Cash vs Mercantile Method of Accounting: Sections 276 to 278 of the Income Tax Act 2025
Under section 276(1) of the Income-tax Act, 2025, income from business or profession and income from other sources is computed using either the cash or the mercantile system of accounting, whichever you regularly follow. Section 277 fixes how inventory is valued and section 278 names three items taxed in the year of receipt or certainty, whatever your method. If the Assessing Officer finds the books unreliable or the method not regularly followed, the income can be assessed on best judgment.
This guide covers all three sections with worked examples for tax year 2026-27. All provisions are quoted from the Act as amended by the Finance Act, 2026. It is general information, not tax advice.
What is the difference between cash and mercantile accounting?
Under the cash system you record income when money is received and expense when money is paid. Under the mercantile system you record income when it is earned (the invoice is raised) and expense when it is incurred, whether or not money has moved. The Act itself does not define the two terms in sections 276 to 278; it only says the assessee may use either one, as regularly employed.
| Cash system | Mercantile system | |
|---|---|---|
| Sale of Rs 1,00,000 invoiced in March, paid in May | Income of the year of May | Income of the year of March |
| Expense billed in March, paid in May | Expense of the year of May | Expense of the year of March |
| Unpaid bills at year end | Not in the year's profit | Included in the year's profit |
Which heads of income does section 276 cover?
Section 276(1) applies to two heads only: "Profits and gains of business or profession" and "Income from other sources". Salary, house property and capital gains are not computed under this section.
Can I switch between cash and mercantile every year?
The method must be one the assessee regularly employs. Under section 276(3)(b), if the method has not been regularly followed, the Assessing Officer can make an assessment under section 271 (best judgment assessment). The Act text in these sections does not lay out a procedure for changing method, so a change is something to discuss with your CA and apply consistently from a clear start date.
What are income computation and disclosure standards (ICDS)?
Section 276(2) lets the Central Government notify income computation and disclosure standards for any class of assessees or any class of income. If income is not computed as per the notified standards, section 276(3)(c) allows the Assessing Officer to assess under section 271. The standards themselves are notified separately and are not part of the text of these sections, so check the current notification for the class you belong to.
When can the Assessing Officer reject your accounts?
Section 271(1) is the best judgment assessment provision. It requires the Assessing Officer to consider all relevant material and give the assessee an opportunity of being heard before making the assessment to the best of his judgment. Keeping complete, consistent books is the practical defence against all three triggers.
How does the choice of method change taxable profit? Worked example 1
Assumptions: Ravi runs a trading business, tax year 2026-27. Figures are for the full year and he has no opening or closing inventory difference.
| Item | Mercantile (Rs) | Cash (Rs) |
|---|---|---|
| Sales invoiced | 12,00,000 | 12,00,000 |
| Less: sales not yet received at 31 March 2027 | nil (counted) | (2,00,000) |
| Income counted | 12,00,000 | 10,00,000 |
| Expenses incurred | 7,50,000 | 7,50,000 |
| Less: expenses not yet paid at 31 March 2027 | nil (counted) | (50,000) |
| Expense counted | 7,50,000 | 7,00,000 |
| Profit | 4,50,000 | 3,00,000 |
The Rs 1,50,000 gap (4,50,000 minus 3,00,000) is a timing difference, not a saving: the Rs 2,00,000 receivable and Rs 50,000 payable fall into the next tax year under the cash method. Other provisions of the Act, such as conditions on specific deductions, can still apply on top of either method.
Does my method matter for expenses that are allowed only when paid?
Yes, in one direction. Section 37(1) allows certain sums as a deduction only in the tax year they are actually paid, irrespective of the method of accounting regularly followed. So a mercantile-system business cannot deduct these just because the liability was booked. The sums listed in section 37(2) are:
- tax, duty, cess, surcharge or fee under any law (37(2)(a));
- employer contributions to provident, superannuation, gratuity or other employee welfare funds (37(2)(b)), and leave encashment payable to employees (37(2)(c));
- interest on loans from specified financial entities, such as banks and public financial institutions (37(2)(e));
- amounts payable to Indian Railways (37(2)(f)), and amounts owed to a micro or small enterprise beyond the time limit in section 15 of the MSMED Act, 2006 (37(2)(g)).
Under 37(3), sums in 37(2) other than the MSE item are still allowed in the year the liability arose if paid on or before the due date of filing the return under section 263(1) for that year. Example: Ravi (mercantile) books Rs 40,000 of employer provident fund contribution for tax year 2026-27 but pays it after his return due date, in the next year. The deduction goes to the year of payment. More detail is in our guide to payments allowed only on actual payment.
How is inventory valued under section 277?
Section 277(1) applies when computing business or profession income. The rules are:
- General inventory: lower of actual cost or net realisable value, computed as per the ICDS notified under section 276(2) (277(1)(i)).
- Taxes in cost: valuation of purchases, sales and inventory includes any tax, duty, cess or fee actually paid or incurred to bring the goods or services to their location and condition on the valuation date (277(1)(ii)). Under 277(4) this covers all such payments irrespective of any right arising as a consequence of the payment.
- Unlisted or rarely quoted securities: securities not listed on a recognised stock exchange, or listed but not quoted with regularity, are valued at actual cost initially recognised as per the ICDS (277(1)(iii)).
- Other securities: lower of actual cost or net realisable value as per the ICDS (277(1)(iv)).
- Scheduled banks and public financial institutions: securities inventory they hold is valued as per the ICDS after taking into account the extant Reserve Bank of India guidelines (277(2)). "Public financial institution" has the meaning in section 2(72) of the Companies Act, 2013 (277(5)).
- Category-wise comparison: for securities, cost and net realisable value are compared category-wise, not in total (277(3)).
Inventory valuation: worked example 2 (goods with duty) and example 3 (securities)
Goods. Meena, a wholesaler, buys goods for Rs 2,00,000 and pays Rs 10,000 of duty to bring them to her warehouse. At year end (31 March 2027) their net realisable value is Rs 2,30,000.
- Actual cost = 2,00,000 + 10,000 = Rs 2,10,000 (the duty is included under 277(1)(ii)).
- Net realisable value = Rs 2,30,000.
- Lower of the two = Rs 2,10,000, the closing inventory value.
Listed securities held as inventory. A dealer holds two categories of securities that fall under clause (iv). Compare category by category.
| Category | Cost (Rs) | Net realisable value (Rs) | Value taken (Rs) |
|---|---|---|---|
| A | 5,00,000 | 4,60,000 | 4,60,000 |
| B | 3,00,000 | 3,40,000 | 3,00,000 |
| Total | 8,00,000 | 8,00,000 | 7,60,000 |
A comparison of the totals (8,00,000 against 8,00,000) would show no loss. The category-wise test under 277(3) brings in the Rs 40,000 fall in category A, and the gain in category B is not set off. How securities are grouped into categories is a matter for the notified ICDS, which is not reproduced in these sections.
Which income is taxed on receipt or certainty under section 278?
| Item (section 278) | Taxed in which tax year |
|---|---|
| Interest received on compensation or enhanced compensation (278(1)) | The year it is received, regardless of section 276 |
| Claim for escalation of price in a contract, or export incentives (278(2)) | The year reasonable certainty of realisation is achieved |
| Assistance (subsidy, grant, cash incentive, duty drawback, waiver, concession, reimbursement) from Government or an authority, as described in section 2(49)(w) (278(3)) | The year it is received, if not charged to tax in an earlier tax year |
Real-life examples
A farmer-landowner receives interest on compensation. Suresh's land was acquired years ago. In tax year 2026-27 he receives Rs 1,20,000 as interest on enhanced compensation. Even if he had accrued interest in earlier years in his books, section 278(1) makes it his income of 2026-27, the year he receives it.
A contractor with an escalation claim. Anita, a civil contractor on the mercantile system, raises a price escalation claim of Rs 4,00,000 in March 2027. The client has not accepted it. Under section 278(2) the claim becomes income in the tax year in which reasonable certainty of realisation is achieved, so it is not taxed merely because it was raised.
A manufacturer receives a subsidy. Kiran's unit receives a state cash incentive of Rs 3,00,000 in January 2027 that falls in section 2(49)(w) and was not charged to tax earlier. Under section 278(3) it is income of tax year 2026-27, the year of receipt. Note that clauses (i) and (ii) of section 2(49)(w) carve out some assistance, such as amounts already reducing the actual cost of an asset, so check the definition before treating a receipt as covered.
Common mistakes
- Mixing methods. Booking sales on mercantile and expenses on cash invites a challenge under section 276(3)(b).
- Ignoring ICDS. Computing income differently from the notified standards is a ground for assessment under section 276(3)(c).
- Leaving duty and fees out of inventory cost. Section 277(1)(ii) and (4) bring in taxes and duties paid, irrespective of any right arising.
- Comparing securities in total. Cost against net realisable value is a category-wise test.
- Deferring subsidy, compensation interest or incentive income. Section 278 overrides the method you follow.
Quick reference
| Question | Answer | Provision |
|---|---|---|
| Which methods are allowed? | Cash or mercantile, as regularly employed | 276(1) |
| Who notifies ICDS? | Central Government | 276(2) |
| Triggers for assessment under section 271 | Accounts unreliable; method not regular; ICDS not followed | 276(3) |
| Inventory (general) | Lower of cost or net realisable value | 277(1)(i) |
| Securities comparison | Category-wise | 277(3) |
| Interest on compensation | Taxed on receipt | 278(1) |
| Escalation claims, export incentives | Taxed when realisation is reasonably certain | 278(2) |
Where this is in the Act
- Section 276: method of accounting; ICDS; grounds for assessment under section 271.
- Section 277: method of accounting in certain cases (inventory valuation).
- Section 278: taxability of certain income.
- Section 271: best judgment assessment. Section 2(49)(w): assistance, subsidy and grants.
- See also our guide to assessment procedure, scrutiny and best judgment.
How can CA firms keep track of each client's method?
A CA firm has to remember which clients follow cash or mercantile, which are covered by ICDS, and which have year-end inventory or incentive receipts to review. Finexo's practice management software lets you keep these client notes and year-end checklists with due dates in one place. It does not compute tax or prepare returns for you.
This article explains the Income-tax Act, 2025 as amended by the Finance Act, 2026. It is general information, not tax advice. Confirm the position for a specific case with a chartered accountant.
Frequently Asked Questions
Which accounting methods are allowed under the Income Tax Act 2025?
Section 276(1) allows either the cash or the mercantile system of accounting, as regularly employed by the assessee, for business or profession income and income from other sources.
What happens if I do not follow my accounting method regularly?
Under section 276(3)(b), the Assessing Officer can make an assessment in the manner provided in section 271, which is best judgment assessment. The same applies if accounts are incorrect or incomplete, or income is not computed as per notified ICDS.
How is closing inventory valued under section 277?
Generally at the lower of actual cost or net realisable value as per the notified ICDS. Taxes, duties, cess or fees paid to bring goods to their location and condition are included. Unlisted or rarely quoted securities are valued at actual cost.
Is cost compared with net realisable value for securities in total or category-wise?
Section 277(3) says the comparison of actual cost and net realisable value of securities is made category-wise.
When is interest on enhanced compensation taxed?
Section 278(1) treats it as income of the tax year in which it is received, irrespective of the accounting method in section 276.
When is a price escalation claim or export incentive taxed?
Under section 278(2), in the tax year in which reasonable certainty of realisation is achieved.
Does mercantile accounting let me deduct unpaid statutory dues?
Not for the sums listed in section 37(2), such as taxes, duties, employer fund contributions and bank interest. Section 37(1) allows them only when actually paid, irrespective of your method, subject to the return-due-date relief in section 37(3).