Method of Accounting on FD interest : On accrual or on receipt ?

Every penny earned as interest on your Fixed or Recurring Deposit is taxable. Most banks will pay quarterly interest on your Fixed Deposits. This interest will keep compounding. An interesting situation arises when you get into a multi year Fixed Deposit. In such cases, you really should understand what are the options to pay taxes - should you pay the interest accrued in every financial year OR should you wait for the FD to mature. The choice is yours. This post tries to explain the two methods of accounting – mercantile(accrual) and cash.

Background
A simple tax planning tool often overlooked by most taxpayers is of selecting an appropriate accounting method for their incomes. The Income-tax Act permits two methods of accounting—mercantile (accrual) and cash. Under the mercantile method, income and expenses are accounted as and when the right to receive or the right to pay arises. Under the cash method, income and expenses are accounted on actual receipt or payment.

What are two methods of accounting?

• Cash Method of Accounting: Under the cash method, incomes and expenses are taken into account on actual receipt or payment. i.e those transactions are considered which physically happen through cash or bank accounts. For example, if you pay your telephone bill on say 15th April 2012, it will be accounted for in the financial year 2012-13 (1-Apr-2012 to 31-Mar-2013) although the bill may be pertaining to the month of March 2012.
• Mercantile or Accrual method: Under this method transactions are considered as and when they are incurred or earned whether they are are received or not. For example:  Salary relating to a particular year is taxable in that year itself irrespective of whether it is actually received or not.

Why are we talking about method of accounting?
Suppose I make a Fixed Deposit for Rs 1,00,000 for 3 years at 10% p.a on 1st April 2011 (the financial year 2011-2012 or Assessment year 2012-13) in cumulative option.  This means that the interest rates is calculated on a quarterly basis and the interest is reinvested into the fixed deposit.  The interest in various quarters are given below :

Quarter	Interest after every quarter(Rs)	Balance(Rs)
1.	2500.00	102500.00
2.	2562.50	105062.50
3.	2626.56	107689.06
4.	2692.23	110381.29
5.	2759.53	113140.82
6.	2828.52	115969.34
7.	2899.23	118868.58
8.	2971.71	121840.29
9.	3046.01	124886.30
10.	3122.16	128008.45
11.	3200.21	131208.67
90.5625 days.	3253.27	134461.94
Total:	Total Interest Earned:   Rs 34461.94	Maturity Value:  Rs 134461.94

So interest in a year is more than 10,000 Rs. So do we account for the interest every year or on maturity at the end of three years? Answering this question requires understanding the method of accounting. 

The scope of income and its tax ability always depend upon system of accounting followed by the assessee. Remember that the selection of the accounting method is a choice with the assessee.

More about Methods of Accounting

• The cash method of accounting effectively postpones (but does not permanently reduce) your tax liability to the year of actual receipt of income, whereas under the mercantile method, the tax on the income has to be paid even if the income has not been received.
• As far as 'Income from house property and capital gains' are concerned, a taxpayer has no option but to follow the mercantile method of accounting. For instance
• Salary relating to a particular year is taxable in that year itself irrespective of whether it is actually received or not
• Rent receivable for house property that has been let out is taxable irrespective of whether it is actually received.
• Capital gains are chargeable to tax in the year in which the asset is transferred, irrespective of whether the sales consideration is actually received.
• When it comes to income under the heads ‘Profits and Gains of business or profession’ and ‘Income from other sources’ (like business profits, professional income and investment income other than capital gains), we have the choice of accounting for them on either basis–cash or mercantile. This is specified in Section 145 of the Income-tax Act, 1961. 
• With respect to Fixed Deposits Clause 14 of the  The Bank Term Deposit Scheme , 2006 which became effective from 28-07-2006 clearly stipulates a choice for subscriber to pay tax on interest on accrual or receipt basis which states 
• Interest on these term deposits shall be liable to tax under the Act on the basis of annual accrual or receipt, depending upon the method of accounting followed by the assessee.
• The tax on such interest shall be deducted in accordance with the provisions of section 194 A or Section 195 of the Act.
• While a one-time change in method of accounting is normally allowed, changes in method of accounting from year to year for income from the same source, just to save taxes, is not.

How to pick method of accounting?

• You must examine the nature of income and the deductions available before deciding whether to account for the income on a cash basis or mercantile basis.
• If there is a risk of companies defaulting on their interest payment obligations in respect of company fixed deposits (FD) and debentures, it is prudent to account such income on a cash basis so that you do not end up paying tax on income that you do not eventually receive.
• If you decide to use cash accounting method for interest on cumulative deposits i.e you pay tax only on receipt of the interest, then interest paid on maturity will be higher as it is lump sum. In some cases, it may even move your income tax bracket to a higher level, which may be undesirable.
• It may be beneficial to follow the mercantile method and claim the deduction each year, rather than allow the interest to accumulate and be offered to tax on maturity under the cash method.
• If you follow the cash method of accounting, one important aspect to remember is that the tax credit for the tax deducted at source on such income will be available only in the year in which such income is offered to tax, though, the tax would generally be deducted by the payer on an accrual basis each year. Therefore, you need to ensure that the tax deduction certificates (irrespective of the year in which they were issued) are matched with the income offered to tax in the relevant year. Now with TDS information available in Form 26 AS it’s easier to find TDS. You might get letter from Income tax office for TDS not matching.

Summary
Normally, it is always prudent to present interest income on annual accrual. This will keep TDS deducted by banks, Form 26 AS and your income tax declaration in sync and also will not burden you with extra tax in the year of its maturity. 

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The book "From the Rat Race to Financial Freedom" has many such investment concepts explained in a very simple and uncomplicated manner, especially in the Indian context.

Cheers

Manoj Arora

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