Two businesses with identical sales can show very different profits in the same month, purely because of how they record transactions. Cash accounting tracks money as it moves; accrual accounting tracks obligations as they arise. The choice shapes your profit picture, your tax timing, and how lenders read your accounts.
This guide explains both methods in the Indian context, what Section 145 of the Income Tax Act allows, and how to decide. It builds on our main guide to bookkeeping for small businesses.
Quick answers
What is cash accounting?
You record income and expenses only when money is actually received or paid.
What is accrual accounting?
You record income and expenses when they are earned or incurred, regardless of payment.
Which does Indian law allow?
Section 145 permits cash or mercantile (accrual) for business and professional income, applied consistently.
Do companies have a choice?
No. Companies must keep accounts on the accrual basis under the Companies Act, 2013.
Which is more accurate?
Accrual, because it matches income with the expenses that earned it.
Can I switch methods?
You can, but the method must be followed consistently and a switch should be justified.
What are cash and accrual accounting?
Cash basis accounting records income when cash is received and expenses when cash is paid. Accrual basis accounting, also called the mercantile system, records income when it is earned and expenses when they are incurred, regardless of when money changes hands.
Under Section 145 of the Income Tax Act, 1961, income from business or profession may be computed under either the cash or the mercantile system, provided the chosen method is followed regularly.
Key terms explained
- Cash basis: record only when money is received or paid.
- Accrual (mercantile) basis: record when income is earned or expense incurred.
- Section 145: the Income Tax Act provision allowing either method for business income.
- Matching principle: the accrual idea that expenses are recorded in the same period as the revenue they generate.
- Accounts receivable and payable: amounts owed to and by the business that only accrual accounting tracks.
How each method works in practice
Suppose you raise an invoice of Rs 1,00,000 in March but the client pays in April. Under cash accounting, the income appears in April when the money arrives. Under accrual accounting, the income appears in March when you earned it by completing the work.
The same logic applies to expenses. A March electricity bill paid in April is a March expense under accrual and an April expense under cash, which is why accrual gives a truer month-by-month picture of profitability.
Who should use which method?
Cash accounting suits very small, cash-light businesses and some professionals, because it is simple and ties directly to bank movements. Accrual accounting suits businesses with credit sales, inventory, or significant receivables and payables, because it reflects the real state of the business.
Companies do not get to choose. Under Section 128 of the Companies Act, 2013, a company must maintain its books on the accrual basis, so the cash method is effectively limited to non-company businesses and professionals.
How to choose, step by step
- Check your entity type. If you run a company, accrual is mandatory and the decision is made for you.
- Look at how you sell. Heavy credit sales and receivables point to accrual.
- Consider inventory. Businesses holding stock need accrual to match cost with sales.
- Weigh simplicity against accuracy. Cash is simpler; accrual is more accurate.
- Apply it consistently. Whatever you pick, follow it regularly, as Section 145 requires.
- Document any change. If you switch later, record the reason and apply it from a clean cut-off.
Cash vs accrual at a glance
| Feature | Cash basis | Accrual basis |
|---|---|---|
| Income recorded | When received | When earned |
| Expense recorded | When paid | When incurred |
| Tracks receivables/payables | No | Yes |
| Complexity | Lower | Higher |
| Allowed for companies | No | Yes (mandatory) |
Common mistakes with accounting methods
- Switching methods mid-year without reason. Profits distort and the tax position becomes hard to defend. Apply one method consistently across the year.
- Using cash accounting with heavy credit sales. Profit looks healthy while receivables pile up unpaid. Move to accrual once credit sales matter.
- Mixing methods across income heads. Inconsistent records invite scrutiny. Keep the method uniform for the same source of income.
Tax and compliance consequences
Under Section 145(3), if the Assessing Officer is not satisfied with the correctness or completeness of the accounts, the assessment can be made on a best-judgment basis, which is rarely in the taxpayer's favour.
Failure to maintain proper books as required under Section 44AA can attract a penalty of up to Rs 25,000 under Section 271A, regardless of which method you adopt.
How these rules interact
Section 145 permits the choice of method for business income, while Section 128 of the Companies Act, 2013 overrides that choice for companies by mandating the accrual basis.
The consistency requirement in Section 145 works alongside the book-keeping duty in Section 44AA, so the method you choose must be both consistent and properly recorded.
Which one reflects profit better?
| Scenario | Cash basis | Accrual basis |
|---|---|---|
| Large unpaid invoices | Understates profit | Reflects earned profit |
| Prepaid annual expense | Overstates expense now | Spreads it correctly |
| Investor or lender view | Less reliable | Preferred |
Key takeaways
- Cash accounting records money movements; accrual records earned income and incurred expense.
- Section 145 allows either method for business income if applied consistently.
- Companies must use the accrual basis under the Companies Act, 2013.
- Accrual gives a truer profit picture and is preferred by lenders and investors.
- Whatever you choose, apply it consistently and keep proper books.
Frequently asked questions
Can a small business use cash accounting in India?
Yes. Non-company businesses and professionals can use the cash basis under Section 145, as long as they apply it consistently.
Why do companies have to use accrual accounting?
The Companies Act, 2013 requires companies to maintain books on the accrual basis, so the cash method is not available to them.
Which method gives a more accurate profit?
Accrual, because it matches income with the expenses incurred to earn it within the same period.
Can I switch from cash to accrual?
Yes, but the change should be justified, applied from a clean cut-off, and followed consistently afterward.
Does the method affect my tax timing?
Yes. The method changes the year in which income and expenses are recognised, which can shift when tax is payable.
Is cash accounting allowed for professionals?
Yes. Professionals can generally use the cash basis under Section 145 if they apply it regularly.
What is the mercantile system?
Mercantile is another name for the accrual system, where income and expenses are recorded when earned or incurred.
Not sure which method suits your books?
The right method depends on how you sell, what you hold in stock, and your entity type, and changing it later is harder than getting it right early. You can read how the Regikart team sets up books on our accounting and bookkeeping page, or contact us / WhatsApp +91 70444 94804 (Mon-Sat, 9 am-7 pm IST).
About the author
Regikart CA Team
Chartered Accountants at Regikart. Want to discuss this in the context of your business?
