THE MERCANTILE METHOD OF ACCOUNTING & THE ACCRUAL SYSTEM UNDER THE INCOME-TAX ACT, 1961

THE MERCANTILE METHOD OF ACCOUNTING & THE ACCRUAL SYSTEM UNDER THE INCOME-TAX ACT, 1961

1. Introduction

The method of accounting adopted by an assessee forms the very foundation upon which taxable income is computed under the Income-tax Act, 1961 (“the Act”). Section 145 permits an assessee to follow either the cash system or the mercantile system (also referred to as the accrual method), provided it is regularly employed.

The mercantile system, which dominates commercial practice, recognises income and expenditure when rights and obligations accrue, irrespective of actual receipt or payment. Over time, courts have harmonised this principle with two critical doctrines:

                1.            The “real income” theory; and

                2.            The “crystallisation of liability” doctrine.

With the introduction of ICDS (Income Computation and Disclosure Standards) under Section 145(2), the statutory framework has further evolved, altering certain nuances of accrual jurisprudence.

This article examines the statutory position, judicial evolution, and practical consequences of the mercantile system — with a case law

Mercantile vs. Cash Method

Under the mercantile (accrual) method, income is recorded when the right to receive arises and expenses are booked when the liability crystallises, irrespective of whether cash is received or paid. This often leads to earlier taxation of income and earlier recognition of expenses.

In contrast, under the cash method, income is taxed only on actual receipt and expenses are allowed only on actual payment. Cash method reduces timing disputes but does not reflect the real financial position of a business.

The mercantile system is generally used by companies and larger enterprises because it aligns with commercial accounting and statutory reporting, while the cash system is typically used by small businesses or individuals due to its simplicity

2. Statutory Architecture: Section 145 and ICDS

2.1 Section 145(1)

Income under “Profits and Gains of Business or Profession” and “Income from Other Sources” shall be computed:

in accordance with either:

                •              cash system; or

                •              mercantile system**,

                •              regularly employed.

Hybrid methods are impermissible (CBDT Circular No. 1/2016).

2.2 Section 145(3) – Rejection of Books

Books may be rejected where:

method not regularly followed;

income cannot be properly deduced;

ICDS not followed.

2.3 ICDS — A Statutory Override to Certain Judicial Principles

ICDS restricts prudence principles (e.g., ICDS I).

It mandates income recognition even where uncertainty exists beyond what courts formerly permitted.

It materially affects construction contracts, government grants, borrowing costs, forex items, etc.

3. Mercantile System: Concept & Essential Principles

Under the mercantile method:

3.1 Income is recognised when:

a right to receive arises;

it becomes legally enforceable;

it is real and not hypothetical.

3.2 Expenditure is recognised when:

liability crystallises;

it is ascertained or ascertainable with reasonable certainty.

This aligns with the traditional accounting principles of matching and periodicity.

4. Judicial Evolution of the Accrual Principle

Indian courts have steadily refined what constitutes “accrual”. Below are the most authoritative precedents, each verified for accuracy.

4.1 Income must be “real”, not hypothetical

(a) Shoorji Vallabhdas & Co. v. CIT (1962) 46 ITR 144 (SC)Held: income cannot be said to accrue if the right to receive is modified or does not materialise. Mere book entries do not create taxable income.

(b) Godhra Electricity Co. Ltd. v. CIT (1997) 225 ITR 746 (SC)Revenue sought to tax enhanced charges though the matter was under dispute.

Held: no real accrual until dispute is settled; hypothetical income cannot be taxed.

(c) CIT v. Excel Industries Ltd. (2013) 358 ITR 295 (SC)Income accrues only when it becomes due and enforceable, not upon mere claim. The Court emphasised that taxation must follow real income and matching concept.

4.2 Uncertainty in collection prevents accrual

(a) UCO Bank v. CIT (1999) 237 ITR 889 (SC)Interest on NPAs does not accrue due to uncertainty of recovery.

This principle has been upheld even post-ICDS, unless specifically overridden.

4.3 Expenditure recognition — liability must crystallize

(a) Bharat Earth Movers v. CIT (2000) 245 ITR 428 (SC)Held: if liability has arisen in the accounting year and is reasonably estimable, deduction cannot be denied even if payment is deferred.

(b) Rotork Controls India (P) Ltd. v. CIT (2009) 314 ITR 62 (SC)Provisions (e.g., warranty liability) are allowable where:

                1.            obligation exists;

                2.            based on past experience;

                3.            reliably estimated.

Clear distinction made between ascertained liability (allowable) and contingent liability (not allowable)

Accrual After ICDS – Modified Jurisprudence

ICDS has statutorily altered several judicial doctrines:

ICDS I – Accounting Policies

Prudence cannot delay recognition of income.

ICDS III / IV – Revenue Recognition

Revenue must be recognised using specific milestones even if uncertainty exists.

ICDS on Construction Contracts

Percentage of completion method mandated, overruling earlier favourable rulings (e.g., Bilahari Investments).

CBDT Circular No. 10/2017 clarifies ICDS is binding for income computation though books may follow existing AS.

5 Contentious Areas & Litigation Trends

(a) Accrual of disputed receivables

Post-ICDS, assessing officers often attempt to tax disputed income earlier; taxpayers rely on Godhra Electricity and Excel Industries.

(b) Retention money in contracts

Courts hold retention does not accrue until contractual obligations are fulfilled:

CIT v. Simplex Concrete Piles (India) Ltd. (1988) 179 ITR 8 (Cal).

This principle continues unless ICDS applies.

(c) Accrual of interest on sticky loans

Judicial view continues in favour of assessee (UCO Bank), subject to ICDS and RBI norms.

(d) Accrual vs GST timing mismatch

Businesses face significant reconciliation challenges.