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Method of Accounting for IT Payers

Last updated : January 28th, 2020 09:59 am

Method of Accounting for IT Payers

A method of accounting is a convention which should be adopted by a business which is maintaining accounting books. The method of accounting which should be followed by businesses is specified in the Income Tax Act. Income Tax assessees are allowed to follow either the cash or accrual system of accounting. When an assessee has opted to follow either of the systems, it should be followed consistently. A cash system of accounting functions by tracking the movements in the company’s cash flows. On the other hand, an accrual system functions by tracking the changes in a company’s equity. The cash system is generally followed by small businesses which are owned and managed by sole proprietors, whereas all companies follow the accrual system. The cash system allows easy maintenance of accounting records. However, a detailed position of the financial affairs of a business can be made available only by using the accrual system.

There may be a change in the method of accounting. In case the change is not accompanied by any proper reason, it can result in the best judgment assessment. The best judgment is an order passed by the Government. The order contains an estimate of the assessee’s taxable income as per the calculation made by the Government. The best judgment assessment is performed in case the information submitted by the assessee is incorrect or incomplete.

Accrual and Cash Systems

• According to the accrual system, income and expenses of a company should be updated in the accounting books based on the assignment of legal rights. According to the cash system, accounting entries should be updated as per the cash flows of the company.
• The method of accounting opted for the assessee determines the accuracy of the income reported in the financial statements. Reporting of income can be carried out after making suitable income recognition entries in the accounting books. The entries are made to authenticate the fact that the company has earned revenue or income. The nature of entries made depends on whether the method of accounting followed is cash basis or accrual basis.
• In case the accrual method is followed by the company, the company should make a distinction between receipt of income and anticipation of income. The right to receive income may be established before the time of receiving the income. The right may also be ascertained at the time of receiving the income or after the time of receipt. When a company is receiving income, there are three applicable scenarios:
  • The right to receive income and actual receipt may take place at the same time. The establishment of the right and receipt of monetary resources can be simultaneous. In simultaneous cases, the company should immediately recognise the receipt of income.
  • The right to receive income may be established before the receipt takes place. In such cases, the receipt does not manifest when the company acquires the right. When the right is acquired, the company recognises it in the accounting books as income. The management of the company may have doubts concerning the ultimate realizability of the income. Ultimate realisability is a concern indicated by the management regarding the company’s income. The concern addresses the issue of whether the income may be received. When there is a doubt concerning the ultimate realisability, recognition should be made in the accounting books. However, in such instances, a provision can be made against the account of the customer.
  • The right to receive income may be established after the receipt takes place. In such cases, at the time obtaining the receipt it is recognised as income received in advance.
• Adherence to the three principles is necessary to comply with the accrual concept. The accrual concept mentions the time for recognising income in the accounting books. As per the accrual concept, income should be recognised when the company obtains a legal privilege for the receipt.
• As per the accrual concept, the receipt of monetary resources varies from the right to receive the resources. The accounting books should be separately updated for both types of transaction. Also, the payment of monetary resources should be distinguished from the obligation to make a payment. The accounting books should be suitably updated for both the events.

Advantages of the Accrual System

• The accrual concept implies that businesses should record all incomes in the accounting books. Incomes which are received, incomes which are yet to be received and incomes which are received in advance should be recorded. The practice of recording all incomes ensures that the company is reporting correct profits.
• The accrual concept aims to evaluate every financial transaction. The evaluation is performed with respect to the impact on the company’s capital. Hence, the accrual concept measures changes in net income separately from changes in cash flows.
• The accrual concept implies that expenditures should be entered in the accounting books at the time of incurrence. Incurrence means the legal obligation to pay the expense. Hence, the accounting books can be updated for the expense even though payment is not yet made for the expense.
• The accrual concept is used to identify the amount of revenue to be recognised easily. The concept also determines the amount of expense to be matched to the revenue. The purpose of the matching is to enable the company to perform precise income measurement. As a result of the exact measurement, the company can provide a precise position of financial affairs to the investors.

Conditions to be Followed in Accrual and Cash Systems

• The accrual concept mandates the conditions for advance payment of expense and receipt of income:
  • If an advance is extended, accounting books should not be updated to show the expense. The advance should be entered in the accounting books as an asset.
  • If an advance is received, accounting books should be updated to show an income. The advance should be entered in the accounting books as a liability.
• Receipt of income and receipt of cash should be treated differently as per the accrual concept. Similarly, the incurrence of expenditure and outflows of cash should be treated differently. Inflows and outflows of cash should be treated according to the related incomes and expenditures.
• According to the accrual concept, revenue is recognised when a sale is made. The sale is made when the property in goods passes to the buyer. Hence, he becomes legally liable to pay for the goods. Income recognition can be performed when goods are delivered, or services are rendered.

Compliance Requirements for Accrual and Cash Systems

• Income from business and other sources should be calculated by using the accrual concept. However, if the assessee is regularly following the cash system of accounting, the use of the cash system will be permitted.
• All assesses should follow the income computation and disclosure standards mentioned by the government of India. The applicable standards should be as per the Companies (Indian Accounting Standards) Rules, 2015.
• In the following circumstances, the Assessing Officer has the power to decide that the assessee should be subject to the best judgment assessment:
  • When the assessee is not following any particular system consistently
  • If the assessee is maintaining incorrect or incomplete books of accounts
  • In case the assessee has not followed the Companies (Indian Accounting Standards) Rules, 2015 at the time of calculating the taxable income.
• The company may purchase services to ensure that the manufacturing equipment used in the business function according to quality specifications mandated by the Government. The supply of services attracts GST. The GST paid by the company on the services should be added to the cost of the equipment.
• The company should value the inventory at the lower of purchase cost or net realisable value. The inventory of the company may include securities which are not listed with a stock exchange. The securities should be reflected in the accounting books at the value, which matches the cost of purchase. The subsequent fluctuations in the market value of the securities should not be updated in the accounting books.

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