Cash to Accrual Accounting: Triggers, Tax Rules and the Audit Test
Every company must keep accrual-basis books from incorporation (Companies Act s.128(1)). For income tax, s.145 (1961) and s.276 (2025) allow cash or mercantile accounting. Who must switch, and what an audit does and does not change.
CA Harun Raaj
Chartered Accountant · Harun Raaj & Associates
Key point: Section 128 of the Companies Act 2013 requires every company to maintain accrual-basis books from the date of incorporation, with no turnover floor or grace period.
Illustrative case: a Mumbai software startup incorporated in April 2023 kept its books on a cash basis. When it applied for a ₹75 lakh working capital line in 2025, the bank rejected the financials: the Companies Act had required accrual accounting from day one of incorporation. The retroactive switch cost the company its bank window — and it was preventable, because the Companies Act requires accrual books for every company from incorporation.
What the law actually says
Section 145, ITA 1961 and Section 276, ITA 2025
Income chargeable under "Profits and gains of business or profession" or "Income from other sources" "shall ... be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee" (s.145(1), ITA 1961) — identically, "computed as per either cash or mercantile system of accounting regularly employed by the assessee" (s.276(1), ITA 2025, in force from Tax Year 2026-27, i.e. 1 April 2026 onward).
The critical phrase is "regularly employed" — and regularly followed. Where the method "has not been regularly followed by the assessee", or the accounts are incorrect or incomplete, "the Assessing Officer may make an assessment in the manner provided in section 144" — best-judgment assessment (s.145(3), ITA 1961; s.276(3) read with s.271, ITA 2025). Consistency is therefore not a preference; it is the condition on which the assessee's own method is accepted.
The Central Government may separately notify income computation and disclosure standards "to be followed by any class of assessees or in respect of any class of income" (s.145(2)/s.276(2)) — and income not computed per those notified standards equally opens the door to best-judgment assessment.
Section 128, Companies Act 2013
"Every company shall prepare and keep at its registered office books of account ... for every financial year which give a true and fair view of the state of the affairs of the company ... and such books shall be kept on accrual basis and according to the double entry system of accounting" (s.128(1)). A one-day-old private limited company with ₹1 in share capital must maintain accrual-basis books. Cash-basis financial statements cannot give the "true and fair view" the section demands.
Who must switch — legal mandate vs practical pressure
Only company incorporation is a legal mandate to use accrual: s.128(1). The audit thresholds below do not force a method switch by law — they trigger audit, and auditors and lenders then expect accrual-basis accounts. Read them as practical pressure, not as a statutory order to switch.
Company incorporation, illustrated: Priya ran a consultancy as a sole proprietor from 2019 to 2023 on the cash basis, declaring income only when clients paid. In June 2023 she incorporated a private limited company and transferred the business. On the incorporation date, three clients owed her ₹8.2 lakh for completed work. That ₹8.2 lakh had to appear as a trade receivable in the company's opening balance sheet — accrual books recognise earned-but-unreceived income — even though Priya never recognised it under the proprietorship's cash-basis books. Work through the tax treatment of the transfer and the collections with your CA; the accounting recognition and the tax timing need not coincide.
An LLP is not governed by the Companies Act: s.34(1) of the LLP Act expressly permits books "on cash basis or accrual basis" regardless of audit. Audit becomes compulsory only where turnover exceeds ₹40 lakh and contribution exceeds ₹25 lakh — where turnover "does not exceed, in any financial year, forty lakh rupees, or" contribution "does not exceed twenty-five lakh rupees" the LLP "shall not be required to get its accounts audited" (Rule 24(8), LLP Rules 2009). Past that point lenders and auditors will typically expect accrual-basis accounts, but that is their expectation, not a statutory method mandate: s.145(1)/s.276(1) allow any assessee to follow cash regularly employed. For proprietors and partnerships, tax audit applies once business turnover crosses ₹1 crore — or ₹10 crore where cash receipts and payments each stay within 5% — or profession receipts cross ₹50 lakh (s.44AB, ITA 1961; s.63, ITA 2025 from tax year 2026-27). Companies crossing MCA-notified Ind AS thresholds face accrual-based standards (including performance-obligation revenue recognition and on-balance-sheet leases) that can materially change reported income — confirm the applicable threshold and standards for your year before assuming Indian GAAP figures carry over. Banks extending working-capital facilities typically expect accrual accounts in the statutory format — debtor ageing and accrued liabilities are invisible in a cash-basis book.
Step-by-step: how to make the switch properly
- Identify the trigger date precisely — incorporation date for companies, the year the audit threshold is crossed for LLPs and tax-audit assessees, or the MCA-notified transition date for Ind AS.
- Take a complete accrual inventory as on the switch date — outstanding debtors, creditors, advances received but not earned, prepaid expenses, accrued but unbilled income, and outstanding expenses incurred but not paid.
- Recognise opening adjustments in Year 1. The transition year typically shows higher income (debtors and accrued income now included) and higher expenses (creditors and provisions now recognised). Document a detailed transition workings note.
- Guard against double-taxation and double-deduction. Income recognised on cash basis in Year 0 must not be recognised again on accrual in Year 1 for the same item; an advance deducted in Year 0 must not be deducted again in Year 1. Get the transition workings note reviewed before filing.
- Disclose the method change to the auditor — nature of change, reason, and quantified financial effect — and keep the disclosure on record.
- Switch the accounting system from the first day of the new financial year. Mixing periods — part-year cash, part-year accrual — compounds reconciliation errors. Set up transition journals and the chart of accounts before the year begins.
- Engage the auditor before year-end, not after. The statutory or tax auditor reviews completeness of the opening balance, Year-1-vs-Year-0 consistency, and format compliance. Bringing the firm in 3–4 months before year-end allows time to correct classification errors.
- For notified-standards transitions, follow the transition provisions — first-time adoption adjustments typically bypass the profit and loss account. Get specialist advice before the transition date.
If your business is approaching an incorporation, audit, accounting-standards, or lending trigger, speak to your chartered accountant before the transition year closes — the opening balance sheet is far easier to get right the first time than to correct afterward.
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