Note on Cash Basis of Accounting followed by non-corporate entities in India
1. Non-corporate entities in India may include an individual, a proprietary concern, a Hindu Undivided Family (HUF), a partnership firm, a LLP, a trust, etc.
2. Unlike a corporate, the respective laws applicable to such entities in India do not specify the method of accounting to be compulsorily followed by them. As a result, a reference can be made to Section 145 of the Income Tax Act, 1961 (“the Act”) which states:
“ Method of accounting
145. (1) Income chargeable under the head "Profits and gains of business or profession" or "Income from other sources" shall, subject to the provisions of sub-section (2), be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee.”
3. As a result non-corporate entities are free to adopt either the cash basis of accounting or the accrual basis of accounting with the condition that the method of accounting should be regularly followed. A blend of both the methods of accounting was earlier allowed to be followed till the amendment of Section 145 of the Act from assessment year 1997-98.
4. The Guidance Note on Terms Used in Financial Statements defines the different methods of accounting as follows:
“ ….
1.06 Accrual Basis of Accounting
The method of recording transactions by which revenues, costs, assets and liabilities are reflected in the accounts in the period in which they accrue. The ‘accrual basis of accounting’ includes considerations relating to deferrals, allocations, depreciation and amortisation. This basis is also referred to as mercantile basis of accounting.
3.12 Cash Basis of Accounting
The method of recording transactions by which revenues and costs and assets and liabilities are reflected in the accounts in the period in which actual receipts or actual payments are made.
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5. As compared to the accrual basis of accounting, the cash basis of accounting has some fundamental weaknesses including:
a. The incomes and expenses are recognized as and when funds are actually received or paid. This does not reflect a true picture of the performance of the business for a year since the incomes and expenses included may pertain to different years.
b. Receivables for which the business has a right to receive money and payables for which the business is bound to pay, do not get reflected in the financial statements.
c. Fixed assets are reflected at the value of money actually spent. A reduction in their value (depreciation), being a non-cash expense, is not provided for.
6. Though the cash basis of accounting has the above fundamental weaknesses and the financial statements of the business may not represent a correct picture of its financial performance and financial position, the Act allows adoption of such method of accounting.
7. The Guidance Note on Terms Used in Financial Statements defines depreciation and depreciable assets as follows:
“ ….
4.12 Depreciable Asset
Asset which is expected to be used during more than one accounting period, has a limited useful life, and is held by an enterprise for use in the production or supply of goods, and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.
4.13 Depreciation
A measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. It is allocated so as to charge a fair proportion in each accounting period during the useful life of the asset. It includes amortisation of assets whose useful life is predetermined and depletion of wasting assets.
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8. Going by the strict principles of cash basis of accounting, any revenue, cost, liability or asset which does not involve movement of funds are not required to be recorded in the books of account. Hence, depreciation need not be recognized in the books of accounts maintained on cash basis. Further, for the purpose of determining income from business / profession under the Act, separate deduction is available with respect to depreciation under section 32. Hence, even though depreciation is not provided in the books of accounts, a deduction would be available under the Act.
9. To summarise the above discussion, under the cash basis of accounting, we need not provide depreciation in the books of accounts since it is a non-cash expense and the same can be claimed separately while computing taxable income.
10. The Act requires an auditor to audit the books of accounts of an assessee and to express his opinion on the fairness of the financial statements for various purposes including Section 10(23C), Section 12A(b), Section 44AB, etc. The auditor is required to state whether the financial statements represent a “true and fair view” of the state of affairs and the performance of the business for the period under report.
11. The term “true and fair” has not been defined, but AS-I on disclosure of accounting policies notified under Section 145 (2) of the Act states:
“ ….
(4) Accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business, profession or vocation in the financial statements prepared and presented by on the basis of such accounting policies. For this purpose, the major considerations governing the selection or application of accounting policies are following:
(i) Prudence: Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information.
(ii) Substance over form: The accounting treatment and presentation in financial statements of transactions and events should be governed by their substances and not merely by the legal form.
(iii) Materiality: Financial statements should disclose all the material items, the knowledge of which might influence the decision of the user of the financial statements.
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12. The ITAT Pune in Western Maharashtra Development corporation.Ltd v/s CIT 2008 22 SOT 13 Pune held as under:
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9. A plain reading of the above extracts from the notified Accounting Standard would show that irrespective of whatever be the method of accounting employed by the assessee, it is sine qua non that the financial statements prepared on the basis of such method of accounting must represent a true and fair view of the state of affairs of the business. To that extent, the method of accounting employed by the assessee has to give way to the accounting policies aimed at true and fair view of the affairs of the business. One of the major considerations for having such accounting policies is 'prudence'. What follows is that the considerations of prudence have to be blended with the strict principles of mercantile or cash method of accounting, even when an assessee is following mercantile or cash method of accounting, and an improvised method of mercantile or cash method of accounting, which may result from such a blending of considerations of prudence with the strict principles of mercantile or cash method of accounting, meets the requirements of Section 145 of the Act.
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Conclusion:
To conclude, taking into consideration the concept of prudence as brought out in AS-I on disclosure of accounting policies notified under Section 145 (2) of the Act and the view of the ITAT, Pune, depreciation on depreciable fixed assets needs to be provided every year so that the financial statements represent a true and fair view of the financial position and performance of the business for the year irrespective of the method of accounting followed and also to comply with the reporting requirements under the Act.
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