Direct Tax Laws & International Taxation · Profits and Gains of Business or Profession

Maintenance of Accounts, Audit and Method of Accounting (CA Final DT)

Updated 5 October 2026

Method of accounting decides when business income and expenses are recognised: you may follow the cash or mercantile system, regularly employed, subject to the ICDS. Maintain prescribed books, value inventory at lower of cost and net realisable value, and check tax audit limits: business turnover above ₹1 crore, or ₹10 crore if cash receipts and cash payments are each 5% or less of total receipts and total payments, and professional receipts above ₹50 lakh.

Understand Maintenance of Accounts, Audit and Method of Accounting

Business income is computed on the basis of the method of accounting you regularly follow. Two methods are allowed: the cash system (income and expense are recognised when money is received or paid) and the mercantile system (recognised when the right to receive arises or the liability is incurred, whether or not money moves). The method must be cash or mercantile and regularly employed. The Act does not use the word "hybrid", but a mixed method, where some items are on cash basis and some on mercantile for the same business, is not recognised under the Act's method-of-accounting provision and may be rejected. If you carry on two or more separate businesses, each business may follow a different method, but each must stay consistent within itself.

The method is not a free choice every year. It must be regularly employed. If you change it, the change must be bona fide, and the income must not escape tax or get taxed twice because of the switch. The assessing officer can compute income on a best-judgment basis if the method is not regular or the accounts are not reliable.

On top of the method, the Central Government has notified Income Computation and Disclosure Standards (ICDS). They apply only to computing income chargeable under the heads "Profits and gains of business or profession" and "Income from other sources", for assessees following the mercantile system as well as the cash system. They do not apply to other heads. If an ICDS conflicts with the Act, the Act prevails. There are ten ICDS: accounting policies, inventories, construction contracts, revenue recognition, tangible fixed assets, effects of changes in foreign exchange rates, government grants, securities, borrowing costs, and provisions, contingent liabilities and contingent assets. ICDS are used for computing taxable income only. They do not change the books of account, which you keep under the accounting framework applicable to you. So tax profit can differ from book profit, and you make the ICDS adjustments in the computation.

Inventory valuation matters because closing stock directly changes profit. Under ICDS, inventory is valued at the lower of cost and net realisable value (NRV). Cost is found by FIFO or weighted average; LIFO is not allowed. Items that are not ordinarily interchangeable are valued by specific identification. The closing stock of one year is the opening stock of the next.

Two compliance layers sit on top. First, you must maintain books of accounts in the manner prescribed, and keep them for the prescribed period. Second, if your turnover or gross receipts cross the stated limits, or you are under a presumptive scheme and claim a profit lower than the presumptive rate while your income exceeds the basic exemption limit, you must get the accounts audited by a chartered accountant and file the report in the prescribed form before the due date. Exam questions usually test a limit, a due date or a consequence, applied to a short case.

Key rules to remember

Methods of accounting: Cash system or Mercantile system, regularly employed. A mixed (hybrid) method for the same business is not recognised and may be rejected.; Method must be consistent. A change must be bona fide and must not distort income. Separate businesses may follow different methods.
Inventory valuation (ICDS): Value of closing stock = Lower of (Cost, Net Realisable Value); Apply item by item, or to groups of similar items. Cost by FIFO or weighted average. LIFO is not allowed.
Opening stock rule: Opening stock of the year = Closing stock of the previous year; Use the same figure to avoid double counting or omission of profit.
Tax audit: business (general limit): Total sales, turnover or gross receipts > ₹1,00,00,000; Limit rises to ₹10,00,00,000 if cash receipts and cash payments are each 5% or less of total receipts and total payments.
Tax audit: profession: Gross receipts > ₹50,00,000; Applies to a person carrying on a profession such as medicine, law or accountancy.
Tax audit: presumptive cases: Presumptive business scheme: audit applies if the assessee claims profit lower than the presumptive rate and income exceeds the basic exemption limit. Audit also applies if the assessee opts out of the scheme within the five-year lock-in period and income exceeds the basic exemption limit. Presumptive professional scheme: audit applies if the assessee claims profit lower than the presumptive rate and income exceeds the basic exemption limit. The opt-out within the lock-in period rule applies only to the presumptive business scheme.; Read the exact condition for each presumptive scheme in the question. The trigger is the lower-profit claim together with income above the basic exemption limit (and, for the business scheme only, an opt-out within the lock-in period). Turnover alone does not decide it.
Audit report due date: Report to be furnished on or before one month before the due date of return; Where the return due date for an audited assessee is 31 October, the report is due by 30 September.
Penalty for not getting accounts audited: 0.5% of total sales, turnover or gross receipts, subject to a maximum of ₹1,50,000; Not levied if you show reasonable cause for the failure.
Books of accounts (individual and HUF): Business: income > ₹2,50,000 or turnover > ₹25,00,000 in any of the three preceding years. If the business is newly set up, books are needed where income or turnover is expected to exceed these limits. Non-specified profession: gross receipts > ₹1,50,000 in any of the three preceding years, or expected to exceed that in a newly set-up profession.; Otherwise, only the books necessary to compute total income are needed. The ₹1,50,000 gross receipts test applies only to non-specified professions. Certain specified professions must always maintain prescribed books.
Retention of books: Keep books and documents for 6 years from the end of the tax year to which they relate; Applies to books required to be maintained under the prescribed rules. Count the 6 years from the end of that tax year, not from the date of the entry.
Limit on audits per CA: A chartered accountant can sign a maximum of 60 tax audit reports in a financial year. This is a statutory limit under the tax audit provision of the Income-tax Act, 2025.; Exceeding this limit is also professional misconduct under the Chartered Accountants Act. The exam may test it in an ethics-linked question.

How to solve Maintenance of Accounts, Audit and Method of Accounting questions

Use this order for any question on method of accounting, books or tax audit. It keeps you from missing a trigger or a consequence.

1Identify the assessee and the activity: business, profession, or presumptive scheme. Note whether the person is an individual, HUF, firm or company.
2Fix the method of accounting from the facts: cash or mercantile, and whether it is regularly employed. If mixed within the same business, say that a hybrid system is not allowed.
3Check whether an ICDS changes a book treatment, for example inventory, revenue, foreign exchange or borrowing costs. State the ICDS rule and compute the tax figure.
4For inventory, compute cost, compute NRV, take the lower for each item or group, and total. Adjust profit by the change in closing stock.
5Test for tax audit: compute turnover or gross receipts, check the cash 5% condition, then check the presumptive-scheme conditions.
6If audit applies, state the due date of the report, who can sign it, and the form. Link the audit report due date to the return due date.
7State the consequence of default: penalty, rejection of method, or best-judgment computation.
8Write the answer as provision, facts, conclusion. Keep each limit and date exact.

Quickest way: Three-gate check for tax audit and books

When to use it: Use this for MCQs and short case questions asking whether audit or books are required.

Gate 1: Is it a business or a profession? Business uses turnover; profession uses gross receipts.
Gate 2: Compare with the limit. Business: ₹1 crore, or ₹10 crore if cash receipts and cash payments are each at most 5%. Profession: ₹50 lakh.
Gate 3: If the person is under a presumptive scheme, read the claim. A lower-than-presumptive profit with income above the exemption limit can trigger audit even when turnover is small.
If any gate says audit, add the due date: one month before the return due date.
For inventory, write only: lower of cost and NRV, item by item, and the profit moves opposite to the write-down.

Common mistakes in Maintenance of Accounts, Audit and Method of Accounting

Treating a hybrid method as allowed, for example cash for income and mercantile for expenses of the same business.
Students remember that the Act allows two methods and assume both can be mixed.
Fix: State that the method must be cash or mercantile, and regularly employed. A mixed method is not recognised under the Act's method-of-accounting provision for the same business and may be rejected by the officer. Separate businesses may use different methods.
Using the ₹10 crore audit limit without checking the cash condition.
The ₹10 crore figure is remembered, but the 5% test on both cash receipts and cash payments is skipped.
Fix: Always test cash receipts and cash payments separately against 5% of total receipts and total payments. If either exceeds 5%, apply the ₹1 crore limit.
Using LIFO or the market price as 'cost' for inventory.
Book accounting habits and examples from other subjects carry over.
Fix: Under ICDS, cost uses FIFO or weighted average, specific identification for non-interchangeable items, and closing stock is the lower of cost and NRV.
Adding turnover from a different activity or counting only cash sales.
Students look at the main trade and ignore other receipts of the same business.
Fix: Use total sales, turnover or gross receipts of the business. Read the facts for each business carried on.
Applying book accounting standards instead of ICDS to compute taxable profit.
Students follow the ledger treatment and forget that tax rules override it.
Fix: Compute book profit first, then apply ICDS adjustments one by one. State that if the Act conflicts with ICDS, the Act prevails.
Giving the audit report due date as the return due date.
Both dates sit close and are mixed up.
Fix: The audit report is due one month before the return due date. For a 31 October return, write 30 September.

Worked examples

Example 1

Mr Rao runs a wholesale trading business. Total sales for the tax year are ₹8,50,00,000. Cash receipts are 3% of total receipts and cash payments are 4.5% of total payments. He has not opted for any presumptive scheme. (a) Is a tax audit required? (b) Would your answer change if cash payments were 7% of total payments?

Show the solution

Provision: for a business, tax audit applies if turnover exceeds ₹1 crore. The limit is raised to ₹10 crore if cash receipts and cash payments are each 5% or less of total receipts and payments.
Part (a) facts: turnover is ₹8,50,00,000. It is above ₹1 crore but below ₹10 crore.
Cash receipts at 3% are within 5%. Cash payments at 4.5% are within 5%. Both conditions are met, so the ₹10 crore limit applies.
Since ₹8.5 crore is not above ₹10 crore, tax audit is not required under the turnover test.
Part (b) facts: cash payments of 7% exceed 5%, so the raised limit is not available. The ₹1 crore limit applies.
Turnover of ₹8.5 crore exceeds ₹1 crore, so tax audit is required.

Answer: (a) No tax audit is required because both cash conditions are met and turnover is below ₹10 crore. (b) Yes, tax audit is required, because cash payments exceed 5% and turnover is above ₹1 crore.

Example 2

A trader values closing stock at cost in books: Item A cost ₹1,20,000, NRV ₹1,05,000; Item B cost ₹80,000, NRV ₹95,000; Item C cost ₹50,000, NRV ₹45,000. Profit as per books, with closing stock at cost, is ₹6,00,000. The items are not interchangeable and are valued individually. Compute the tax profit after correcting the closing stock.

Show the solution

Provision: inventory is valued at the lower of cost and NRV, item by item here.
Item A: cost ₹1,20,000 and NRV ₹1,05,000. Lower is ₹1,05,000.
Item B: cost ₹80,000 and NRV ₹95,000. Lower is ₹80,000.
Item C: cost ₹50,000 and NRV ₹45,000. Lower is ₹45,000.
Correct closing stock = 1,05,000 + 80,000 + 45,000 = ₹2,30,000.
Stock at cost in books = 1,20,000 + 80,000 + 50,000 = ₹2,50,000.
Reduction in closing stock = 2,50,000 − 2,30,000 = ₹20,000. A lower closing stock lowers profit.
Profit = 6,00,000 − 20,000 = ₹5,80,000.

Answer: Closing stock is ₹2,30,000 and the profit is ₹5,80,000. The closing stock of ₹2,30,000 becomes the opening stock of the next tax year.

Exam tips

Write the audit limits and the 5% cash condition exactly. Examiners often change one number in the facts to flip the answer.
In inventory questions, show the item-by-item comparison in a small list. Then state the effect on profit. Marks are given for the working.
In case-scenario MCQs, look for the trigger words: cash payments percentage, presumptive scheme, hybrid method, change in method.
For ICDS questions, say what the ICDS requires, then compute the tax profit, then state that the Act overrides in case of conflict.
In ethics-linked parts, remember that a chartered accountant can sign a maximum of 60 tax audit reports in a financial year. This is a statutory limit under the tax audit provision of the Income-tax Act, 2025, and exceeding it is also professional misconduct under the Chartered Accountants Act. Also remember the due date of the report.

Practice questions from Profits and Gains of Business or Profession

Maintenance of Accounts, Audit and Method of Accounting: frequently asked questions

What is the difference between cash and mercantile system for CA Final DT?

In the cash system you recognise income when you receive money and expense when you pay it. In the mercantile system you recognise income when the right to receive it arises and expense when the liability is incurred. Either may be used if regularly followed, but not a mix of both for the same business.

When is a tax audit required for a business?

A tax audit is needed when turnover exceeds ₹1 crore. The limit becomes ₹10 crore if cash receipts and cash payments are each 5% or less of total receipts and total payments. Presumptive-scheme cases have their own conditions.

Do ICDS apply to everyone?

ICDS apply only to computing income under the heads Profits and gains of business or profession and Income from other sources, for assessees under the cash or mercantile system. They do not replace the Act. If there is a conflict, the Act prevails.

How is closing stock valued for tax?

Value it at the lower of cost and net realisable value, item by item or for groups of similar items. Cost is found by FIFO or weighted average, not LIFO. Specific identification is used for items that are not interchangeable.

What is the due date of the tax audit report?

The report must be furnished one month before the due date of filing the return. If the return due date is 31 October, the report is due by 30 September.