Month: August 2021

Management Notes

Termination of Estate

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The income of an estate of a deceased person is that which is received by the estate during the period of administration or settlement. The period of administration or settlement is the period actually required by the administrator or executor to perform the ordinary duties of administration, such as the collection of assets and the payment of debts, taxes, legacies, and bequests, whether the period required is longer or shorter than the period specified under the applicable local law for the settlement of estates. For example, where an executor who is also named as trustee under a will fails to obtain his discharge as executor, the period of administration continues only until the duties of administration are complete and he actually assumes his duties as trustee, whether or not pursuant to a court order. However, the period of administration of an estate cannot be unduly prolonged. If the administration of an estate is unreasonably prolonged, the estate is considered terminated for Federal income tax purposes after the expiration of a reasonable period for the performance by the executor of all the duties of administration. Further, an estate will be considered as terminated when all the assets have been distributed except for a reasonable amount which is set aside in good faith for the payment of unascertained or contingent liabilities and expenses (not including a claim by a beneficiary in the capacity of beneficiary). Notwithstanding the above, if the estate has joined in making a valid election under section 645 to treat a qualified revocable trust, as defined under section 645(b)(1), as part of the estate, the estate shall not terminate under this paragraph prior to the termination of the section 645 election period. See section 645 and the regulations thereunder for rules regarding the termination of the section 645 election period.

Generally, the determination of whether a trust has terminated depends upon whether the property held in trust has been distributed to the persons entitled to succeed to the property upon termination of the trust rather than upon the technicality of whether or not the trustee has rendered his final accounting. A trust does not automatically terminate upon the happening of the event by which the duration of the trust is measured. A reasonable time is permitted after such event for the trustee to perform the duties necessary to complete the administration of the trust. Thus, if under the terms of the governing instrument, the trust is to terminate upon the death of the life beneficiary and the corpus is to be distributed to the remainderman, the trust continues after the death of the life beneficiary for a period reasonably necessary to a proper winding up of the affairs of the trust. However, the winding up of a trust cannot be unduly postponed and if the distribution of the trust corpus is unreasonably delayed, the trust is considered terminated for Federal income tax purposes after the expiration of a reasonable period for the trustee to complete the administration of the trust. Further, a trust will be considered as terminated when all the assets have been distributed except for a reasonable amount which is set aside in good faith for the payment of unascertained or contingent liabilities and expenses (not including a claim by a beneficiary in the capacity of beneficiary).

(c)

(1) Except as provided in subparagraph (2) of this paragraph, during the period between the occurrence of an event which causes a trust to terminate and the time when the trust is considered as terminated under this section, whether or not the income and the excess of capital gains over capital losses of the trust are to be considered as amounts required to be distributed currently to the ultimate distributee for the year in which they are received depends upon the principles stated in § 1.651(a)-2. See § 1.663-1 et seq. for application of the separate share rule.

(2)

(i) Except in cases to which the last sentence of this subdivision applies, for taxable years of a trust ending before September 1, 1957, subparagraph (1) of this paragraph shall not apply and the rule of subdivision (ii) of this subparagraph shall apply unless the trustee elects to have subparagraph (1) of this paragraph apply. Such election shall be made by the trustee in a statement filed on or before April 15, 1959, with the district director with whom such trust’s return for any such taxable year was filed. The election provided by this subdivision shall not be available if the treatment given the income and the excess of capital gains over capital losses for taxable years for which returns have been filed was consistent with the provisions of subparagraph (1) of this paragraph.

(ii) The rule referred to in subdivision (i) of this subparagraph is as follows: During the period between the occurrence of an event which causes a trust to terminate and the time when a trust is considered as terminated under this section, the income and the excess of capital gains over capital losses of the trust are in general considered as amounts required to be distributed for the year in which they are received. For example, a trust instrument provides for the payment of income to A during her life, and upon her death for the payment of the corpus to B. The trust reports on the basis of the calendar year. A dies on November 1, 1955, but no distribution is made to B until January 15, 1956. The income of the trust and the excess of capital gains over capital losses for the entire year 1955, to the extent not paid, credited, or required to be distributed to A or A’s estate, are treated under sections 661 and 662 as amounts required to be distributed to B for the year 1955.

(d) If a trust or the administration or settlement of an estate is considered terminated under this section for Federal income tax purposes (as for instance, because administration has been unduly prolonged), the gross income, deductions, and credits of the estate or trust are, subsequent to the termination, considered the gross income, deductions, and credits of the person or persons succeeding to the property of the estate or trust.

Management Notes

Gains & Losses from Sale of Long-term Business Property

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An asset is something of value that your business owns, like buildings, machinery, equipment, and vehicles. When you sell a capital asset (used for investment or to make a profit), you can sell it at a gain or loss. The difference between the original cost (called the basis) and the sales price is either a capital gain or a capital loss.

For example, if you own business equipment, you may add to the basis by upgrading the equipment or reduce the basis by taking certain deductions and by depreciation. The cost at purchase plus the changes create an adjusted basis at the time you sell the equipment. The difference in this adjusted basis and the sales price is either a capital gain or a capital loss.

Capital gains tax is a tax charged on all capital gains. These gains are taxed differently, depending on how long they are held. If you own the asset for more than a year before you sell it, your capital gain is long-term. If you hold it one year or less, the gain is short-term.

To calculate your capital gains tax rate for your tax return, you must separate short-term and long-term capital gains on all the assets you sold during the year to get a net short-term and net long-term capital gain (or loss).

The net long-term capital gain is taxed is usually no higher than 15% for most taxpayers, but there are some exceptions.

A net short-term capital gain is usually taxed as ordinary income, based on your tax rate.

At the time of Sale of any Real Estate Property, Tax is liable to be paid on the Gains earned on the sale of the Real Estate Property. Such Gains could either be Short Term Capital Gains or Long Term Capital Gains. The basis of such Classification in the Income Tax Return has been given below:

  • Short Term Capital Gain (STCG): If the Real Estate Property is held for less than 24 Months.
  • Long Term Capital Gain (LTCG): If the Real Estate Property is held for more than 24 Months (Reduced from 36 to 24 Months from FY 2017-18 onwards).

Full Value of Consideration

Full Value of Consideration means what the transferor receives or is entitled to receive as consideration for the Sale of Property /Asset. This Value may be in cash or in kind i.e. in exchange for an Asset.

In case of exchange of an asset, the full value for the computation of Capital Gains shall be the Fair Market Value of the Property (Asset) granted in exchange. Fair Market Value in relation to Capital Gains means the price which the Property (Asset) would normally fetch if sold in the open market on the Relevant Date.

In case, the full value of consideration is received in installments in different years, the entire value of consideration shall be the Market Value of the Property/Asset granted in exchange.

Expenses on Transfer

Expenses on Transfer include any expenditure incurred, whether directly or indirectly, for the purpose of transfer like Advertisement Expense, Brokerage Expense, Stamp Duty, Registration Fees, and Legal Expenses etc. However, any expense which has been claimed as a deduction under any other provision of the Income Tax Act cannot be claimed as a deduction under this Clause.

Cost of Acquisition

Cost of Acquisition is the price which the assessee has paid, or the amount which the assessee has incurred, for acquiring the Property /Asset. The Expenses incurred at the time of completing the title are a part of the cost of acquisition.

In cases where the Capital Asset became the property of the assessee in any of the manners mentioned below, the cost of acquisition shall be deemed to be the cost for which the previous owner of the property acquired it:

  • On the Distribution of Assets/ Total Partition of HUF.
  • Under a Gift or Will.
  • By Succession, Inheritance or Devolution.
  • On Distribution of Assets on Liquidation of a Company.

Capital gains on depreciable asset

Under Section 50 of Income Tax Act, if you have sold a capital asset forming part of a block of assets, including building and machinery, on which the depreciation has been allowed under the law, the income arising from the sale is treated as short-term capital gain.

The reader must note here that as land is not a depreciable asset and so, cannot form part of a block of assets in absence of rate of depreciation. Hence, the provisions of Section 50 cannot be invoked, in case of sale of land. If land is held for a period of more than 24 months, the gains earned through the transactions is taxed as long­term capital gains.

Computation of profit or loss from sale of business property in an asset block

Unlike regular accounting where the depreciation is calculated with reference to the cost or written down value of each asset, the depreciation for a particular block of assets is computed in an aggregate manner. If there are more than one assets in one particular block of assets, the depreciation is calculated on the value arrived at after adding the cost of acquisition for the assets purchased during the year and falling under the same block of assets, to the written down value of the block at the beginning of the year and by reducing the sale price of one or more assets sold during the year.

Management Notes

Amortization, Characteristics, Entries

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Amortization refers to the systematic allocation of the cost of an intangible asset (e.g., patents, copyrights, goodwill) or the repayment of a loan principal over its useful life or loan term. For intangible assets, it follows the matching principle in accounting, spreading the expense to align with the revenue it generates. Unlike depreciation (for tangible assets), amortization typically uses the straight-line method, assuming equal expense distribution each period. For loans, amortization involves gradual principal repayment through periodic installments, reducing the outstanding balance over time. It impacts financial statements by lowering asset book value (balance sheet) and recording periodic expenses (income statement). Under IFRS and GAAP, amortization stops if the asset’s residual value is reassessed or impaired. Proper amortization ensures accurate profit measurement and compliance with accounting standards.

Characteristics of Amortization:

  • Gradual Allocation of Cost

Amortization involves systematically allocating the cost of an intangible asset over its useful life. Instead of recording the full expense at once, the cost is divided into equal or appropriate portions for each accounting period. This gradual recognition ensures that the expense matches the periods in which the asset contributes to revenue generation. By spreading the cost, amortization prevents sudden impacts on profits and provides a more accurate picture of an entity’s financial performance, aligning with the matching principle in accounting.

  • Applicable to Intangible Assets

Amortization is specifically applied to intangible assets such as patents, trademarks, copyrights, franchises, goodwill, and software. These assets lack physical substance but provide long-term benefits to a business. The process helps in systematically reducing their book value until it reaches zero or their residual value, whichever is applicable. Unlike depreciation (for tangible assets), amortization only applies to non-physical assets and usually uses the straight-line method unless otherwise specified. It reflects the consumption or expiration of the economic benefits embedded in intangible assets.

  • Non-Cash Expense

Amortization is a non-cash expense, meaning it does not involve any actual cash outflow during the accounting period. The cash payment for acquiring the intangible asset is made upfront or in installments, but amortization simply spreads that cost in the books over time. This characteristic makes it important in financial analysis because it reduces reported profits without affecting cash flows. It helps stakeholders distinguish between accounting expenses and actual cash expenditures, thus aiding in more accurate cash flow management and analysis.

  • Based on Useful Life

The amount of amortization depends on the useful life of the intangible asset, which is the period over which it is expected to generate economic benefits. This useful life is estimated based on legal, contractual, or economic factors. For example, a patent might have a legal life of 20 years but could be amortized over 10 years if the company expects to benefit from it only during that period. Amortization stops when the asset is fully amortized or disposed of.

  • Matches Expenses with Revenue

Amortization follows the matching principle in accounting, which requires expenses to be recorded in the same period as the revenues they help generate. By allocating the cost of intangible assets over their useful lives, amortization ensures that financial statements accurately reflect the cost of using these assets in generating income. This leads to fairer and more consistent profit measurement across accounting periods, preventing overstatement of income in earlier years and understatement in later years when benefits are still being received.

  • Straight-Line Method Preference

In most cases, amortization is calculated using the straight-line method, which allocates an equal amount of expense in each period of the asset’s useful life. This approach is preferred because intangible assets often provide consistent benefits over time. However, other methods can be used if the asset’s benefits are consumed unevenly. The choice of method should reflect the pattern in which economic benefits are derived. The straight-line method’s simplicity, predictability, and ease of calculation make it the most widely adopted practice.

Entries of Amortization:

S. No. Situation Journal Entry Explanation

1

Recording amortization expense

Amortization Expense A/c Dr.

  To Accumulated Amortization A/c

Records the amortization amount for the period, reducing the value of the intangible asset over time.

2

Directly reducing asset value

Amortization Expense A/c Dr.

  To Intangible Asset A/c

Used when amortization is directly deducted from the asset account rather than accumulated separately.

3

At year-end transfer of expense to Profit & Loss

Profit & Loss A/c Dr.

  To Amortization Expense A/c

Transfers amortization expense to P&L, reducing net profit for the period.

4

Fully amortizing an asset

Accumulated Amortization A/c Dr.

  To Intangible Asset A/c

Removes the asset’s cost and related accumulated amortization upon completion of its useful life.

5

Amortization in case of disposal of asset

 Bank A/c Dr.

Accumulated Amortization A/c Dr.

  To Intangible Asset A/c

  To Gain on Disposal A/c (if any)

Records disposal, removes asset’s cost, accumulated amortization, and recognizes any gain.

6

Loss on disposal

 Bank A/c Dr.

Accumulated Amortization A/c Dr.

Loss on Disposal A/c Dr.

  To Intangible Asset A/c

Records loss when sale proceeds are less than the net book value.
Management Notes

Agricultural/Farming Income Income Tax Act, 1961

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Under the Income Tax Act, 1961, agriculture income is defined and treated uniquely compared to other forms of income. This special treatment is rooted in the importance of agriculture to the Indian economy and the large population dependent on it for their livelihood.

Definition of Agricultural Income:

Section 2(1A) of the Income Tax Act, 1961 defines agricultural income as:

  1. Any rent or revenue derived from land which is situated in India and is used for agricultural purposes.
  2. Any income derived from such land by agricultural operations including processing of the agricultural produce, raised or received as rent-in-kind so as to render it fit for the market, or sale of such produce.
  3. Income derived from buildings on or identified with agricultural land. The crucial requirement here is that the building should be occupied by the cultivator or the receiver of rent or revenue of the land.

The interpretation of what constitutes “agricultural operations” includes all activities starting from basic operations like plowing and sowing to subsequent processes such as weeding, digging the soil around the growth, removal of undesirable undergrowths, and all operations which foster the growth and preservation of the same produce.

Tax Exemption of Agricultural Income

Agricultural income is exempt from income tax under Section 10(1) of the Income Tax Act, 1961. This exemption is pivotal in supporting the agricultural sector by alleviating the tax burden on farmers. However, the calculation of tax on non-agricultural income of individuals receiving agricultural income is influenced by the agricultural income in a manner that effectively raises the tax rate on non-agricultural income.

Integration of Agricultural and Non-Agricultural Income for Tax Calculation

Although agricultural income is exempt from tax, it plays a role in determining the tax rate applicable to non-agricultural income if the total income, including agricultural income, exceeds the basic exemption limit. This is done through a method called “partial integration” under Sections 2(1A) and 10(1). The steps are as follows:

  1. Calculate the total income excluding agricultural income.
  2. Add the basic exemption limit to the agricultural income.
  3. Add the above result to the non-agricultural income.
  4. Calculate tax on the total amount from step 3.
  5. Subtract the tax calculated on the sum of the basic exemption limit and agricultural income from the tax computed in step 4.

The outcome ensures that a taxpayer with agricultural income does not pay more tax on non-agricultural income than a taxpayer with a similar amount of non-agricultural income but without any agricultural income.

Special Provisions and Considerations:

  1. Lease Land for Agriculture:

Income derived from land given on lease for agricultural purposes can also be considered agricultural income if the land is being used directly for agricultural operations.

  1. Composite Rent:

Where the rent received is partly agricultural and partly non-agricultural, the income needs to be appropriately apportioned.

  1. Income from Farm Buildings:

Necessary farm buildings that are on or near the agricultural land and are used as dwellings for those employed on the land or for storing produce also qualify under agricultural income.

Judicial Interpretations and Rulings

Various rulings and judicial interpretations have clarified aspects of what constitutes agricultural income. For instance, income from dairy farming, poultry farming, stock breeding, or sale of spontaneously grown trees is not considered agricultural income. However, income from operations such as breeding and rearing of livestock, which are essentially agricultural operations, is considered agricultural.

Challenges and Criticisms

While the exemption of agricultural income under the Income Tax Act is aimed at supporting farmers, it is often criticized for enabling tax evasion, especially when high-income earners exploit this provision to shield their income from taxes by reclassifying it as agricultural. This has led to calls for more stringent definitions and perhaps limits on what can be exempted under this head.

Management Notes

Passive income

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Passive income comprises of earnings which are derived via a rental property, limited partnership, or any other enterprise in which any individual is not involved in active participation. Usually, passive income is taxable.

Paying Income tax is one thing, which most of the people do not like. Everyone tries to minimize their income tax by some or the other means.

A few analysts consider portfolio income as passive income, and hence, interest and dividends would be regarded as passive income. Passive income requires little to no effort in order to earn and maintain. It is termed as progressive passive income when an earner puts in little effort to generate income.

A passive income investment will make the life of an investor easier in several ways, especially when a hands-off approach is chosen. The four passive income investment options include – Real Estate, Peer-to-Peer Lending, Dividend Stocks, and Index Funds. These four options indicate varying levels of risk and diversification. As with any kind of financial investment, it’s vital to gauge the expected returns with respect to a passive income opportunity versus the potential for loss.

There are three types of passive activities:

Cash flows via property income, inclusive of profits from ownership of capital, rent via ownership of resources such as rental income, cash flows from a property or from any piece of real estate, and in the form of interest through owning financial assets.

  • Trade/business-related activities in which an individual does not take part in the operations of a business other than investing during the year.
  • Royalties, i.e. payments initiated by one firm (the licensee) to another firm/an individual (the licensor) for the right to utilise the latter’s intellectual property (music, video, book).

Tax free Passive income

Agricultural Income:

Agricultural Income is exempted from tax. However, the income from agriculture (if earned more than Rs 5000 a year) has to be taken into consideration for calculating the tax payable.

Dividends received from your shares or equity mutual funds

You receive dividends from your stocks or equity mutual funds (dividend option). This dividend money you get is also tax-free in your hand. However, the bad side of the story is that company anyways pays the dividend distribution tax to govt before giving the dividends to its shareholders. Hence, anyways we are getting slightly less share of profits in our hand anyway.

Now after budget 2018, the dividends from equity shares or mutual funds will be taxed at a flat rate of 10% above the threshold limit of Rs 1,00,000 in a financial year. Before budget 2018, the profits from equity after a year was 100% tax free.

Profits from shares or equity mutual funds after a year

When you earn any profits from your shares or equity mutual funds after holding it for minimum 1 yrs, it is called Long-term Capital gains, and it is 100% tax exempted as per current tax rules.

Now after budget 2018, the profits from shares or equity will be taxed at a flat rate of 10% above the threshold limit of Rs 1,00,000 in a financial year. Before budget 2018, the profits from equity after a year was 100% tax free.

Any amount received through WILL or Inheritance

There is no inheritance tax in India now. So, anything you get in inheritance through WILL is not taxable in your hands. It becomes your property and now when you invest that money, only the interest part earned on that property will be taxed.

Money received from your EPF account after 5 yrs

The money one gets from their EPF account is also tax-free, provided the money is taken out after 5 yrs of service.

Money got under VRS scheme up to Rs 5 Lacs

If a person takes VRS (Voluntary retirement scheme) than any amount received up to Rs 5 lacs is income tax-free. However, not everyone is eligible for it. Only employees of Public sector companies or an authority established under a Central or State govt is eligible for this.

Maturity or Claim amount received by Life Insurance Company

The money you get from life insurance companies on maturity, claim or surrender is 100% tax-free provided, If the premium paid does not exceed 20% of the sum assured. I am quoting new amendments which have come in recent years.

As per amendments introduced in the Finance Act, 2003, (i.e., with effect from April 1, 2003), any proceeds received on account of maturity/surrender of an insurance policy were exempt from tax only if the premium paid did not exceed 20% of the sum assured.

Interest on saving bank interest up to Rs 10,000 a year

From 2013 onwards, a new section 80 TTA is introduced under which, the interest on your saving bank account up to Rs 10,000 is not taxable. So if your saving bank interest for a year is Rs 20,000, then out of that Rs 10,000 is exempted and only the rest Rs 10,000 will be added to your taxable income.

Management Notes

Basis of Accounting, Cash basis and Accrual Basis

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Basis of Accounting refers to the method by which financial transactions are recorded and recognized in the accounting system. There are two primary types: Accrual Basis and Cash Basis. Under the accrual basis, revenues and expenses are recognized when they are earned or incurred, regardless of cash flow. The cash basis, on the other hand, records transactions only when cash is received or paid. The choice of accounting basis affects how financial performance and position are reported and can impact decision-making and analysis.

Cash basis

Cash Basis Accounting is a simple method where revenues and expenses are recorded only when cash is actually received or paid. In this system, income is recognized when cash is collected, and expenses are recognized when payments are made, regardless of when the transaction occurred. It is commonly used by small businesses and individuals due to its simplicity and focus on actual cash flow. However, it may not provide a complete picture of a business’s financial health, as it ignores receivables, payables, and other non-cash transactions.

Functions of Cash basis:

  • Simple and Easy to Use:

One of the main functions of cash basis accounting is its simplicity. It requires no complex financial tracking or extensive knowledge of accounting principles. Businesses record income when cash is received and expenses when payments are made. This ease of use makes it particularly attractive for small businesses, freelancers, and sole proprietors with limited accounting resources.

  • Focuses on Cash Flow:

Cash basis accounting emphasizes actual cash flow, helping businesses closely monitor their available cash. Since it records only when cash is received or spent, businesses can easily see how much cash they have on hand. This is critical for small businesses or startups that rely on maintaining positive cash flow for their day-to-day operations and short-term decision-making.

  • Immediate Recognition of Transactions:

In cash basis accounting, transactions are recognized immediately upon receipt or payment of cash. This function simplifies financial record-keeping, as there is no need to track receivables, payables, or adjust for accruals. As a result, business owners can directly link their bank statements to their accounting records, creating a clear and straightforward financial picture.

  • Lower Administrative Costs:

Cash basis accounting typically requires less administrative effort and fewer resources than accrual accounting. It eliminates the need for tracking accounts receivable, accounts payable, and making complex adjustments. This function reduces bookkeeping time and costs, making it an affordable option for small businesses without the need for extensive accounting departments.

  • Tax Benefits:

In many tax systems, cash basis accounting can offer potential tax benefits. Since income is recognized only when cash is received, businesses may be able to defer income tax liability if payments from customers are delayed until the next tax year. This can help manage tax obligations and smooth out cash flow, especially for businesses with fluctuating income.

  • Provides a Clear Picture of Immediate Liquidity:

Cash basis accounting gives an accurate view of a company’s current liquidity. Since it only records cash transactions, it shows exactly how much cash is available at any given time. This function is particularly useful for businesses needing to make short-term decisions based on available resources.

  • Reduces Complexity in Financial Reporting:

With cash basis accounting, there are no complex financial reports to prepare. There are no accruals, prepayments, or provisions to account for, reducing the complexity of financial statements. For smaller businesses, this function means less reliance on professional accountants or financial experts, simplifying reporting and compliance.

  • Better for Small or Cash-Based Businesses:

Cash basis accounting functions well for businesses that operate primarily on a cash basis, such as retail stores, food service providers, and small service-oriented businesses. Since these businesses receive payments immediately and have minimal credit sales or long-term receivables, cash basis accounting aligns well with their operations, making financial management straightforward and efficient.

Cash basis Book entry:

Date Transaction Debit Credit Description
YYYY-MM-DD Cash Sale Cash Sales Revenue Cash received from sales.
YYYY-MM-DD Cash Purchase Purchases Cash Cash paid for inventory or supplies.
YYYY-MM-DD Cash Received from Customer Cash Accounts Receivable Cash received for previously sold goods.
YYYY-MM-DD Cash Payment to Supplier Accounts Payable Cash Payment made to supplier for outstanding bills.
YYYY-MM-DD Cash Expense Payment Expenses Cash Cash paid for operating expenses (e.g., rent).
YYYY-MM-DD Owner’s Capital Contribution Cash Owner’s Equity Cash invested into the business by the owner.
YYYY-MM-DD Cash Withdrawal for Personal Use Owner’s Equity Cash Cash withdrawn by the owner for personal use.
YYYY-MM-DD Loan Received Cash Loan Payable Cash received from a loan.
YYYY-MM-DD Loan Payment Loan Payable Cash Cash payment made towards loan repayment.
YYYY-MM-DD Cash Dividend Distribution Retained Earnings Cash Cash dividends paid to shareholders.

Accrual Basis:

Accrual Basis Accounting is a method where revenues and expenses are recorded when they are earned or incurred, regardless of when cash is actually received or paid. Under this system, revenue is recognized when goods or services are delivered, and expenses are recorded when obligations arise. This method provides a more accurate picture of a company’s financial performance by matching revenues with related expenses within the same accounting period. While more complex than cash basis accounting, it is widely used by larger businesses and follows generally accepted accounting principles (GAAP).

Functions of Accrual basis:

  • Matching Principle:

One of the primary functions of accrual basis accounting is the matching principle, which states that revenues should be matched with the expenses incurred to generate them within the same accounting period. This function allows businesses to accurately assess profitability by linking income with its associated costs, providing a clearer picture of financial performance.

  • Comprehensive Financial Reporting:

Accrual accounting enhances financial reporting by providing a complete view of a company’s financial activities. It includes not only cash transactions but also accounts receivable and payable, ensuring all financial obligations and rights are recognized. This comprehensive reporting is crucial for stakeholders who need to evaluate a company’s performance over time.

  • Improved Financial Forecasting:

By recognizing revenue and expenses when they occur, accrual basis accounting allows for better financial forecasting and planning. Businesses can analyze trends and patterns based on actual performance rather than cash flow timing. This function is particularly beneficial for long-term strategic planning and investment decisions.

  • Enhanced Creditworthiness:

Companies using accrual accounting can present a more accurate picture of their financial health, improving their creditworthiness. Lenders and investors often prefer accrual basis financial statements because they reflect all obligations and income, not just cash transactions. This transparency can lead to better financing options and terms.

  • Facilitates Compliance with Standards:

Accrual basis accounting complies with generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). Many public companies are required to use this method for financial reporting. This function ensures that businesses meet regulatory standards and enhances the reliability and comparability of financial statements.

  • Management of Receivables and Payables:

Accrual accounting requires businesses to track accounts receivable and accounts payable, providing insights into outstanding debts and future cash inflows. This function helps businesses manage cash flow more effectively, ensuring they can meet their obligations while maximizing revenue collection.

  • Historical Financial Analysis:

Accrual basis accounting enables more effective historical financial analysis by providing a consistent view of revenues and expenses over time. Businesses can analyze trends, assess long-term performance, and make informed decisions based on historical data, leading to more strategic growth initiatives.

  • Supports Investment Decisions:

Investors rely on accrual basis financial statements for making informed investment decisions. The recognition of revenue and expenses at the time they are earned or incurred provides a more accurate representation of a company’s operational performance. This function helps investors assess potential risks and returns effectively.

Accrual basis Book entry:

Date Transaction Debit Credit Description
YYYY-MM-DD Sale on Credit Accounts Receivable Sales Revenue Revenue recognized when goods/services are delivered.
YYYY-MM-DD Purchase on Credit Purchases Accounts Payable Expense recognized when goods/services are received.
YYYY-MM-DD Payment Received for Accounts Receivable Cash Accounts Receivable Cash received for previously recognized revenue.
YYYY-MM-DD Payment Made to Supplier Accounts Payable Cash Payment for previously recognized expense.
YYYY-MM-DD Accrued Salaries Salary Expense Accrued Salaries Payable Salary expense recognized before payment.
YYYY-MM-DD Accrued Interest Expense Interest Expense Accrued Interest Payable Interest expense recognized as incurred.
YYYY-MM-DD Depreciation Expense Depreciation Expense Accumulated Depreciation Depreciation recognized for the accounting period.
YYYY-MM-DD Unearned Revenue Cash Unearned Revenue Cash received in advance; revenue recognized later.
YYYY-MM-DD Expense Prepaid Prepaid Expense Cash Expense paid in advance; recognized over time.
YYYY-MM-DD Adjusting Entry for Accruals Various Expenses Various Payables Adjustments made for accrued or deferred items.

Key differences between Cash basis and Accrual Basis

Aspect Cash Basis Accrual Basis
Revenue Recognition Cash Received Earned
Expense Recognition Cash Paid Incurred
Complexity Simple Complex
Financial Reporting Limited Comprehensive
Matching Principle Not Applicable Applicable
Cash Flow Focus Yes No
Tax Implications Immediate Deferred
Usage Small Businesses Larger Businesses
Accounts Receivable Not Recorded Recorded
Accounts Payable Not Recorded Recorded
Timeframe Current Future/Current
Regulatory Compliance Limited Required
Financial Insights Short-term Long-term
Investment Analysis Limited Enhanced

 

Management Notes

Deductions from AGI

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Adjusted gross income (AGI) is an individual’s total gross income minus specific deductions. It is used to calculate taxable income, which is AGI minus allowances for personal exemptions and itemized deductions. For most individual tax purposes, AGI is more relevant than gross income.

Gross income is sales price of goods or property, minus cost of the property sold, plus other income. It includes wages, interest, dividends, business income, rental income, and all other types of income. Adjusted gross income is gross income less deductions from a business or rental activity and 21 other specific items.

Several deductions (e.g. medical expenses and miscellaneous itemized deductions) are limited based on a percentage of AGI. Certain phase outs, including those of lower tax rates and itemized deductions, are based on levels of AGI. Many states base state income tax on AGI with certain deductions.

Adjustments

Gross income is reduced by certain items to arrive at adjusted gross income. These include:

  • Expenses of carrying on a trade or business including most rental activities (other than as an employee)
  • Certain business expenses of teachers, reservists, performing artists, and fee-basis government officials.
  • Health savings account deductions.
  • Certain moving expenses.
  • One-half of self-employment tax.
  • Allowable contributions to certain retirement arrangements (SEP IRA, SIMPLE IRA, and qualified plans) and Individual Retirement Accounts (IRAs).
  • Penalties imposed by financial institutions and others on early withdrawal of savings.
  • Alimony paid (which the recipient must include in gross income).
  • College tuition, fees, and student loan interest (with limitations and exceptions).
  • Jury duty pay remitted to the juror’s employer.
  • Domestic production activities deduction.
  • Certain other items of limited applicability.
Management Notes

Estimated Tax penalty

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An Income Tax penalty is a punitive measure which applies to assessees who make default in compliance with the Income Tax Act. The Act has introduced various penalties for contraventions committed by taxpayers. The penalty prescribed as per the Income Tax Act can either be mandatory or leviable at the discretion of a tax authority. In this article, the various income tax penalties are discussed.

Audit and Audit Report

  • If the assessee fails to get his accounts audited, obtain audit report, or furnish report of such auditor, a penalty will be leviable at the ₹1,50,000 or ½% of the total sale/ Turnover/ gross receipts whichever is lesser.
  • Failure of assessee to furnish Audit report related to foreign transaction, a penalty @ ₹1,00,000 will be payable.

TDS/TCS

  • Where a person fails to deduct tax at source, he will be liable to pay a penalty equal to the amount of tax which he has failed to deduct/ pay.
  • Where a person fails to collect tax at source, he will be liable to pay a penalty equal to the amount of tax which he has failed to collect.
  • Failure to furnish TDS/TCS statement or furnishing incorrect statements, shall attract a penalty ranging from ₹10,000 to ₹1,00,000.
  • Failure to furnish information/ furnishing inaccurate information related to TDS deduction related regarding Non-residents shall attract a penalty of ₹100,000.

Penalty for Failure to Comply with Notice

According to the Income Tax Act, an Income Tax Assessing Officer is allowed to issue a notice demanding the taxpayer to file an income tax return. The officer can demand the assessee to produce documents pertaining to an income tax assessment. If a taxpayer may fail to comply with a notice from an Income Tax Officer. In such cases, the taxpayer shall be liable for a penalty of Rs.10,000 for each instance of failure to comply. The officer may also require the taxpayer to furnish in writing any information. The taxpayer should get the accounts audited or re-audited by a Chartered Accountant.

Undisclosed income

  • Where the income determined includes undisclosed income, a penalty @10% is payable. However, no such penalty will be leviable, if such income was included in the return and tax was paid before the end of the relevant previous year.
  • Where Search has been initiated on/ after 1/7/2012 but before 15/12/2016,
  • If undisclosed income is admitted during the course of search and assessee pays tax and interest and files return, a penalty @ 10% of such undisclosed income is payable.
  • If undisclosed income is not admitted but the same is furnished in the return filed after such search, 20% of such undisclosed income is payable.
  • In all other cases, penalty is leviable @ 60%

Penalty for Concealing Income

The taxpayer may endeavour to reduce his tax liability by concealing income or by furnishing inaccurate particulars of income. In such cases, a penalty can be levied by the Assessing Officer. Penalty for such contravention shall be 100% to 300% of the tax evaded.

Penalty for Not Maintaining Book of Accounts

The Income-tax Act mentions that a taxpayer is bound by the need to maintain books of account. The taxpayer may fail to maintain books of account. In such cases a penalty of up to Rs.25000 is applicable.

Default in making payment of tax

The amount of penalty leviable will be as determined by the Assessing Officer. However, the amount will not exceed the amount of tax in arrears.

Management Notes

Individual Income Tax Return: Filing Status

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Income Tax Return (ITR) is a form in which the taxpayers file information about his income earned and tax applicable to the income tax department.

The department has notified 7 various forms i.e. ITR 1, ITR 2, ITR 3, ITR 4, ITR 5, ITR 6 & ITR 7 till date.Every taxpayer should file his ITR on or before the specified due date. The applicability of ITR forms varies depending on the sources of income of the taxpayer, the amount of the income earned and the category the taxpayer like individuals, HUF, company, etc.

if your gross annual income is more than the basic exemption limit as specified below:

Particulars Amount
For individuals below 60 years Rs 2.5 Lakh
For individuals above 60 years but below 80 years Rs 3.0 Lakh
For individuals above 80 years Rs 5.0 Lakh

Types of Income Tax payers

The Income tax Act has classified the types of taxpayers in categories so as to apply different tax rates for different types of taxpayers.

Taxpayers are categorized as below:

  • Individuals, Hindu Undivided Family (HUF), Association of Persons (AOP) and Body of Individuals (BOI)
  • Firms
  • Companies

ITR-1 OR SAHAJ

This Return Form is for a resident individual whose total income for the AY 2021-22 includes:

Income from Salary/ Pension.

  • Income from One House Property (excluding cases where loss is brought forward from previous years).
  • Income from Other Sources (excluding Winning from Lottery and Income from Race Horses)
  • Agricultural income up to Rs.5000.

Types of Income / Heads of Income

Everyone who earns or gets an income in India is subject to income tax.(Yes, be it a resident or a non-resident of India ).For simpler classification, the Income tax department breaks down income into five main heads:

Head of Income Nature of Income covered
Income from Other Sources Income from savings bank account interest, fixed deposits, winning in lotteries is taxable under this head.
Income from House Property Income earned from renting a house property is taxable under this head of income.
Income from Capital Gains Surplus Income from sale of a capital asset such as mutual funds, shares, house property etc is taxable under this head of Income.
Income from Business and Profession Profits earned by self-employed individuals, businesses, freelancers or contractors & income earned by professionals like life insurance agents, chartered accountants, doctors and lawyers who have their own practice, tuition teachers are taxable under this head.
Income from Salary Income earned from salary and pension is taxable under this head of income

Management Notes

Interest & Dividend Income

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Interest Income

Interest that gets accumulated in your savings bank account must be declared in your tax return under income from other sources. Do note that bank does not deduct TDS on savings bank interest. Interest from both fixed deposit and recurring deposits is taxable while interest from savings bank account and post office deposits are tax-deductible to a certain extent. But they are shown under income from other sources. Interest income from a savings bank account or a fixed deposit or from a post office savings account are all shown under this head.

Deduction on Interest Income Under Section 80TTA

For a residential individual (age of 60 years or less) or HUF, interest earned upto Rs 10,000 in a financial year is exempt from tax. The deduction is allowed on interest income earned from:

  • Savings account with a bank.
  • Savings account with a co-operative society carrying on the business of banking.
  • Savings account with a post office.

Avoiding TDS on Fixed Deposits

Banks are required to deduct tax when interest income from deposits held in all the bank branches put together is more than Rs.40,000 in a year (Prior to FY 2019-20, it was Rs.10,000). A 10% TDS is deducted if PAN details are available. It is 20% if the bank does not have your PAN details. The details of TDS deducted on Fixed Deposit Interest is in the Form 26AS. If your total income is below the taxable limit, you can avoid tax deduction on fixed deposits by submitting Form 15G and Form 15H to the bank requesting them not to deduct any TDS. Form 15H is for senior citizens (60 years or older); Form 15G is for everybody else. These forms are for residents only and for those whose taxes add up to zero. These forms must be submitted at the start of the financial year. If you missed submitting them, then you can claim a refund by filing an income tax return. These forms are valid for one year only. Therefore, they must be submitted each year to keep banks from deducting tax.

Tax on Fixed Deposits

Fixed deposit interest that you receive is added along with other income that you have such as salary or professional income, and you’ll have to pay tax on that income at a tax rate that’s applicable to you. TDS is deducted on interest income when it is earned, though it may not have been paid. Example: The bank will deduct TDS on interest accrued each year on a FD for 5 years. Therefore, it is advisable to pay your taxes on an annual basis instead of doing it only when the FD matures. Senior citizens, with effect from 1 April 2018, will enjoy an income tax exemption upto Rs 50,000 on the interest income they receive from fixed deposits with banks, post offices etc under Section 80TTB.

Dividend

Dividend usually refers to the distribution of profits by a company to its shareholders.

However, in view of Section 2(22) of the Income-tax Act, the dividend shall also include the following:

(a) Distribution of accumulated profits to shareholders entailing release of the company’s assets.

(b) Distribution of debentures or deposit certificates to shareholders out of the accumulated profits of the company and issue of bonus shares to preference shareholders out of accumulated profits.

(c) Distribution made to shareholders of the company on its liquidation out of accumulated profits.

(d) Distribution to shareholders out of accumulated profits on the reduction of capital by the company.

(e) Loan or advance made by a closely held company to its shareholder out of accumulated profits.

Tax rate on dividend income

The dividend income shall be chargeable to tax at normal tax rates as applicable in case of an assessee except where a resident individual, being an employee of an Indian company or its subsidiary engaged in Information technology, entertainment, pharmaceutical or bio-technology industry, receives dividend in respect of GDRs issued by such company under an Employees’ Stock Option Scheme. In such a case, dividend shall be taxable at concessional tax rate of 10% without providing for any deduction under the Income-tax Act. However, the GDRs should be purchased by the employee in foreign currency.

Taxable in the hands of resident shareholder

A person can deal in securities either as a trader or as an investor. The income earned by him from the trading activities is taxable under the head business income. Thus, if shares are held for trading purposes then the dividend income shall be taxable under the head business or profession. Whereas, if shares are held as an investment, then income arising in nature of dividend shall be taxable under the head other sources.

The income, taxable under the head PGBP, is computed in accordance with the method of accounting regularly followed by the assessee. For the purpose of computation of business income, a taxpayer can follow either mercantile system of accounting or cash basis of accounting. However, the method of accounting employed by the assessee does not affect the basis of charge of dividend income as Section 8 of the Act provides that final dividend including deemed dividend shall be taxable in the year in which it is declared, distributed or paid by the company, whichever is earlier. Whereas, interim dividend is taxable in the previous year in which the amount of such dividend is unconditionally made available by the company to the shareholder. In other words, interim dividend is chargeable to tax on receipt basis.

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