If you have not been reporting the interest income from your fixed deposits while filing tax returns, there is reason to worry. All interest income from bank FDs (including the 5-year tax saving FD), bank recurring deposits, company FDs, non-convertible debentures (NCD) and National Savings Certificate (NSC), among others, is taxable. Even when your bank cuts TDS at 10% on your Bank FD, you are liable to pay the balance tax if you fall under a higher income slab. However, there is flexibility on how you report this income.

You are allowed to report interest income either on cash or accrual basis--you can account for the income either when you receive it or when interest is due. For instance, in the cash method, if you have invested in a three-year bank FD where the interest pay out is cumulative, you can safely put off reporting the interest income for the first two years. If the interest pay out is non-cumulative, you have to report the income that year itself. Under the accrual or mercantile method, the tax on the interest income has to be paid even if the income has not been received. Even when the interest pay out is cumulative, the investor has to report the income for each year.

Which method should you follow?

By allowing you to defer tax liability until later, the cash method takes away the immediate burden for those facing cash flow problems. However, there are issues. On products like bank FDs where the bank cuts TDS on interest received, if it is in excess of `10,000 every year, the tax credit for the same will be available only in the year in which the income is offered to tax. Since the issuer would have already deducted the tax in earlier years, you would have to reconcile the same in the final year.

If you follow the cash method, there is a risk that your income may come under a higher tax slab in some years, as a result you will end up shelling more tax on the interest income than earlier. Even under the same slab, deferring the tax would result in a high sudden outgo in the year of receipt. That is why, experts advise investors to stick with the accrual method. Even though you will be hit with tax on income which you have not received, the tax pay out will be spread across many years. It is better for individual taxpayers to follow accrual method of accounting as it brings clarity to your financials and you can carry out your tax-planning on a yearly basis. Bear in mind that where TDS is not cut, the onus will be on you to compute the total interest income for the year. If you remain in the same tax slab for the entire tenure of the investment, deferring the tax liability until maturity makes more sense. Although the total tax liability under both methods would remain the same, paying tax on yearly accrual basis could mean an opportunity loss on the money paid as tax over the years. The return you would make from investing this money until maturity of the instrument, and then paying tax will yield a better result.

While you are free to choose what method of accounting to follow, you cannot switch at any time. If you are reporting interest income on your bank FD on cash basis today, you cannot start reporting it on accrual basis from next year without justification. While a one-time change in method of accounting is typically allowed, frequent changes is frowned upon by the taxman.