Basic principles of VAT

Accounting Technician students studying Papers A1, B1 and C1 need to develop competence in the accounting treatment of VAT. Students at the first level of the Professional Scheme may also find this short paper useful.

Value added tax is a form of indirect taxation levied throughout the European Union.

It was introduced in the UK in the early 1970s when it replaced another indirect tax, ‘purchase tax’.

In general, VAT taxes individuals, not businesses. So that while registered businesses must charge VAT to their customers, they may also reclaim (with a few exceptions) any VAT they pay to suppliers. The net amount is paid over to HM Customs and Excise.

VAT legislation requires registered businesses to maintain proper records, including copies of invoices on which VAT is charged or payable, and to make regular returns. These are usually quarterly although in the case of smaller businesses may be annual.

VAT accounting is usually on an accruals basis – that is to say outstanding invoices are taken into account – although again smaller businesses (those with a turnover below £600,000) may by concession account on a ‘cash’ basis (when only VAT amounts actually paid and received are accounted for).

There are also (a reducing number) of special schemes for particular types of business (sale of second hand cars, for example) requiring particular information to be kept.

Smaller unregistered businesses, those making only ‘exempt’ supplies (such as banks) and individuals cannot reclaim or set off any VAT paid – and it becomes a cost to them.

To be able to register for VAT, UK businesses must currently have an annual turnover of at least £54,000 (or expect it to exceed this figure in the next 30 days).

VAT chargeable sales by registered businesses are referred to as its ‘outputs’, and the VAT charged as ‘output tax’. In a VAT context, purchases are ‘inputs’ and the VAT charged on them ‘input tax’. The standard rate of VAT is currently 17.5 per cent. It does not apply to all goods since some are either zero-rated (food, for example) while others are outside its scope (exempt). And certain goods and services enjoy a reduced rate. For example, domestic fuel is now subject to a 5 per cent rate.

Since registered businesses in effect act as a collecting agent for HM Customs and Excise, VAT charged by them does not form part of their turnover, nor VAT payable part of their costs. Any outstanding amount will, however, appear on the business balance sheet. In most circumstances HM Customs and Excise will be a creditor. Some businesses, book publishers for example, may be able to regularly claim back more VAT paid than charged. And in these circumstances the VAT repayment due will be a debtor.

All this can be accommodated within the double-entry book-keeping system. To do this, the layout of day books need to include separate columns to derive totals for gross, VAT and VAT net amounts.
Personal accounts are debited or credited as appropriate with the individual gross amounts, including VAT, of invoices received or issued, since these are the settlements required.

Inputs and input tax column totals (net and VAT) will be posted separately – one to a cost account, the other to the VAT account. Outputs and output tax will be treated in similar fashion – the net total to a sales account, the VAT total to the VAT account.

The cash book will also have a VAT column for amounts that do not pass through sales or purchase ledgers. So again, in the case of purchases, the total of VAT paid on such items will be debited to the VAT account and the net-of-VAT amount debited to the appropriate expense account.

Likewise, receipts that do not pass through the sales ledger will be split between VAT and net elements, the first being credited to the VAT account and the latter to an appropriate income account.

In this way the VAT account should always show the net amount payable to or reclaimable from HM Customs and Excise.

Of course, VAT rules are complex with many rules on what is chargeable and what is not and what constitutes an allowable invoice.

Should the VAT inspector arrive, do not be surprised if a few queries are raised and some small adjustment made.

Case study
During December, High Melton Cleaning Services, which has a November year end, had the following credit transactions:

1 Purchases from Stonehill Supplies: £450 less 20 per cent trade discount.
2 Sold goods to Northcliffe Park: £200.
5 Sold goods to Seaview Flats: £120.
8 Purchased goods from Cleaning Chemicals Ltd: £3,000 subject to 10 per cent trade discount.
12 Received credit note from Cleaning Chemicals: goods returned, list price, £500 (£450 net of 10 per cent trade discount which was applied to the original invoice).
14 Sold goods to Victoria Hotel: £1,000.
16 Sold goods to Hare and Hounds Inn: £400.
18 Sold goods to Dolphin Inn: £300.
24 Issued credit note to Northcliffe Park, goods returned £20.
28 Sold goods to Jolly Sailors Inn: £100.
31 Sold goods to Bagdale Hill: £700.

All transactions were subject to VAT. The amount of VAT owed to HM Customs and Excise on 1 December was £710.

How would these transactions be entered into the day books, nominal, sales and purchase ledger?

The answer is set out in Figure 1.

Philip E Dunn, Esk Valley Business School