ORDER
R. V. EASWAR, J. M. :
In these appeals by the assessee the only question is whether the departmental authorities were justified in making additions of Rs. 44,90,434 and Rs. 25,42,968 on account of interest accrued to the assessee.
2. The appeals arise this way. The assessee is a public limited company. It was registered in the year 1970 to carry on the business of merchant-cum-development banking in all its aspects. The company could not, however, undertake development banking for want of resources and had to confine its activities to merchant banking with industrial consultancy. In the year 1980, a special resolution was passed in the annual general metering of the company to change the main object to include financial consultancy, computerised data processing, housing finance, hire - purchase and equipment leasing, export and import finance, etc. In pursuance of the new object the company utilised its funds more towards housing finance besides also utilising them in the field of equipment leasing and consultancy. Over a period of years, the emphasis of the business shifted to housing finance. From what was only 24.16% of the total loans in the year 1980, housing loans jumped to 68.90% in the year 1985. For the years under appeal also there was a further jump in the composition of the housing loan vis-a-vis the total loans given by the assessee.
3. The huge jump in housing advances also brought within its wake of problems for the assessee. The problem was recovery of the interest on such loans which slowed down substantially mainly because the interest was paid by the borrower only on the completion of their housing projects. In recognition of this reality, the assessee-company began entering into agreements for housing loans under which the interest itself would be due for payment only on completion of the house building projects.
4. Upto and including the accounting year ended 31st Dec., 1995, the assessee was following the mercantile system of accounting in respect of all its transactions. The previous year for the asst. yr. 1987-88 was a period of fifteen months from 1st Jan., 1986, to 31st March, 1987, and the previous year for the asst. yr. 1988-89 was a period of twelve months from 1st April, 1987, to 31st March, 1988. The change in the accounting year had been accepted by the IT authorities. On 12th Nov., 1986, the Board of Directors of the company passed a resolution regarding the change of the accounting system of the company. The resolution itself is as under :
'Item 18 (c) : Change of the accounting system of the company.
Resolved that the accounting system of the company be changed with effect from the year 1986 from the existing 'Mercantile system' i.e., accrual basis to 'Combined System' taking interest on loan only on cash realisation basis, while all other income and all expenses will be on accrual basis.'
'Resolved further that an application be submitted to the appropriate income-tax authority for permission of such change with prayer for expeditious decision.'
An application for the change was made to the ITO on 11th Dec., 1986, the salient contents of which are as under :
'The recovery of our interest on loan has slowed down substantially in recent years since the interest on such loans are paid by the borrowers on completion of their industrial and housing projects. In fact, we had entered into the agreements for housing loans where the interest will start for payment on completion of the house building projects. The Central Govt. is very keen to promote house building in a big way in urban areas where at present there is acute shortage of accommodation both for office as well as residential purposes. In line with the Govt. policies, we thought it fit to promote house building activities in Calcutta by landing more and more funds for construction of buildings.
The principal as well as interest has become in certain cases doubtful of recovery on account of delay in completion of the industrial projects by the borrowers. We are giving below a table showing the interest which was credited to our profit and loss account for the last few years and the interest which is outstanding and not realised as at the end of the year :
Year
Int. credited to P&L; A/c
Outstanding Int. accumulated at the end of each a/c year
Ratio
1981
52,08,497
5,29,501
1.1%
1982
52,05,038
12,95,929
23.9%
1983
61,51,714
23,85,839
38.7%
1984
57,18,089
40,28,510
70.4%
1985
49,72,219
54,93,301
110.4%
From the above, it may kindly be noted that our outstanding interest as at the end of the year has been more than the interest for the year 1985. This shows that we are paying income-tax on interest which has not been realised and accumulating to the huge amount of 54.93 lakhs.
We shall have to pay debenture interest to our holders since under a scheme of amalgamation as approved by the Calcutta High Court, 50% of the shares held by the shareholders of United Bank of India Ltd. which was merged with this company, was converted into debentures and every six months we are required to pay the debenture interest which comes to 12.22 lakhs every year.
Therefore, in the interest of business expediency and commercial prudence and in view of substantial changes in the investment pattern of our funds from industrial to housing, we will have to follow our interest income on loans on cash basis. We will however continue to follow mercantile system of accounting in respect of all other transactions excepting interest income on loans to parties.
We would request you to please consider our case and give your approval for change in the method of accounting in respect of interest income on loans from mercantile to cash system.
An early action on your part will be highly appreciated.'
By a letter dt. 26th Feb., 1987, the ITO refused to grant the permission for the change. The company, however, proceeded to go ahead with the change notwithstanding the refusal of the ITO to accept it and prepared its accounts on that basis. In the printed accounts for the year ended 31st March, 1987, in para 3 of schedule 12 to the accounts, it was stated as under :
'For a realistic and fair presentation interest income on loan has been recognised, unlike previous year, on realisation basis during the period. As a result income for the period is lower by Rs. 44,90,438.'
In the auditors report to the shareholders, which is at page 16 of the paper book filed by the assessee, mention was made about the change in the method of accounting in respect of the interest income in the following words :
'During the period under audit there has been a change in the method of accounting of interest income on loans from accrual to cash basis. Due to this change in the system of accounting of interest income the profit for the period has been shown less by Rs. 44,90,438.'
Subject to the above, the auditors certified that the accounts for the year ended 31st March, 1987, gave a true and fair view of the profit for the said period.
5. The directors report on the accounts for the period ended 31st March, 1987, also referred to the change in the method of accounting in the following words :
'During the period under review the accounting policy of the company with regard to interest income on loan has been changed from accrual to realisation basis with a view to make a realistic and appropriate presentation of the financial statements. It has been the experience of your directors that in case of term loan for industrial finance or housing finance, which is the main business of your company, realisation of the interest on loans are being consistently slowed down accumulating the accrued interest from year to year adversely affecting companys liquidity. The situation has further been aggravated by the depressive economic condition and industrial decline in the eastern sector of the country. To ensure check on further erosion of companys liquidity, your directors had to change the accounting method. Keeping in view the above situation and the low profit for the period under review, your directors are not in a position to recommend any dividend for the period. However, your directors are confident that such a realistic approach in accounting would have positive reflection in results of operations in future years.'
6. The interest income which was accounted by the assessee on cash basis or receipt basis from the accounting period relevant to the asst. yr. 1987-88 was continued to be accounted in the same basis in all the subsequent years including the asst. yr. 1988-89 which is before us. It is not in dispute that the assessee has regularly accounted the interest income on cash basis after the change and this fact has been accepted by the CIT(A) in his common order in para 23.
7. The assessee filed returns of income on the basis of the new method of accounting in respect of the interest income and included therein the interest income only on cash or receipt basis. The ITO refused to compute the assessees income on this basis. He computed the income on the basis adopted by the assessee in the earlier years and he gave the following reasons for the refusal to compute the interest income on cash basis :
'(i) That the assessee-company is having income from the sources, namely, interest on loans, interest on loans to subsidiary, interest on bank deposits, equipment leasing rent, consultancy fees, dividend and interest from investments in shares and debentures since the inception of the business;
(ii) That the assessee has been following mercantile system of accounting hereto since the beginning of the business and has been showing all income on accrual basis including interest income on loans. Thus, the departure from the previously employed system (mercantile system to cash system) is not permissible for this asst. yr. 1987-88 as the accounts would then cease to reflect the true profit and loss of the assessee-company;
(iii) No resolution of the Board of Directors of the assessee approving the change from accrual to cash basis appears to have been passed and considered by the shareholders in a general meeting;
(iv) That there is no cogent evidence available from the 16th Annual Report of the company which can establish that the assessee - company had decided to change its existing regular method of accounting by another regular method; and
(v) That where the assessee followed a particular system of accounting, it cannot effect a change in the method in respect of a particular items of income i.e., interest income of loans only in this case.'
8. In the assessment order for the asst. yr. 1988-89 for the same reasons the interest income was computed on accrual basis. The action of the ITO gave rise to the additions which are contested in the present appeals.
9. The CIT(A) disposed of the matter in the following words :
'In the case of the appellant it is a fact that the appellant has followed the changed system of accounting year after year. The plea of the appellant that it has got the right to change the system of accounting of the one of the sources of income is acceptable. But, it is to be kept in mind that interest income is a source of income which has to be worked out on certain basis. Even if it is acceptable that the appellant can have its interest accounts on cash basis and accounts for expenses such as stationery, salary, rent, telephone expenses, motor car expenses, etc. on mercantile basis. But in the interest accounts itself, by the nature of the business of the appellant, there are receipts of interests as well as payments of interest. The appellant can have cash system of accounting for both the receipt as well as payments of interest or mercantile system of accounting for both the receipts as well as payments as it was having earlier. But the appellant cannot be allowed to have each system for receipts side of the same interest accounts and mercantile system for the payment side of the same interest accounts because that cannot be said to be a recognised and regular system of accounting. The results arising out of such an unsystematic and unequal way of accounting the two sides of the same account would result in lop-sided picture of the actual affairs of the appellants business. If the appellant later on finds it difficult to recover the interests accrued after taking of the possible action including legal action, the appellant is always free to write off the same as bad debts. But by adapting a peculiar unrecognised system of accounting, the appellant cannot be allowed to defer the payment of taxes indefinitely.
In view of the above discussion, I am fully convinced that the action of the AO of computing the interest income on accrual basis for both the years is sound and correct. And, the same is upheld for both the asst. yrs. 1987-88 and 1988-89.'
10. It is the correctness of the aforesaid decision of the departmental authorities, that is challenged before us on behalf of the assessee. Mr. Murarka, learned counsel for the assessee, after explaining the facts of the case and the background which necessitated the change in the method of accounting in respect of the interest income, submitted that in the following decisions such a change has been approved notwithstanding that the change is only in respect of one single item or source of income :
1. Juggilal Kamlapat, Bankers vs. CIT : [1975]101ITR40(All)
2. CIT vs. West Coast Paper Mills Ltd. : [1992]193ITR349(Bom)
3. CIT vs. Citi Bank N. A. : [1994]208ITR930(Bom)
4. CIT vs. Kesoram Industries & Cotton Mills Ltd. : [1993]204ITR154(Cal)
5. Bhagwandas Jagdishprasad & Co. vs. CIT : [1983]144ITR845(MP) .
On the basis of the ratio laid down in the aforesaid judgments, it was submitted by Mr. Murarka that there is no principle that the assessee cannot account for the interest income on cash basis and at the same time account for the interest expenditure on mercantile basis. According to him, the view taken by the CIT(A) on this aspect of the matter was against the ratio laid down in the aforesaid decisions.
11. The learned Departmental Representative strongly relied on the orders of the departmental authorities and also pointed out that the facts in the decisions relied on behalf of the assessee were distinguishable inasmuch as in all those cases the change was in respect of a single source whereas in the present case the change was only in respect of the income aspect of the source without corresponding change in the expenditure aspect thereof. In his submission, such partial change cannot be permitted. He, therefore, contended that the interest income was rightly computed on accrual basis.
12. We have carefully considered the rival contentions. The change adopted by the assessee was in respect of only the interest income and so far as the interest expenditure was concerned, the assessee continued to adopt the mercantile method of accounting. This is common ground. It is also common ground and in fact, it has been accepted by the CIT(A), that the assessee has regularly followed the changed method of accounting in respect of the interest in the subsequent years. Under these circumstances, it is for consideration whether the interest income has to be computed only in accordance with the assessees method, which takes into account the interest receipt only when they are actually received but claims deduction on account of interest on accrual basis. It is now well settled that apart from the cash system of accounting and the mercantile system of accounting, 'there are innumerable other systems of accounting which may be called hybrid or heterogeneous - in which certain elements and incidence of the cash and mercantile system are combined [CIT vs. A. Krishnaswamy Mudaliar : [1964]53ITR122(SC) ]. The Calcutta High Court in the case of Reform Flour Mills P. Ltd. vs. CIT : [1981]132ITR184(Cal) observed that the expression 'Hybrid' indicates the birth of a system born out of an inter-mixture of cash and mercantile system of accounting and 'when the assessee simultaneously in respect of certain transactions following the mercantile system of accounting, in respect of others follows the cash system of accounting, then the proper expression should perhaps be that he maintains a dual or plural system of accounting in respect of different transactions because the expression 'Hybrid' would be the result of inter-mixture of two systems and something of third system emerges.......'. In the case of S. R. V. G. Press Co., Kurnool vs. CIT : [1956]30ITR583(AP) , the Andhra Pradesh High Court, after a reference to the earlier decisions on the point, held at page 591 that if the assessee employs a mixture of the methods of accounting regularly and consistently, the profits would have to be computed in accordance with the respective methods, provided a proper determination of the true profits was possible, because s. 145 clearly makes the method of accounting adopted by the assessee a compulsory basis for computation of the income. An instance of a hybrid system of accounting are afforded in the decision of the Allahabad High Court in the case of Juggilal Kamlapat Bankers vs. CIT (supra) wherein an assessee who was following the mercantile system of accounting, followed the cash system of accounting in respect of the income from rent and it was held that the ITO was bound by the mixed system adopted by the assessee. Way back in 1935, the Rangoon High Court approved in the case of CIT vs. M. A. L. Chettiyar firm (1935) 3 ITR 193, the method of accounting followed by the Nattukotta Chettiars, a trading community in South India, under which accounts were kept in the mercantile basis in respect of transactions with Nattukotta Chettiar community but on cash basis in respect of transactions with outsiders. The Andhra Pradesh decision cited supra also affords an instance, wherein the assessee which maintained its books on the mercantile basis adopted the cash basis of accounting only in respect of the sales-tax. This decision has been approvingly cited by the Calcutta High Court in the case of Reform Flour Mills P. Ltd. vs. CIT (supra). In the case of CIT vs. E. A. E. T. Sundararaj : [1975]99ITR226(Mad) , the Madras High Court was also faced with the similar situation where the assessee which was maintaining the books generally on mercantile basis adopted the cash basis in respect of the sales-tax collections and payments. The method was approved and the following observations at page 231 are relevant :
'An assessee may employ one method of accounting for one part of his business or one class of customers, and a different method for another part of his business or another class of customers. He may also keep accounts in respect of different parts of the same business on different basis. If such different methods are employed regularly and consistently the profits have to be computed in accordance with the respective methods, provided it results in a proper determination of the true profits.'
In the case of CIT vs. North Arcot District Co-operative Spinning Mills Ltd. : [1984]148ITR406(Mad) , the assessee was generally adopting the mercantile system of accounting but in respect of the import of plant and machinery from foreign suppliers he was adopting the cash system of accounting and debited the interest not when it was due, but only when it was actually paid. Since this method was being regularly adopted, the same was approved.
13. We may now refer to some decisions of the Calcutta High Court wherein the principles regarding the acceptance of the change in the method of accounting were laid down. In the case of Reform Flour Mills P. Ltd. vs. CIT (supra) it was held that an assessee who is following a particular system of accounting and claims to effect a change in the same, cannot treat a particular transaction differently or separately from the method followed by him. It was held that in such a case, there is no question of any change as such in the method of accounting and, therefore, the claim of the assessee cannot be accepted. In that case it was found that the assessee accounted for the interest receivable from one debtor from mercantile system to the cash system, which was not permitted. The present case does not fall within the ratio of this decision because the assessee before us has not changed the system of accounting for interest income in respect of one loan or one debtor only, but has effected a general change in the system of accounting for interest from the mercantile method to the cash method in respect of all the loans advanced by it. In the case of Snow White Food Products Co. Ltd. vs. CIT : [1983]141ITR861(Cal) , it was held after a reference to the various authorities on the point as under at page 872 (of ITR) :
'From the various decisions cited in this reference and as observed in our judgment in IT Ref. No. 356 of 1977 [Snow White Food Products Co. Ltd. vs. CIT : [1983]141ITR847(Cal) ], the law appears to be settled that an assessee is entitled to change his regular method of accounting by another regular method and such a change can be effected in respect of a part of the assessees income.
There is nothing on record to show that in the two assessment years involved, interest received from any debtor was accounted for by the assessee on the mercantile basis. We are, therefore, unable to accept the contention of the Revenue that the change in the method of accounting was being followed in respect of only one item in the assessees account.'
The High Court further proceeded to lay down the conditions on the satisfaction of which alone any change in the method of accounting can be accepted. The first condition was that the change should have been made bona fide. On this aspect, it was held that s. 145 in terms does not require any enquiry into the bona fides of the assessee in following a regular method of accounting and that the bona fides of the change would be establishes if the assessee establishes that the new method of accounting has been followed regularly by it in the subsequent years. The second condition was that the assessee should lead evidence to show that the changed method of accounting has in fact been employed by it in all the subsequent years thus showing that the new method has been adopted for regular employment and not as a casual departure or only for the year under consideration. In the present case, the bona fides of the change have not been challenged by the departmental authorities. It may be recalled that the assessee had submitted an application seeking the change and in that application elaborate reasons with facts and figures were furnished by the assessee in support of the change. Portions of the application have been extracted in the earlier part of our order. The existence of the reasons or the facts necessitating the change were never doubted by the IT authorities and in fact, the refusal communicated to the assessee was rather cryptic in the sense that it merely stated that the ITO was not in a position to allow the change as requested by the assessee. The CIT(A) has also conceded the assessees right to change the system of accounting in respect of one of the sources of income and has also found as a fact that the changed system of accounting in respect of the interest income was regularly followed year after year. Thus, the bona fides of the change stand established as well as the regular employment or adoption thereof in the succeeding years. The assessees case thus falls squarely within the ratio of the judgment of the Calcutta High Court cited above.
14. The point to be considered now is the whether the assessee could follow the cash system in respect of the interest income and seek, at the same time, to continue the mercantile system in respect of interest expenditure. If the ratio of the judgments referred to above is properly appreciated, it is clear that there can be no objection to the method. A perusal of all the authorities on the issue, including those cited hereinabove, indicates that in order that a change in the accounting method should get the approval of the IT authorities, it is not necessary for the assessee to establish anything more than that the change has been made bona fide, that the same has been regularly employed in the subsequent years and that the true profits can be deduced even from the changed system. The emphasis in all the decided cases in on the adoption of the new system of accounting on a regular basis rather than as a casual departure on the a temporary basis. The real objection of the IT authorities in the present case, when they say that the assessee cannot be permitted to follow the cash system in respect of the interest income while allowing the assessee to continue to follow the mercantile system in respect of interest expenditure, is that there would be loss of revenue and thereby prejudice would be caused to the IT Department. A perusal of the decided cases on this point shows that the fact that there would be loss of revenue cannot be a valid objection to the changed system of accounting being accepted. In the case of Indo-Commercial Bank Ltd. vs. CIT : [1962]44ITR22(Mad) , the Madras High Court held that the detriment to the Revenue was not a relevant factor in deciding whether the change in the method of valuation of stock, which is a part of the method of accounting, can be accepted or not. This decision was followed by the Kerala High Court in the case of Forest Industries Travancore Ltd. vs. CIT : [1964]51ITR329(Ker) . In the case of CIT vs. West Coats Paper Mills Ltd. (supra) where the assessee changed its method of accounting for bonus from cash system to mercantile system on the basis of the recommendation of the Company Law Board and claimed both the actual bonus paid as well as the liability for bonus as deduction in the year of change and where such claim was resisted by the IT authorities on the ground that there would be loss of revenue, it was held by the Bombay High Court that whenever there is a change of the method, something of this kind is bound to happen in the year of change but that will be no reason for not allowing the claim on the basis of the changed method, provided the bonus liability had not been allowed in any of the earlier assessment years. In the case of Salig Ram Kanhayalal vs. CIT , the Punjab and Haryana High Court held that there were times when some peculiar business transactions do not admit of one or the other form of accounting and in such a situation the ITO has only to look at the substance of the situation and decide the matter in such a manner that neither the assessee is put to hardship nor the Revenue is put to unreasonable loss. The Calcutta High Court took the same view in the case of CIT vs. Hazaribagh Coal Syndicate Pvt. Ltd. : [1989]177ITR135(Cal) . In the case of CIT vs. Rajasthan Investment Co. (P) Ltd. : [1978]113ITR294(Cal) , the Calcutta High Court held that where an investment company, which maintained accounts on mercantile basis and was compelled thereby to pay income-tax on interest amounts not actually realised by it and changed over to cash basis in order to reflect the true and correct state of affairs in the accounts, and where the change-over was made bona fide and was based on sufficient reasons, the profits have to be computed in accordance with the new method of accounting and that the IT authorities were not justified in not recognising the same. The Gujarat High Court took the same view in the case of CIT vs. Ganga Charity Trust Fund : [1986]162ITR612(Guj) . It is pertinent to note that the facts of these two cases bear close similarity to the facts of the present case. The reason for the change in the present case also is that the mercantile system followed in respect of this interest income created undue hardship to the assessee in the sense that it had to pay tax on the unrealised interest and, therefore, a change-over to the cash system of accounting for interest income was found necessary. As already stated, that bona fide of the reasons has not been disputed by the IT authorities. Further, the interest liability of the assessee consisted of the following :
'1-4-1987
to
31-3-1988
(Asst. yr. 1988-89)
1-1-1986
to
31-3-1987
(Asst. yr. 1987-88)
On Bank Borrowings
2,01,946
3,89,073
On Debentures
2,22,884
15,28,606
On Deposits (Fixed period)
19,145
38,996
14,43,975
19,56,675
These figures have been taken from schedule 10 to the printed accounts for the asst. yr. 1988-89. As the break-up would show the interest liability cannot be wished away or refused to be taken into consideration by the assessee in ascertaining the true profits. It is, therefore, not possible to adopt the cash system of accounting even in respect of the interest liability. That would show an unrealistic picture of the financial position of the assessee-company. On the contrary, not taking into account the interest accrued, but taking into account only the interest actually realised would not reflect a distorted picture of the financial position; rather that would show a realistic position. The details given by the assessee in its application for permission for the change in the method of accounting themselves bear testimony to the unrealistic position exhibited in the accounts upto the year ended 31st Dec., 1985, till which year the assessee was following the mercantile system in respect of both interest income and interest expenditure. For instance, the interest credited for that year to the P&L; a/c on accrual basis is Rs. 49.72 lakhs whereas the outstanding interest accumulated on the loans advanced by the assessee as on that date was Rs. 54.93 lakhs. Thus, far from being an unscientific system of accounting, the system sought to be followed by the assessee from the asst. yr. 1987-88 attempts to exhibit a realistic picture. Therefore, the mere fact that under the same head, namely, interest, the assessee seeks to adopt two different systems of accounting, namely, cash system for the income and mercantile system for the expenditure, cannot deprive the assessee of its right to have this method accepted and given effect to in the assessments. The new method appears to us to be an inevitable concomitant or incident of the hybrid or plural system of accounting.
15. We are aware that still it may sound somewhat strange to say that even under the same head of account, entries can be made under different methods of accounting. But it has to be borne in mind, as stated earlier, that in a mixed system of accounting such a thing is bound to happen. The profits for the year of change may be understated, but that will be made up by an over-statement of the profits in the future years when the interest is realised. Accountants themselves recognise conservatism as one of the doctrines of accounting, provided it is not 'carried beyond what is warranted by reasonable doubts' and must be set right as soon as circumstances permit (see 'Advanced Accounting' by Yorston, Smith and Brown, 6th Edn., Vols. 1 & 2, pages 14-15). Conservatism should be permitted to prevail to prevent an unrealistic picture being painted of the true profits; it must outweigh considerations arising from strict application of the accounting principles which may mar the real growth of the company; it must be followed if (sic) otherwise tax may have to be collected from notional income rather than from real income. The mixed system or the hybrid or plural system followed by the assessee in the present case has been certified to exhibit a true and fair view of the profits by the auditors. Their certificate implies that it (the mixed or plural system) has been accepted as part of the 'generally accepted accounting principles' of which Lord Denning said that it is enough that such a principle is generally approved or permitted as legitimate by the accounting profession though in practice only the company follows it (see Associated Portland Cement Mfg. Ltd. vs. Price Commission decided in 1974) [Source : Financial accounting study material (Group Alpha) issued by the Institute of Chartered Financial Analysts of India, Hyderabad, page 8 of Notes on Generally Accepted Accounting Principles, conservation & concepts).
16. For the reasons stated above, we are of the view that the assessees system of accounting requires to be accepted and the additions of Rs. 44,90,434 and Rs. 25,42,968 have to be deleted. We direct accordingly and allow the appeals.