The Hindu Business Line : Where method matters

Method of accounting is the foundation for determining the operating results and financial status of an enterprise. With most economies reeling under recession, every taxpayer is impacted either directly or indirectly. One of the recognised and celebrated methods of accounting is the ‘mercantile system’, which has been accepted by accounting bodies throughout the world, notwithstanding its inherent limitations. The mercantile system is faulted for recogni sing and taxing incomes the moment a contractual right accrues in favour of the payee, but such income in reality might not be realised at all. The tax paid on the unrealised income, in addition to being a bad debt, adds to the liquidity crunch of the taxpayer. Restricting the tax burden, thus, only to the extent of the income actually realised seems to be a prudent approach.

Changeover prohibited?

Does the tax law prohibit a changeover in the method of accounting adopted by taxpayers? The obvious answer is ‘no’. The changeover, moreover, is not as simple as is claimed. Section 145, dealing with the method of accounting, says that income from business or profession or from residual source known as ‘other sources’ is to be computed in accordance with the method of accounting regularly employed by the taxpayer. Hence, the precondition for computation of income for tax assessment is “regular” method of accounting of the taxpayer. A changeover, if bona fide, would provide a realistic measure of income and the tax burden thereon is justified. However, the bona fide of the change has to be approved by the revenue authorities and, in the event of rejection, by the appellate authorities.

The Echke Ltd case

In the Echke Ltd vs CIT (2009 310 ITR 44 Gujarat), the assessee changed the method of accounting from the mercantile to the cash system. The principal reason for the change was that its commission income admitted on mercantile basis was not realised subsequently due to deterioration in the financial position of the payer of such income. It was found that the assessee after changeover had followed the same method of accounting subsequently and, hence, satisfied the test of consistency. The court held that the assessee had to establish the change as bona fide and also the test of consistency. To prove the bona fide, the realities of business and compelling reasons which have prompted the change must be presented to the tax authorities. The consistency test could be passed only by continuance of such practice in the subsequent periods. If a taxpayer frequently changes the method of accounting or recognising income, then it might create suspicion and the change could be rejected. Naturally, the test of consistency requires passage of time after the change to fortify that the change was necessitated by valid reasons and was followed consistently thereafter by the entity.

Time for change

The present recession provides definite scope for taxpayers to review the method of accounting followed by them. Paying tax on the income actually realised seems to be a prudent and could be an efficient tax strategy. However, for corporates, there is no reprieve in view of Section 209(3)(b).

The cash basis of accounting could be adopted by non-corporate entities who have commenced business recently, and for whom the aspect of change in the method of accounting would not be an issue if the cash method is followed right from inception. Incidentally, by following the cash system, taxpayers need not follow the accounting standards notified under Section 145 of the I-T Act.

(The author is an Erode-based chartered accountant.)

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