Section 145 : Method of Accounting
What is Section 145?
Section 145 of the Income Tax Act, 1961 provides the method of accounting by the individual taxpayer. To maintain a similar process of recording income, expenses, assets and liabilities of every business, certain standards are designed which are known as the methods of accounting.
The methods of accounting are divided into two types:
Time of recording a transaction in books of accounts is when there is inflow or outflow of cash. In simple words, cash coming in is called as cash inflow and cash going out is called as cash outflow.
A transaction is recorded when there is an income, or an expense accrues. In this method, the transactions are recorded despite whether the cash is received or paid.
Income chargeable under the head" Profits and gains of business or profession" or" Income from other sources" shall be computed in accordance with the method of accounting regularly employed by the assessee: Provided that in any case where the accounts are correct and complete to the satisfaction of the Assessing Officer but the method employed is such that, in the opinion of the Assessing Officer, the income cannot properly be deduced therefrom, then the computation shall be made upon such basis and in such manner as the Assessing Officer may determine: Provided further that where no method of accounting is regularly employed by the assessee, any income by way of interest on securities shall be chargeable to tax as the income of the previous year in which such interest is due to the assessee: Provided also that nothing contained in this sub- section shall preclude an assessee from being charged to income- tax in respect of any interest on securities received by him in a previous year if such interest had not been charged to income- tax for any earlier previous year.
Section 145(1) provides that income chargeable under the head “Profits and gains of business or profession” or “Income from other sources” shall be computed by either cash or mercantile system of accounting regularly employed by the individual who is paying taxes. There are some assessees which follow the mixed method of accounting, i.e. both Cash method and Mercantile Method which does not compute the accurate income. Now the assessees cannot use the mixed method. They have to either use Cash method or Mercantile Method.
Provision 1: When the accounts are correct and complete but the method of accounting deployed does not compute accurate income then, the computation of income will be done by the assessing officer with the accounting method of his choice.
Provision 2: When an assessee has no regular method of accounting his income will be calculated as per the method of accounting deployed for the last financial year.
Provision 3: If any interest on security that an individual receives has not been charged in the earlier years, that does not mean that he won’t be charged for that in this year.
The Central Government may notify in the Official Gazette from time to time accounting standards to be followed by any class of assessees or in respect of any class of income.
Where the Assessing Officer is not satisfied about the correctness or completeness of the accounts of the assessee, or where the method of accounting provided in sub- section (1) or accounting standards as notified under sub- section (2), have not been regularly followed by the assessee, the Assessing Officer may make an assessment in the manner provided in section 144.
The assessing officer can reject the books of accounts concerning the following discrepancies
Improper Accounting Method
No production of accounts for verification
Failure to produce records
Non-maintenance of stock register
After rejecting the books of accounts due dissatisfaction with the correctness of the accounts produced by the assessee, the Assessing Officer must pass the best judgement which is complying all the considerations of Section 145 of the Income Tax Act 1961.
Key Points relating to the Rejection of Books of Account
1. Opportunity to the assessee The Assessing Officer has to give an opportunity to the assessee to contradict the materials upon which the Assessing Officer wants to reject the books of account.
2. Estimation of profit Once the books of account of the assessee are rejected, profit has to be estimated by proper material available and nevertheless he is not entitled to make a pure guess and make an assessment concerning any evidence or any material at all.
3. Estimate of turnover The estimate of turnover and fixation of gross profit rate are two import parameters which affect the assessment. If these are fixed or calculated in such a way that they adversely affect the assessee’s case, then he is entitled to know the basis and to be given an opportunity to rebut the same.
4. Peak credit No reliance can be placed on rejected account books for working out Peak Credit. An assessee’s business income is estimated after rejecting the books of account produced by the assessee; it is not reasonable on the part of the Income Tax Officer to work out the Peak credit on the basis of such books of accounts.
5. Reference to Valuation Officer The Assessing Officer may, for the purposes of assessment or reassessment, make a reference to a Valuation Officer to estimate the value, including fair market value, of any asset, property or investment and submit a copy of the report to him only after rejecting the books of accounts.
6. Comparing gross profit of earlier years If there is a heavy loss suddenly in the business of the assessee, it is his duty to explain the fall, if so happens and to substantiate the reasons. Even if, thereafter, the Assessing Officer considers the material placed before him by the assessee to be unreliable keeping in view the comparative statement of accounts of the earlier years, he cannot proceed to changes in the accounts purely due to guessing work. He can do only if he relates to some evidence or material on the records.?If the profit shown by the assessee in his return is not accepted, it is for the taxing authorities to prove that the assessee made more profits. The rejection of books of accounts under Section 145(3) cannot be sustained merely on the fact that the gross profit of the assessee is low during the relevant period as compared to the book results of other years. Similarly, the system of accounting adopted by the assessee cannot be rejected merely on the ground that the gross profits disclosed by his books were low as compared with those of others in the same line of business.
7. Estimation of income/profit Once the books are properly rejected, the income has to be estimated, and in making the estimate of such income, the best record along with other things will become the relevant material.
8. Power to be exercised judicially The power to reject the books of accounts by the Assessing Officer is to be exercised judicially. The Assessing Officer is to bring on record material on the basis of which he has arrived at the conclusion with regard to correctness or completeness of the accounts of the assessee or the method of accounting employed by it.
9. Power of First Appellate Authority It is well-settled position of law that the Commissioner of Income Tax (Appeals) during the appellate proceedings exercises all the powers vested with Assessing Officer to be exercised while framing the assessment order. Therefore, the Commissioner (Appeals) can reject the books of accounts of the assessee by invoking the provisions of Section 145(3) of the Act for the first time while framing the appellate order provided with all other conditions exist warranting reject of such books of accounts.
10. No presumption The Assessing Officer should not presume any material as valid for rejecting the books of account. He must scrutinise it in every aspect and then reject it.
11. Explanation of the assessee If the explanation given by the assessee is not satisfactory according to the Assessing Officer, then he can reject the books of account.
What is Section 145A?
Notwithstanding anything to the contrary contained in section 145, the valuation of purchase and sale of goods and inventory for the purposes of determining the income chargeable under the head “Profits and gains of business or profession” shall be
(a) in accordance with the method of accounting regularly employed by the assessee; and
(b) further adjusted to include the amount of any tax, duty, cess or fee (by whatever name called) actually paid or incurred by the assessee to bring the goods to the place of its location and condition as on the date of valuation.
Provisions of Section 145A
For the purpose of determining the income chargeable under the head “Profits and Gains of business or profession”:
i. the valuation of inventory shall be made at lower of actual cost or a net realisable value computed in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145.
ii. the valuation of purchase and sale of goods or services and of inventory shall be adjusted to include the amount of any tax, duty, cess or fee actually paid or incurred by the assessee to bring the goods or services to the place of its location and condition as on the date of valuation.
iii. the inventory being securities not listed on a recognised stock exchange, or listed but not quoted on a recognised stock exchange with regularity from time to time, shall be valued at actual cost initially recognised in accordance with the income computation and disclosure standards
iv. the inventory being securities other than those referred to in clause (iii), shall be valued at lower of actual cost or net realisable value in accordance with the income computation and disclosure standards notified under sub-section (2) of section 145.
Section 145B is broadly categorized into three sub-sections 145B(1), 145B(2) and 145B(3)
Provision of Section 145B(1)
Notwithstanding anything to the contrary contained in section 145, the interest received by an assessee on any compensation or on enhanced compensation, as the case may be, shall be deemed to be the income of the previous year in which it is received.
Provision of Section 145B(2)
Any claim for escalation of price in a contract or export incentives shall be deemed to be the income of the previous year in which reasonable certainty of its realisation is achieved.
Provision of Section 145B(3)
The income from subsidy, grant or reimbursement shall be deemed to be the income of the previous year in which it is received, if not charged to income-tax in any earlier previous year.
The assessee must follow any one of the accounting methods Cash Accounting or Mercantile Accounting for their income from profit and gains of business or profession and income from other sources. The Central Government can make changes in the provisions related to the accounting standards. All the assessees should follow those changes despite their income slab. The Assessing Officer, before rejecting the books of account, has to bring on record material on the basis of which he has arrived at the conclusion with regard to correctness or completeness of the accounts of the assessee or the method of accounting employed by it. The obligation on the part of the assessee is to bring the accounts/documents before the Assessing Officer whenever it is required. The Assessing Officer may resort to best assessment, the power of which shall be exercised judicially and not violate the principles of natural justice. The valuation of purchase and sale of goods and the deemed to be income of the previous year shall be followed as per the provisions made by the Income Tax Department.