Section 145 of the Income Tax Act –
Method of Accounting, ICDS, Cash vs Mercantile System and Form 3CD Disclosures
Section 145 governs the method of accounting for taxable business and other-source income. It permits the cash or mercantile system, empowers the CBDT to notify ICDS, and allows the AO to reject books of accounts — making it the backbone of every business tax computation in India.
Overview
What Is Section 145 of the Income Tax Act?
Section 145 prescribes the method of accounting for two heads of income — "Profits and gains of business or profession" and "Income from other sources". Consequently, Section 145 touches virtually every business ITR filed in India. The section has three sub-sections that work together: Section 145(1) permits cash or mercantile accounting; Section 145(2) empowers the CBDT to notify ICDS; and Section 145(3) allows the AO to reject books of accounts in specified situations.
The method of accounting must be "regularly employed" by the taxpayer — switching between systems without cause invites scrutiny. Section 145 drives every business tax computation: it decides when income is recognised and when expenses are allowed, and links directly with the tax audit report under Section 44AB.
Books of accounts that are incomplete, inconsistent, or non-ICDS-compliant can be rejected under Section 145(3) — triggering best-judgment assessment under Section 144, where the AO estimates income based on comparable businesses and past trends. Book rejection typically leads to substantial additions, and defending it requires disciplined year-round record keeping.
Section 145(1)
Cash vs Mercantile System – The Two Permitted Methods
Section 145(1) permits two accounting methods — cash accounting and the mercantile system of accounting. Every taxpayer chooses one and applies it consistently. The choice must be documented and followed year on year; a mid-year switch requires justification in the Form 3CD disclosure.
Recognition on Receipt and Payment
Cash accounting recognises income only when received and expenses only when paid. Outstanding receivables and payables do not enter the books. Cash accounting suits small professionals and service providers, is simpler to maintain and reconcile, and is largely outside ICDS scope. Many small practitioners continue to prefer cash accounting.
Accrual Basis Recognition
The mercantile system recognises income when it accrues and expenses when they are incurred — receipt or payment timing does not affect recognition. It is mandatory for most companies under the Companies Act and brings outstanding debtors, creditors, and provisions into the books. All 10 ICDS standards apply to mercantile-system taxpayers.
| Criterion | Cash Accounting | Mercantile System |
|---|---|---|
| Income recognition | When actually received | When earned / accrued |
| Expense recognition | When actually paid | When incurred, even if unpaid |
| ICDS applicability | Largely outside ICDS | All 10 ICDS apply |
| Typical users | Small professionals, consultants | Companies, firms, larger businesses |
| Companies Act compliance | Not compliant for companies | Mandatory for most companies |
Section 145(2)
Income Computation and Disclosure Standards (ICDS)
Section 145(2) empowers the CBDT to notify ICDS. The government notified 10 ICDS standards effective from AY 2017-18. Every mercantile-system taxpayer follows ICDS in addition to the Companies Act and Ind AS. ICDS was introduced to standardise tax-income computation across India and narrow the gap between book profit and taxable profit.
ICDS has been mandatory for mercantile-system taxpayers since AY 2017-18 — covering individuals, firms, LLPs, and companies with business or other-source income.
Ten ICDS standards cover accounting policies, inventories, construction contracts, revenue, fixed assets, forex, government grants, securities, borrowing costs, and provisions.
ICDS does not require separate books of accounts. Taxpayers maintain regular accounts and adjust in the tax computation. ICDS is a computation overlay — not a bookkeeping replacement.
Every ICDS adjustment flows through Form 3CD Clause 13, then into the tax computation and the applicable ITR — ITR-3, ITR-5, or ITR-6.
Reference Table
The 10 ICDS Standards at a Glance
The table below lists all 10 ICDS standards with their subjects and key rules. This is the single most-used reference during every year-end tax computation. ICDS often differs from Ind AS and the Companies Act treatment — removing the "prudence" override, tightening recognition criteria, and excluding provisions like expected credit loss.
| ICDS | Subject | Key Rule |
|---|---|---|
| I | Accounting Policies | No materiality concept; no expected losses without incurrence |
| II | Valuation of Inventories | Lower of cost or NRV; FIFO or weighted-average cost |
| III | Construction Contracts | Percentage-of-completion method mandatory |
| IV | Revenue Recognition | Interest on time basis; royalty on accrual; service on PoC |
| V | Tangible Fixed Assets | Cost includes all directly-attributable expenses |
| VI | Foreign Exchange Rates | Monetary items at closing rate; forward premium over contract life |
| VII | Government Grants | Recognised when reasonable certainty exists |
| VIII | Securities | Category-wise valuation at lower of cost or NRV |
| IX | Borrowing Costs | Capitalisation for qualifying assets only |
| X | Provisions, Contingent Liabilities & Assets | Provisions only when reasonably certain — no probable test |
In Practice
Key ICDS Standards in Day-to-Day Practice
Three ICDS standards drive most tax computation adjustments — ICDS II (Inventories), ICDS IV (Revenue Recognition), and ICDS IX (Borrowing Costs). These three earn the deepest attention every year.
Valuation of Inventories
Revenue Recognition
Borrowing Costs
Section 145(3)
AO's Power to Reject Books of Accounts
Section 145(3) allows the AO to reject books of accounts in specific situations. Rejection triggers best-judgment assessment under Section 144 — every business must maintain defensible books throughout the year. The rejection must be supported with specific defects on record; our Scrutiny Assessment team challenges every casual book-rejection attempt.
✗ Grounds for Book Rejection
- Accounts are incorrect or incomplete
- Method of accounting has not been regularly followed
- ICDS has not been applied to compute income
- Material discrepancies between books and primary records
- Sales or purchase registers missing or unreliable
- Stock records not reconciled with physical inventory
✓ Your Defence Against Rejection
- Complete books of accounts under Section 44AA
- Consistent method of accounting year on year
- Form 3CD Clause 13 discloses all ICDS adjustments
- Reconciliations between Ind AS books and ICDS income
- Challenge specific defects cited by the AO on record
- First-level appeal to CIT(A); further appeal to ITAT
Compliance
Form 3CD Disclosures and Books of Accounts
Section 145 compliance is captured in two specific places — Form 3CD Clause 13 (method and ICDS) and Section 44AA (books of accounts). Both touchpoints need attention in every compliance cycle.
Form 3CD Clause 13 – Method of Accounting and ICDS Disclosures
Books of Accounts Under Section 44AA
Our Services
Complete Section 145 Compliance Services
N D Savla & Associates provides end-to-end Section 145 compliance services across India. We cover proprietorships, partnerships, LLPs, private and public companies, and all professional practices — from method-of-accounting review to ICDS adjustments and book-rejection defence.
Method of Accounting Review – Cash vs Mercantile Selection
ICDS Adjustments for All 10 Standards
Form 3CD Clause 13 Disclosure and Tax Audit Integration
Section 145(3) Book-Rejection Defence and Section 144 Representation
Section 145 Compliance — From Method of Accounting to ICDS Adjustments.
Method of accounting review • Cash vs mercantile selection • ICDS adjustments for all 10 standards • Form 3CD Clause 13 disclosure • Books of accounts advisory • Section 145(3) rejection defence • Section 144 representation.
+91 98190 00511 | +91 91670 58000 | +91 98190 00445 | nainitsavla@savlagroup.in | natasha@savlagroup.in
Contact UsF.A.Q.
Section 145 governs the method of accounting for “Profits and gains of business or profession” and “Income from other sources”. Specifically, Section 145(1) permits cash or mercantile accounting. Additionally, Section 145(2) empowers the CBDT to notify ICDS. Furthermore, Section 145(3) allows the AO to reject books of accounts in specified situations. Therefore, Section 145 is the backbone of every business tax computation.
Cash accounting recognises income on receipt and expenses on payment. Specifically, outstanding receivables and payables stay outside the books. By contrast, the mercantile system recognises income on accrual and expenses when incurred. Additionally, all ICDS standards apply to mercantile-system taxpayers. Furthermore, cash accounting suits small professionals while mercantile suits larger businesses. Therefore, the choice depends on size, complexity, and regulatory requirements.
ICDS are Income Computation and Disclosure Standards notified under Section 145(2). Specifically, the CBDT notified 10 ICDS standards effective from AY 2017-18. Additionally, ICDS applies to every mercantile-system taxpayer — individuals, firms, LLPs, and companies. Furthermore, ICDS does not require separate books of accounts. Moreover, taxpayers adjust tax computations to align with ICDS through Form 3CD disclosure.
Yes, but with justification. Specifically, the method of accounting must be “regularly employed” under Section 145(1). Additionally, any change must be genuine and not tax-motivated. Furthermore, Form 3CD Clause 13 requires disclosure of any change and its impact. Moreover, the AO can challenge changes that appear tax-driven. Therefore, changes in the method of accounting need careful documentation.
Section 145(3) allows book rejection on three grounds. Specifically, where accounts are incorrect or incomplete, where the method is not regularly followed, or where ICDS is not applied. Additionally, rejection triggers best-judgment assessment under Section 144. Furthermore, rejection requires specific defects on record. Therefore, every casual rejection attempt is contestable through scrutiny and appeals.
ICDS adjustments appear as additions or deductions in the tax computation. Specifically, the difference between Ind AS / AS profit and ICDS-compliant profit is the adjustment. Additionally, Form 3CD Clause 13 tabulates every ICDS-wise adjustment. Furthermore, the adjustment flows into ITR-3, ITR-5, or ITR-6 as applicable. Therefore, ICDS adjustments are visible end-to-end across the computation.
No. Section 44AD, 44ADA, and 44AE presumptive-taxation taxpayers are outside ICDS. Specifically, presumptive taxation uses deemed profit rates. Additionally, regular book-based computation does not apply. Furthermore, our Business Tax Filing team reviews whether presumptive or regular taxation is optimal each year. Therefore, small businesses can avoid ICDS complexity through presumptive schemes.
