basis of – cash or mercantile.
This has been specified in Section 145 of the Income-tax Act, 1961. The assessments followed yet another accounting system before enacting section 145 in the assessment year 1997-98, called the hybrid system.
With respect to Fixed Deposits Clause, 14 of The Bank Term Deposit Scheme, 2006, which became effective from 28-07-2006, clearly stipulates a choice for the subscriber to pay tax on interest on an accrual or receipt basis, which states
Interest on these term deposits must be liable to tax under the Act based on annual accrual or receipt, depending upon the method of accounting, which is followed by the assessee.
The tax payable on such interest shall be deducted following section 194A or Section 195 of the Act.
Different Accounting Methods can be Used
The method of accounting differs for each source of income, but within a particular source of income, the process must be the same for all items.
While a one-time change in accounting is usually allowed, changes in the process of accounting from year to year for income from the same source to save taxes are not.
How Can One Choose The Accounting Method?
One must also examine the nature of income and the deductions that are available before deciding whether to account for the income on the basis of cash or mercantile.
Income not guaranteed: In case there is a risk for companies defaulting on their own interest payment obligations in respect of the company fixed deposits (FD) and the debentures, it is well-advised to account such income on the basis of cash so that one doesn’t end up paying tax on the income that they do not eventually receive.
Amount of interest: If one decides on using the cash accounting method for interest on cumulative deposits, i.e. they pay tax only on receipt of the interest, then the interest paid on maturity will be higher as it is a lump sum. For example: if 50,000 Rs are invested in a span of 3 years, then the interest breaks up after every quarter using Rupee times: Calculator on Fixed Deposit is given below.
| Quarter | Interest (in Rs.) | Balance (in 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 Earned Rs 17230.97 | Final Balance Rs 67230.97 |
Assuming That They Started Fixed Deposit on 1st April
- Interest for the first year is 5190.64
- Interest for the second year is 5729.50
- Interest for the third year is 6310.83
Cumulative interest is 17230.97. So on a mercantile basis, one will be paying interest on smaller amounts every year(5190.64,5729.50,6310.83), while on a cash basis, one will be paying in one go for Rs 17230.97.
Interest eligible for deduction under section 80C: However, where the interest on such deposits is suitable for a deduction under section 80C, such as the National Saving certificates(NSC), it may be helpful to follow the mercantile method and claim for the deduction every year, rather than allowing the interest to accumulate and be taxed on maturity by following the cash method.
Tax Deducted at Source or TDS: If one follows the cash method of accounting, one crucial aspect to keep in mind is that the tax credit for the tax deducted at source on such income will be available only in the year in which such payment is offered to tax, though, the tax will generally be removed by the payer on an accrual basis every year.
Thus, one needs to ensure that the tax deduction certificates (irrespective of the year they were issued) are matched with income offered to the tax during the relevant year. Now with TDS information available in Form 26AS, it’s easier to find the TDS. One might get a letter from the Income-tax office for TDS.
For instance, one had opened a Fixed Deposit in a bank for five years. They will get Form 16A from the bank in which the TDS will be deducted for their Fixed Deposit, but this will not be reflected in Form 26AS.
Now, if they filed the return, including the TDS from the bank deposit. They will get the letter from Income Tax saying their TDS claim does not match the Form 26AS and they need to pay the balance amount. To avoid a hassle in one must pay the amount. Then the Form 26AS will get updated with the TDS from the bank account.
Premature Closure or Withdrawal: Investment like fixed deposit can be closed or withdrawn before the original term of the FD.