Case Laws & Commentary · Income-tax Act, 1961 (as amended by the Finance Act, 2026) · bharattax.co Treatise
Status: Live, foundational. Income under 'Profits and gains of business or profession' and 'Income from other sources' is to be computed in accordance with either the cash or mercantile system regularly employed by the assessee; the income-computation and disclosure standards (ICDS) notified under sub-section (2) apply to the mercantile system; sub-section (3) empowers best-judgment assessment under section 144 where the AO is not satisfied with the correctness/completeness of the accounts or where the method/ICDS has not been regularly followed.
FA 2026: No amendment by the Finance Act, 2026.
ICDS: Ten Income Computation and Disclosure Standards notified under section 145(2) apply from assessment year 2017-18 to mercantile-system assessees (other than individuals/HUF not under tax audit).
A. SECTION COMMENTARY
Section 145 fixes the basis of computation. The assessee is free to adopt the cash or the mercantile system, but must employ it regularly; the chosen method governs unless the AO, under sub-section (3), is not satisfied about the correctness or completeness of the accounts, or finds that the method has not been regularly followed, or that the income has not been computed in accordance with the notified ICDS — in which event he may reject the accounts and assess under section 144. The power to reject is real but is hedged: the AO must point to specific defects; he cannot reject merely because the result is low or because he prefers a different method.
Two enduring principles emerge from the case law. First, the AO has not merely a power but a duty to compute the true profits; where the method employed does not disclose the correct profits, he must make such computation as he considers proper (British Paints; A. Krishnaswami Mudaliar). Second, only real income is taxable: income that is hypothetical, or that has not really accrued, cannot be brought to tax merely because the mercantile system would, on a literal view, recognise it (Excel Industries; UCO Bank; Shoorji Vallabhdas). The valuation of stock-in-trade (cost or market, consistently applied) and the recognition of income under long-term contracts are recurring sub-themes.
B. STATUTORY POSITION (verbatim text)
Reproduced from the local Act (base text to the Finance Act, 2025).
145. (1) Income chargeable under the head "Profits and gains of business or profession" or "Income from other sources" shall, subject to the provisions of sub-section (2), be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee.
(2) The Central Government may notify in the Official Gazette from time to time income computation and disclosure standards to be followed by any class of assessees or in respect of any class of income.
(3) Where the Assessing Officer is not satisfied about the correctness or completeness of the accounts of the assessee, or where the method of accounting provided in sub-section (1) has not been regularly followed by the assessee, or income has not been computed in accordance with the standards notified under sub-section
(2), the Assessing Officer may make an assessment in the manner provided in section 144.
C. AUTHORITIES
The authorities define the AO's duty to compute true profits, the limits of rejection of accounts, stock valuation, and the real-income principle.
1. Rejection of accounts and the duty to compute true profits
CIT v. British Paints India Ltd. (1991) 188 ITR 44 (SC)
Court: Supreme Court of India.
Held: Where the method of accounting employed (there, valuing work-in-progress and finished goods at cost of raw materials only, excluding overheads) does not disclose the true profits, section 145 not only empowers but obliges the Assessing Officer to compute the income on such basis and in such manner as he determines to deduce the correct profits and gains; a method, even if regularly followed and adopted on expert advice, can be rejected if it does not reflect true income.
Significance: The leading authority that correct profits prevail over a consistently-followed but distorting method; the AO's power/duty under section 145 to substitute a proper computation is firmly established.
CIT v. A. Krishnaswami Mudaliar (1964) 53 ITR 122 (SC)
Held: If the method of accounting regularly employed is such that, in the opinion of the Assessing Officer, the income cannot properly be deduced therefrom, the AO may adopt a basis that will yield the true income; the proviso to the then section 13 (now section 145(3)) is the source of that power.
Significance: Early statement of the AO's authority to depart from the assessee's method where it fails to disclose true profits — the doctrinal forerunner of British Paints.
Relevance: On rejection of books under section 145(3) and the consequent best-judgment estimate; an honest, reasonable estimate is sustainable even though some guesswork is involved (see section 144).
2. Valuation of stock-in-trade
Chainrup Sampatram v. CIT (1953) 24 ITR 481 (SC)
Held: The valuation of unsold stock at the close of an accounting period is a necessary part of the computation of profits; it is not a source of profit. The established rule is to value stock at cost or market value, whichever is lower; anticipated losses may thus be recognised while anticipated profits are not, which is consistent with prudent commercial accounting.
Significance: The classic Indian authority on stock valuation; the 'cost or market, whichever is lower' principle and the rationale that closing-stock valuation is a computational device, not an accrual of income.
Investment Ltd. v. CIT (1970) 77 ITR 533 (SC)
Held: An assessee is entitled to value its stock-in-trade at cost or market value, whichever is lower, and may adopt a method of valuation consistently; the chosen basis, if bona fide and regularly followed, governs, subject to the overriding requirement that it disclose true profits.
Significance: Affirms consistency in stock valuation and the assessee's right to choose a recognised basis, within the true-profits constraint.
3. The real-income principle and recognition
CIT v. Excel Industries Ltd. (2013) 358 ITR 295 (SC)
Held: Income-tax is a levy on real income, not hypothetical income. Income accrues only when there is a corresponding enforceable right to receive it accompanied by a corresponding liability of the other party to pay; the benefit of advance/duty-entitlement licences accrued only when imports were actually made, not when the entitlement arose. The Court also deprecated re-agitation where the Department had accepted the position in earlier/later years (consistency).
Significance: The modern restatement of the real-income doctrine under the mercantile system; mere book-entry or notional entitlement does not create taxable income.
UCO Bank v. CIT (1999) 237 ITR 889 (SC)
Held: Interest on 'sticky'/doubtful advances need not be recognised as income merely because the mercantile system is followed, where realisation is improbable; a beneficial CBDT circular recognising this practice is binding on the Department. Real income, not notional accrual, is taxed.
Significance: Authority for non-recognition of income whose realisation is uncertain, and for the binding effect of beneficial administrative circulars on income recognition — a recurring theme in NBFC/bank interest cases (and the statutory regime later in section 43D).
Held: Recognition of income from chit transactions on the completed-contract basis, regularly followed by the assessee and not resulting in distortion of profits over the chit period, was accepted; the Court emphasised that the AO should not disturb a regularly-followed method that does not distort profits, and that recognition of income is, in substance, a question of the correct accounting method.
Significance: Endorses a consistently-applied recognition method (completed-contract) where it does not distort profits, reinforcing the consistency and true-profits themes of section 145.
Held: Where the assessee changes its method of accounting, the question for the AO is whether the change is bona fide and whether the new method discloses true profits; the Department too can insist on a method that reflects true income. Recognition of income must accord with the correct method, and the burden is on the party seeking to displace the regularly-followed method.
Significance: Frames the analysis for a change in accounting method and reiterates that the touchstone throughout is the disclosure of true profits.
4. Mercantile system, recognition and book entries
CIT v. Woodward Governor India (P) Ltd. (2009) 312 ITR 254 (SC)
Held: A method of accounting regularly followed is to be presumed correct until the Assessing Officer shows that it does not reflect true profits; under the mercantile system, a liability that has accrued (there, a foreign-exchange loss on a revenue item at year-end) is deductible even before actual disbursement. The Court laid down factors for testing the acceptability of the mercantile method.
Significance: Authority on accrual under the mercantile system and the presumption of correctness of a regularly-followed method; central to section 145 recognition disputes.
Taparia Tools Ltd. v. JCIT (2015) 372 ITR 605 (SC)
Held: Entries in the books of account are not determinative or conclusive of the allowability or timing of a deduction; where the assessee incurs and pays the entire expenditure (there, upfront interest on debentures) in one year, it is allowable in that year, and the 'matching concept' is not to be forced upon the assessee. The true legal position governs, not the book treatment.
Significance: Confirms that book entries do not govern taxability/timing (cf. Kedarnath Jute / Sutlej Cotton); reinforces the real-income and true-profits approach of section 145.
Sakthi Trading Co. v. CIT (2001) 250 ITR 871 (SC)
Held: On the dissolution/discontinuance of a business where the business is continued (no cessation), closing stock is to be valued on the regular basis of cost or market value whichever is lower; the assessee is not compelled to value closing stock at market value so as to bring imaginary or notional profits to tax.
Significance: Affirms the 'cost or market, whichever is lower' rule and guards against taxing notional profit through stock valuation; complements Chainrup Sampatram.
Compiled for the bharattax.co Treatise on the Income-tax Act, 1961 (as amended by the Finance Act, 2026). Statutory text reproduced from the local Act (base text amended up to the Finance Act, 2025), with the publisher footnote apparatus and amendment-marker brackets removed; Finance Act, 2026 changes are flagged in the commentary. Citations are stated as reported; Tribunal / AAR / High Court orders are flagged. Where a section has not been judicially construed, that is stated candidly and the nearest governing authority is given. This material is for professional reference and is not legal advice.
CHAPTER XIV — PROCEDURE FOR ASSESSMENT
Section 145 — Method of Accounting
Case Laws & Commentary · Income-tax Act, 1961 (as amended by the Finance Act, 2026) · bharattax.co Treatise
Status: Live, foundational. Income under 'Profits and gains of business or profession' and 'Income from other sources' is to be computed in accordance with either the cash or mercantile system regularly employed by the assessee; the income-computation and disclosure standards (ICDS) notified under sub-section (2) apply to the mercantile system; sub-section (3) empowers best-judgment assessment under section 144 where the AO is not satisfied with the correctness/completeness of the accounts or where the method/ICDS has not been regularly followed.
FA 2026: No amendment by the Finance Act, 2026.
ICDS: Ten Income Computation and Disclosure Standards notified under section 145(2) apply from assessment year 2017-18 to mercantile-system assessees (other than individuals/HUF not under tax audit).
A. SECTION COMMENTARY
Section 145 fixes the basis of computation. The assessee is free to adopt the cash or the mercantile system, but must employ it regularly; the chosen method governs unless the AO, under sub-section (3), is not satisfied about the correctness or completeness of the accounts, or finds that the method has not been regularly followed, or that the income has not been computed in accordance with the notified ICDS — in which event he may reject the accounts and assess under section 144. The power to reject is real but is hedged: the AO must point to specific defects; he cannot reject merely because the result is low or because he prefers a different method.
Two enduring principles emerge from the case law. First, the AO has not merely a power but a duty to compute the true profits; where the method employed does not disclose the correct profits, he must make such computation as he considers proper (British Paints; A. Krishnaswami Mudaliar). Second, only real income is taxable: income that is hypothetical, or that has not really accrued, cannot be brought to tax merely because the mercantile system would, on a literal view, recognise it (Excel Industries; UCO Bank; Shoorji Vallabhdas). The valuation of stock-in-trade (cost or market, consistently applied) and the recognition of income under long-term contracts are recurring sub-themes.
B. STATUTORY POSITION (verbatim text)
Reproduced from the local Act (base text to the Finance Act, 2025).
145. (1) Income chargeable under the head "Profits and gains of business or profession" or "Income from other sources" shall, subject to the provisions of sub-section (2), be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee.
(2) The Central Government may notify in the Official Gazette from time to time income computation and disclosure standards to be followed by any class of assessees or in respect of any class of income.
(3) Where the Assessing Officer is not satisfied about the correctness or completeness of the accounts of the assessee, or where the method of accounting provided in sub-section (1) has not been regularly followed by the assessee, or income has not been computed in accordance with the standards notified under sub-section
(2), the Assessing Officer may make an assessment in the manner provided in section 144.
C. AUTHORITIES
The authorities define the AO's duty to compute true profits, the limits of rejection of accounts, stock valuation, and the real-income principle.
1. Rejection of accounts and the duty to compute true profits
CIT v. British Paints India Ltd. (1991) 188 ITR 44 (SC)
Court: Supreme Court of India.
Held: Where the method of accounting employed (there, valuing work-in-progress and finished goods at cost of raw materials only, excluding overheads) does not disclose the true profits, section 145 not only empowers but obliges the Assessing Officer to compute the income on such basis and in such manner as he determines to deduce the correct profits and gains; a method, even if regularly followed and adopted on expert advice, can be rejected if it does not reflect true income.
Significance: The leading authority that correct profits prevail over a consistently-followed but distorting method; the AO's power/duty under section 145 to substitute a proper computation is firmly established.
CIT v. A. Krishnaswami Mudaliar (1964) 53 ITR 122 (SC)
Held: If the method of accounting regularly employed is such that, in the opinion of the Assessing Officer, the income cannot properly be deduced therefrom, the AO may adopt a basis that will yield the true income; the proviso to the then section 13 (now section 145(3)) is the source of that power.
Significance: Early statement of the AO's authority to depart from the assessee's method where it fails to disclose true profits — the doctrinal forerunner of British Paints.
Kachwala Gems v. JCIT (2007) 288 ITR 10 (SC) — cross-reference
Relevance: On rejection of books under section 145(3) and the consequent best-judgment estimate; an honest, reasonable estimate is sustainable even though some guesswork is involved (see section 144).
2. Valuation of stock-in-trade
Chainrup Sampatram v. CIT (1953) 24 ITR 481 (SC)
Held: The valuation of unsold stock at the close of an accounting period is a necessary part of the computation of profits; it is not a source of profit. The established rule is to value stock at cost or market value, whichever is lower; anticipated losses may thus be recognised while anticipated profits are not, which is consistent with prudent commercial accounting.
Significance: The classic Indian authority on stock valuation; the 'cost or market, whichever is lower' principle and the rationale that closing-stock valuation is a computational device, not an accrual of income.
Investment Ltd. v. CIT (1970) 77 ITR 533 (SC)
Held: An assessee is entitled to value its stock-in-trade at cost or market value, whichever is lower, and may adopt a method of valuation consistently; the chosen basis, if bona fide and regularly followed, governs, subject to the overriding requirement that it disclose true profits.
Significance: Affirms consistency in stock valuation and the assessee's right to choose a recognised basis, within the true-profits constraint.
3. The real-income principle and recognition
CIT v. Excel Industries Ltd. (2013) 358 ITR 295 (SC)
Held: Income-tax is a levy on real income, not hypothetical income. Income accrues only when there is a corresponding enforceable right to receive it accompanied by a corresponding liability of the other party to pay; the benefit of advance/duty-entitlement licences accrued only when imports were actually made, not when the entitlement arose. The Court also deprecated re-agitation where the Department had accepted the position in earlier/later years (consistency).
Significance: The modern restatement of the real-income doctrine under the mercantile system; mere book-entry or notional entitlement does not create taxable income.
UCO Bank v. CIT (1999) 237 ITR 889 (SC)
Held: Interest on 'sticky'/doubtful advances need not be recognised as income merely because the mercantile system is followed, where realisation is improbable; a beneficial CBDT circular recognising this practice is binding on the Department. Real income, not notional accrual, is taxed.
Significance: Authority for non-recognition of income whose realisation is uncertain, and for the binding effect of beneficial administrative circulars on income recognition — a recurring theme in NBFC/bank interest cases (and the statutory regime later in section 43D).
CIT v. Bilahari Investment (P) Ltd. (2008) 299 ITR 1 (SC)
Held: Recognition of income from chit transactions on the completed-contract basis, regularly followed by the assessee and not resulting in distortion of profits over the chit period, was accepted; the Court emphasised that the AO should not disturb a regularly-followed method that does not distort profits, and that recognition of income is, in substance, a question of the correct accounting method.
Significance: Endorses a consistently-applied recognition method (completed-contract) where it does not distort profits, reinforcing the consistency and true-profits themes of section 145.
CIT v. Realest Builders & Services Ltd. (2008) 307 ITR 202 (SC)
Held: Where the assessee changes its method of accounting, the question for the AO is whether the change is bona fide and whether the new method discloses true profits; the Department too can insist on a method that reflects true income. Recognition of income must accord with the correct method, and the burden is on the party seeking to displace the regularly-followed method.
Significance: Frames the analysis for a change in accounting method and reiterates that the touchstone throughout is the disclosure of true profits.
4. Mercantile system, recognition and book entries
CIT v. Woodward Governor India (P) Ltd. (2009) 312 ITR 254 (SC)
Held: A method of accounting regularly followed is to be presumed correct until the Assessing Officer shows that it does not reflect true profits; under the mercantile system, a liability that has accrued (there, a foreign-exchange loss on a revenue item at year-end) is deductible even before actual disbursement. The Court laid down factors for testing the acceptability of the mercantile method.
Significance: Authority on accrual under the mercantile system and the presumption of correctness of a regularly-followed method; central to section 145 recognition disputes.
Taparia Tools Ltd. v. JCIT (2015) 372 ITR 605 (SC)
Held: Entries in the books of account are not determinative or conclusive of the allowability or timing of a deduction; where the assessee incurs and pays the entire expenditure (there, upfront interest on debentures) in one year, it is allowable in that year, and the 'matching concept' is not to be forced upon the assessee. The true legal position governs, not the book treatment.
Significance: Confirms that book entries do not govern taxability/timing (cf. Kedarnath Jute / Sutlej Cotton); reinforces the real-income and true-profits approach of section 145.
Sakthi Trading Co. v. CIT (2001) 250 ITR 871 (SC)
Held: On the dissolution/discontinuance of a business where the business is continued (no cessation), closing stock is to be valued on the regular basis of cost or market value whichever is lower; the assessee is not compelled to value closing stock at market value so as to bring imaginary or notional profits to tax.
Significance: Affirms the 'cost or market, whichever is lower' rule and guards against taxing notional profit through stock valuation; complements Chainrup Sampatram.
Compiled for the bharattax.co Treatise on the Income-tax Act, 1961 (as amended by the Finance Act, 2026). Statutory text reproduced from the local Act (base text amended up to the Finance Act, 2025), with the publisher footnote apparatus and amendment-marker brackets removed; Finance Act, 2026 changes are flagged in the commentary. Citations are stated as reported; Tribunal / AAR / High Court orders are flagged. Where a section has not been judicially construed, that is stated candidly and the nearest governing authority is given. This material is for professional reference and is not legal advice.