Once we know what Income & Expenses are  – we have to decide a way to account for them.

Should we account for Income when it is due to be received OR when it is actually received?

Expenses when they are due to be paid OR when we actually pay them?

As a Freelancer you need to choose between one of the 2 methods of accounting

(1)    Cash Basis of Accounting

(2)     Accrual Basis of Accounting (also called Mercantile Basis)

Accrual Basis of Accounting

Cash Basis of Accounting

1

Income is accounted or booked when the right to receive arises Income is booked when it is actually received

2

Expenses are accounted or booked when the obligation to pay arises Expenses are booked when they are actually paid

3

Tax liability arises when income is booked – tax may become payable when income may not have been received Tax liability arises in the year income is received – so it makes you pay tax only when income is in your hands.

4

Approach can be followed for all heads of Income, compulsorily for Heads of Income of Salaries, House Property and Capital Gains. Only allowed for Profits & Gains from Business & Profession and Income from Other Sources.

5

For Example – You raise an invoice on your client on 2nd Feb but receive the payment on 4th of April. Revenue would be booked in your accounts basis when invoice is raised to the client and the fact that milestones are completed as required. In this same example – Revenue would be accounted for only on 4thApril (which will be the tax year next to the year in which invoice was raised or work got completed) when payment is received.

6

For Example – Your mobile bill dated 15th February to 15th March has been received. This bill will be captured as an expense in the month of March for accounting purposes – though you may or may not pay this until 31st March (you may actually pay in the next tax year). Note that on an estimated basis your mobile cost for remaining 15 days of March may also be accrued using a reasonable basis when your books of accounts are closed on 31st March for tax purposes. For Example – Your mobile bill dated 15th February to 15th March has been received and this bill will be booked as an expense in the month of March when you pay it before the 31st March (therefore gets booked in the same tax year). If you decide to pay it in April it will get booked as an expense in the next tax year (though the expense or mobile usage pertains to the previous tax year).

 

Note that the accounting method you choose will have to be followed for all clients, all revenues as well all expenses. It may appear that by using Cash basis of accounting you tax liability will be reduced. However, the reality is – it may only postpone your tax outgo, you will not be able to achieve a tax reduction as such. Once you choose a method of accounting you are expected to regularly comply with that method. You are not allowed to change the method of accounting often – if your intention is to save taxes or avoid taxes. Usually, it seems more logical to follow the Accrual Basis – unless your receipts are very irregular or are very uncertain.

Keep following a series of posts on Freelancers, which will be coming up shortly!

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