There are two methods of accounting allowed under the Income Tax Act- cash accounting and accrual accounting.
What is cash accounting method?
In this method, income and expenses are recorded in accounts when they are actually debited and credited, respectively. For example, if rent is due on property on the 15th, but is actually received on the 18th, the transaction is recorded in the books on the 18th.
What is accrual based method?
In this method, receipts and payments are recorded when they are accrued and not when they are actually realised. For example, if payment of electricity bill is due on the 10th, but is actually paid on the 15th, the record in books of accounts is made on the 10th itself.
When is a taxpayer liable to pay income tax in each case?
In case of cash-based accounting, tax is payable when the income is actually received and recorded. In case of accrual basis, income tax becomes payable when the receipt is due, whether it is actually received or not.
What kinds of income can cash accounting method be used for?
You can use this method only for Income from Other Sources and Profits & Gains from Business & Profession.
What kinds of income can accrual based method of accounting be used for?
This method can be used for all types of income, and mandatorily for income from house property, salary, and capital gains
What is the tax implication when income is accrued in the current financial year but received in the next one?
When income is due in March, it is recorded in the current year’s accounts for income tax purposes whether it is received in March or April or later, under accrual based method. Under the cash accounting method, the same income will be recorded for tax purposes in the next year’s accounts when it is actually credited.
What about a payment due in March which is paid in April?
This, too, will have a separate treatment under cash accounting and accrual accounting. Under the cash method, the payment will be recorded in the next financial year, i.e. April. While under the accrual method, this payment will be reflected in accounts in this year March itself.
Will cash accounting method reduce tax liability?
Not really. Cash accounting might only postpone tax payment and not actually reduce it.
Is the accrual based method ideal, then?
Not necessarily. If receipts are expected to be irregular and uncertain, the accrual method will put more significant strain on financial planning. What way is suitable depends on the type of profession/business.
Whichever method is used for accounting, needs to be well-thought of, as it cannot be changed again and again, and the change also requires an elaborate process.