Business income must be computed in accordance with the method of accounting regularly employed by the assessee — either the cash system, under which income and expenditure are recognised on actual receipt or payment, or the mercantile (accrual) system, under which they are recognised when the right to receive or the obligation to pay arises, regardless of actual cash movement. The chosen method must be applied consistently from year to year; a taxpayer cannot switch methods opportunistically to manage taxable income in a particular year.

Even where accounts are correctly maintained on a consistently followed basis, the Assessing Officer retains the power to reject the accounts and compute income on a fair and reasonable basis if the method employed does not, in the officer's view, permit the true profits of the business to be properly deduced — a power that has generated substantial litigation over what genuinely constitutes a distortion of true income as opposed to a legitimate accounting choice.

Layered on top of the basic cash/mercantile choice, notified Income Computation and Disclosure Standards (ICDS) govern how specific categories of income and expenditure — such as construction contracts, revenue recognition, valuation of inventories, and foreign exchange fluctuations — must be computed for tax purposes, which can diverge from the treatment followed under applicable financial accounting standards for book-keeping purposes. Taxable income is therefore, in practice, often a distinct computation layered on top of book profits rather than a simple extraction from the financial statements.

Relevant Case Laws

CIT v. A. Krishnaswami Mudaliar (1964) 53 ITR 122 (SC) — held that even where an assessee has consistently followed a particular method of accounting, the Assessing Officer is not bound to accept the resulting income figure if the method does not, on the facts, enable the true profits of the business to be properly ascertained — the touchstone remains whether real income is being deduced, not merely whether a method has been followed consistently.

CIT v. Woodward Governor India (P) Ltd. (2009) 312 ITR 254 (SC) — held that unrealised (mark-to-market) losses on foreign exchange revaluation of trading liabilities on the last day of the accounting year, computed in accordance with the mercantile system and applicable accounting standards, are allowable as a deduction, reaffirming that accrual-basis recognition of a genuine business loss is not rendered notional merely because no cash has actually changed hands.

Frequently Asked Questions

Q. Can a business switch between the cash and mercantile systems from year to year?

A. Not freely — the method must be regularly and consistently employed; a bona fide, properly disclosed change of method is permissible in limited circumstances, but opportunistic switching purely to manage a particular year's tax liability invites challenge.

Q. Does following ICDS change the profit shown in the audited financial statements?

A. No — ICDS applies only for computing taxable income and does not require any change to the books of account or financial statements prepared under applicable accounting standards; adjustments are made only in the tax computation.

Q. Can the Assessing Officer reject audited accounts outright?

A. The officer cannot reject accounts arbitrarily, but under the Krishnaswami Mudaliar principle can decline to accept the resulting income figure where the method employed does not permit true profits to be properly deduced, provided this conclusion is reasoned and evidence-based.

Q. Are unrealised foreign exchange gains taxable in the same way losses are deductible?

A. Generally yes, following the same accrual logic recognised in Woodward Governor — genuine, accounting-standard-compliant mark-to-market gains on revenue account are typically brought to tax on an accrual basis, symmetrically with how losses are allowed.

Precautions to Be Taken

1.      Document the method of accounting adopted clearly in the notes to accounts and apply it with genuine consistency year on year; any change should be disclosed, justified, and ideally supported by a change in circumstances rather than tax planning alone.

2.      Reconcile book profits with taxable income through a clear, working-paper-level ICDS adjustment statement each year, since these two figures are rarely identical and the gap needs to be explainable on demand.

3.      For long-term contracts, construction projects, and inventory valuation, apply the specific ICDS rules rather than defaulting to the financial accounting treatment, since divergence here is one of the more heavily scrutinised areas in assessment.

4.      Where foreign exchange fluctuation affects trading liabilities or receivables, ensure both gains and losses are treated symmetrically and on a consistent accrual basis, since asymmetric treatment (claiming losses but deferring gains) invites disallowance.

5.      Retain the workings behind any provision or estimate embedded in the accounts (warranty provisions, revenue recognised on percentage-of-completion, etc.), since these are the figures most likely to be tested against the 'true profits' standard in scrutiny.

6.      Where the nature of the business changes materially (for instance, moving from project-based to subscription-based revenue), reassess whether the existing accounting method and applicable ICDS treatment still appropriately reflect income.

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