The Hindu Business Line : The now-buried crossbreed

A UNIQUE contribution of India's mercantile community to the world of the accountants is the hybrid system of accounting. It is common knowledge that there are only two recognised systems of accounting — the mercantile system, where income and expenditure are taken on accrual basis, and the cash system, which accounts for income and expenditure on the actual incurring of the same in cash.

Is it possible to have a cash system for recognising income and an accrual system for expenditure accounting? As regards the rest of the world, the answer is `No'. In India, however, the hybrid system has been in vogue for several decades and courts, despite amendments to the law, have upheld this system in tax cases.

The Calcutta HC cases

In two recent rulings, the Calcutta High Court defended the hybrid system even when tax law amendments were brought to its notice. In the Juggilal case (278 ITR page 52 Calcutta), the company concerned, Juggilal Kamlapat Udyog Ltd, maintained its accounts based on the mercantile system in respect of expenditure and on the cash system for receipts.

The company explained that as the party from whom it earned export-handling commission had turned sick and been referred to the Board for Industrial and Financial Reconstruction, income accrual had become doubtful.

The assessing officer (AO) did not accept the explanation and, in addition to what was declared on cash basis, treated the accrued export-handling commission of Rs 1,94,216 (on mercantile basis) due from that company as Juggilal's income. The first two appellate authorities agreed with the AO and the matter reached the Calcutta High Court.

The court ruled that the hybrid system followed by the assessee was permissible in law and the only requirement was that the income should be deducible from such accounting system, and, only if this is not possible that the Revenue authorities can interfere.

But as there was nothing to show that the income could not be deduced from the accounts maintained by the assessee, the AO's inference was considered not permissible. Thus, the findings of all the authorities were quashed as regards the deduction claimed for export-handling commission.

In the other Calcutta High Court case (K. S. Mehta), this ruling was once again reiterated. The court was of the view that if the hybrid system was systematically followed, it cannot be rejected. The AO can intervene only if he can show that income cannot be properly deduced from the accounts. In this case, for outgoings, the mercantile system was adopted and for accounting of income, the cash receipt system. The Income-Tax Department had accepted the system for a number of years but chose to reject it from 1986-87 onwards. Here, again, the Calcutta High Court held that income was deducible even under the hybrid system of accounts maintained by the assessee. It was pointed out before the court that the hybrid system resulted in shifting of the income to a subsequent year and thus presented a distorted picture of the balance-sheet.

The Madras High Court ruling in the G. Padnamabha Chettiyar (182 ITR 1) case was cited on behalf of the Revenue. But the Calcutta High Court was not convinced and held that the hybrid system was recognised in law and should not be rejected as long as the AO did not show that income could not be properly deduced.

The soundness of the Calcutta rulings is open to doubt. Section 145 of the I-T Act was amended with effect from April 1, 1988, and again with effect from April 1, 1989. The company law provision requires that every company should keep its books of accounts on accrual basis and according to the double entry system of accounting — Section 209 (3).

This amendment took effect from June 15, 1986. Even before this amendment, the Department of Company Affairs (DCA) had issued a clarification to the effect that the maintenance of accounts of a company on cash or receipt basis would not amount to keeping proper books of accounts in terms of Section 209 (Letter No. 8/68 (209) 64-PR, February 21, 1965).

The Finance Act 1995 replaced Section 145 of the I-T Act with effect from assessment year 1997-98. The amendment does away with the hybrid system of accounting. The Central Government is empowered to notify the Accounting Standards from time to time, which are to be followed by any class of assessees or in respect of any class of income.

The Government has notified Accounting Standard I, on disclosure of accounting policy, and AS-II, on disclosure of prior period and extraordinary items and changes in accounting policies. The hybrid system will no longer be permitted and the two Calcutta High Court cases should be limited to their own facts.

(The author is a former Chief Commissioner of Income-Tax.)

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