Well, I attempted to understand and have put notes together for a better understanding

The issue:
The NBFC has two categories of loans (assets) performing and non performing assets. The NBFC recognizes the interest income on these performing assets even when such interest income is not received. And, In the case of non performing assets, the interest income is credited to profit and loss account only when it is received .
The questions
1) Is this treatment is valid and in conformity with law?
2) Is this treatment in anyway contrary to the provision of Section 145 that rules out a concept of hybrid system of accounting?
3) Is anything made applicable to bank can also be applied to a finance company that carries out similar activity?
The reference
1) UCO Bank v Commissioner of Income Tax (1999) 237 ITR 889 (SC)
2) Extract of Section 145
3) Shakthi Finance company
The questions
Question 1. Is the treatment is valid and in conformity with law?
An explanation on the treatment of interest income for the NBFC.
1 Performing assets:
The loans that are good assets. These are standard assets. The interest and principal is recoverable.
Interest is recognized when it is due. The income is credited to profit and loss account. All these income are realizable even if its due.
2 Non performing assets.
The loans that are classified as sticky loans. The interest and principal is doubtful to recover.
Interest income on non performing assets is credited to profit and loss account only on receipt. Interest when it is not realizable is not a real or earned income. Hence Interest is recognized only in the year when it is realized.
Interest income
Yes the treatment is valid and in conformity with law. The Income Tax levies taxes only on real income (the income that could be realized) and not on notional income. The above two classification follows the concept of realizable income or real income. Only this provides the correct system of accounting and income. It is worthy to note that that the mercantile system of accounting does not require credit of interest on doubtful debts to profit and loss account as these are not earned.
The same treatment is affirmed by the Apex court in UCO Bank . In this case, The apex court also reviews and distinguishes the case of State Bank of Travancore.
The relevant extract of UCO Bank case are provided here for a ready reference.
On The issue , The court observed that
The question whether interest earned, on what have come to be known as "sticky" loans, can be considered as income or not until actual realisation, is a question which may arise before several Income-tax Officers exercising jurisdiction in different parts of the country. Under the accounting practice, interest which is transferred to the suspense account and not brought to the profit and loss account of the company is not treated as income. The question whether in a given case such "accrual" of interest is doubtful or not, may also be problematic. If, therefore, the Board has considered it necessary to lay down a general test for deciding what is a doubtful debt, and directed that all Income-tax Officers should treat such amounts as not forming part of the income of the assessee until realised, this direction by way of a circular cannot be considered as travelling beyond the powers of the Board under section 119 of the Income-tax Act. Such a circular is binding under section 119. The circular of October 9, 1984, therefore, provides a test for recognising whether a claim for interest can be treated as a doubtful claim unlikely to be recovered or not. The test provided by the said circular is to see whether, at the end of three years, the amount of interest has, in fact, been recovered by the bank or not. If it is not recovered for a period of three years, then in the fourth year and onwards the claim for interest has to be treated as a doubtful claim which need not be included in the income of the assessee until it is actually recovered.Held that.
In the present case, the circulars which have been in force are meant to ensure that while assessing the income accrued by way of interest on a "sticky" loan, the notional interest which is transferred to a suspense account pertaining to doubtful loans would not be included in the income of the assessee, if for three years such interest is not actually received. The very fact that the assessee, although generally using a mercantile system of accounting, keeps such interest amounts in a suspense account and does not bring these amounts to the profit and loss account, goes to show that the assessee is following a mixed system of accounting by which such interest is included in its income only when it is actually received. Looking to the method of accounting so adopted by the assessee in such cases, the circulars which have been issued are consistent with the provisions of section 145 and are meant to ensure that assessees of the kind specified who have to account for all such amounts of interest on doubtful loans are uniformly given the benefit under the circular and such interest amounts are not included in the income of the assessee until actually received if the conditions of the circular are satisfied. The circular of October 9, 1984, also serves another practical purpose of laying down a uniform test for the assessing authority to decide whether the interest income which is transferred to the suspense account is, in fact, arising in respect of a doubtful or "sticky" loan. This is done by providing that non-receipt of interest for the first three years will not be treated as interest on a doubtful loan. But if after three years the payment of interest is not received, from the fourth year onwards it will be treated as interest on a doubtful loan and will be added to the income only when it is actually received.And the appeal is answered in favour of assessee and against the department.
Question 2
Is this treatment in anyway contrary to the provision of Section 145 that rules out a concept of hybrid system of accounting?
The system of accounting regularly followed cannot be rejected as contrary to section 145 of the Act.
Relevant extract from the UCO Bank
We do not see any inconsistency or contradiction between the circular so issued and section 145 of the Income-tax Act. In fact, the circular clarifies the way in which these amounts are to be treated under the accounting practice followed by the lender. The circular, therefore, cannot be treated as contrary to section 145 of the Income-tax Act or illegal in any form. It is meant for a uniform administration of law by all the income-tax authorities in a specific situation and, therefore, validly issued under section 119 of the Income-tax Act. As such, the circular would be binding on the Department.It should also be noted that the Apex court in the context of the assessee crediting the interest on sticky loans to interest suspense account and not to profit and loss account treated it as a mixed system consistently followed and therefore not impermissible under section 145. Though hybrid or mixed system i.e. of both cash and mercantile system is not permissible from 1-4-1997, the system of crediting such interest on sticky loans is not a mixture of cash with mercantile system, So that it need not be taken as a barred from 1-4-1997. This is the income that is real and The real emphasis is only on the real income and its realisability and not on the notional income.
Question No 3.
Is anything made applicable to bank can also be applied to a finance company that carries out similar activity?
Non Banking finance companies also carries out a set of activities that are carried out by a bank. The Activity of making loans in NBFC is also very similar to the banks. Hence any Circular / Case law / Notification / Guideline that is made applicable to a bank could also be made applicable for a NBFC for that line of activity. Otherwise it provides for inequality and will be unconstitutional and against the principal of natural justice.
In the case of THE HIGH COURT OF MADRAS T.C.No.311 of 2001, M/s SAKTHI FINANCE LTD, COIMBATORE Vs COMMISSIONER OF INCOME TAX, COIMBATORE The provision relating to accounting of overdue interest at the time of realization decided in favour of the NBFC assessee.
More particular it is against the department contention that the UCO Bank case could be applied only to Banks and not for NBFC.
The high court has decided this case on the basis of equality and in the principal of natural justice also.
The relevant extract is provided hereunder
17. Since the right of the assessee to change the method of accounting was warranted by the needs of business and the relevancy of the situation, unless and until the Revenue is in a position to show that the real income could be siphoned out of the systems of the accounts maintained and thereby escape the net of taxation, we do not find any hesitation in answering the question in favour of the assessee. As rightly contended by the learned counsel for the assessee, the decision reported in 237 ITR 889 (UCO BANK v. CIT), as to the system of maintenance of accounts and to adopt cash system in the case of advanced packed charges, is not confined to a case of banking institutions only, and it has force in the case of institution engaged in finance transactionsSimilarity of section 145 and RBI guidelines.
Accounting standard as issued by the IT vide Notification 69 (E) dated 25/01/1996 lays down the following critical inputs :
(Relevant portions are presented)
(4) Accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business, profession or vocation in the financial statements prepared and presented on the basis of such accounting policies. For this purpose, the major considerations governing the selection and application of accounting policies are the following, namely :--
(i) Prudence.--Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information ;
…
6) For the purposes of paragraphs (1) to (5), the expressions,--
(a) "Accounting policies" means the specific accounting principles and the methods of applying those principles adopted by the assessee in the preparation and presentation of financial statements ;
(b) "Accrual" refers to the assumption that revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate ;
The above is very similar to the RBI guidelines and further The explanation of the term “Accrual” relates to income that is earned.
ConclusionThe interest on performing assets are earned even if its due and could be included in the profit and loss account, while the Interest on non performing assets until received are are not real and not earned and thus cannot be included in the profit and loss. The same will be considered earned upon receipt only.