CHAPTER 5 Value added tax Learning objectives By the end of this chapter you should be able to: Calculate the level of VAT for inclusion on an invoice Ascertain the VAT liability of a business through offsetting VAT paid against VAT collected Record the accounting entries for VAT in the ledgers Calculate the VAT on invoices where VAT has already been included Calculate the VAT due when discounts are offered. Introduction Value added tax(vat) is a tax on sales used in the UK. For most goods and services sold in the UK part of the selling price will not contribute to the business s profits but will be passed on to the government in the form of tax revenue. VAT is administered in the UK by HM Revenue and Customs a branch of the UK government. It is an indirect tax, which means that it is not collected by the government directly but is collected by businesses on behalf of the government. It is a requirement on EU members to impose a form of VAT. The minimum level allowable by the EU is set at 15% (though some countries impose an equivalent to VAT as high as 25%). Some goods and services are zero rated (e.g. food in supermarkets), and UK domestic fuel for heating is subject to VAT at 5%. From 4 January 2011, most goods and services in the UK will be subject to VAT at the rate of 20% (it had been 17.5% prior to 2011). Businesses with a taxable turnover above a certain amount are obliged to register for VAT and then have to make payments to the government on a regular basis. From 2011 the standard rate of UK Value added tax will be 20% M05_WOOD5008_01_SE_C05.docx.doc 1 4/5/2011
The administration of VAT WOOD: Business Accounting Basics, 01 VAT is collected by businesses involved in the production of a good or service who sell this on to another consumer regardless of whether this is the final consumer, or whether this consumer will, in turn, add something to the good and then sell it on to another consumer. However, businesses are allowed to claim back the VAT that is paid on the purchase of products and other inputs into the production process. Rather than having to collect VAT on any sales made and also pay VAT on any purchases made, businesses can use the amount paid on purchases to offset (reduce) the amount paid on any sales made. The final consumer of the product has no-one to sell the product to and therefore the final consumer will pay the full 20% VAT. Example 5.1 During May 2012, a business sells 15,000 of goods (before the addition of VAT). During the same period, the business has also purchased goods for 9,000 (also before the addition of VAT). VAT due on sales = 15,000 20% = 3,000 VAT paid on purchases = 9,000 20% = 1,800 The difference between the two will be the VAT due = 1,200. VAT and double-entry bookkeeping The double-entry system can be modified for the inclusion of VAT with a few simple amendments. It will also need including in day book entries before these are posted to the ledger accounts. Given that the tax is collected by traders and businesses on behalf of the government, invoice totals will include the VAT. However, we must ensure that only the net amount (excluding VAT) is entered into the sales, purchases and returns accounts. M05_WOOD5008_01_SE_C05.docx.doc 2 4/5/2011
Credit purchases Credit purchases are posted to the ledger accounts as follows: DEBIT ENTRIES Purchases account Dr. Creditor s account Dr. VAT on purchases VAT account CREDIT ENTRIES Creditor s account Cr. Full amount owed You will notice that there are two debit entries for the one credit entry. The total of the two debits the net purchase (without VAT) and the VAT itself will equal the credit entry the credit purchase with VAT included (the gross total) which is credited to the supplier s account. Credit sales These are treated in the same way. Credit sales with VAT Debit Debtor s account with gross amount Credit Sales account with net sale (no VAT) VAT account with VAT on sale Returns The same applies to both returns inwards and returns outwards. Returns inwards with VAT Debit Returns inwards with net amount Credit Debtor s account with gross amount M05_WOOD5008_01_SE_C05.docx.doc 3 4/5/2011
VAT on returns inwards Returns outwards with VAT Debit Creditor s account with gross amount Credit Returns outwards with net amount VAT on returns outwards As stated earlier, the selling price of a good will include VAT, which means that part of the business s overall sales revenue will not contribute to the business s profits. A more comprehensive example follows. Example 5.2 The following example shows how entries are posted from the day books to the ledger accounts, with the monthly totals being transferred to the accounts in the general ledger including the VAT account. Most examination assessment questions will not go into this much detail but the example is useful in showing you how the system works in full. Sales day book 2018 Net VAT Gross April 5 G Charman 400.00 80.00 480.00 April 24 H Morris 300.00 60.00 360.00 Transferred to General Ledger 700.00 140.00 840.00 Purchases day book 2018 Net VAT Gross April 1 HWilde 200.00 40.00 240.00 April 12 B Dean 50.00 10.00 60.00 April 22 HWilde 150.00 30.00 180.00 M05_WOOD5008_01_SE_C05.docx.doc 4 4/5/2011
Transferred to General Ledger 400.00 80.00 480.00 Returns inwards day book 2018 Net VAT Gross April 24 G Charman 40.00 8.00 48.00 Transferred to General Ledger 40.00 8.00 48.00 Returns outwards day book 2018 Net VAT Gross April 7 HWilde 20.00 4.00 24.00 April 19 B Dean 10.00 2.00 12.00 Transferred to General Ledger 30.00 6.00 36.00 As covered in Chapter 4, the individual transactions are posted to the personal accounts of the debtors and creditors and the monthly totals are posted to the sales, the purchases, the returns, and the VAT accounts in the general ledger. For example, when looking at the above sales day book, the individual entries debited to the debtors accounts will total 840, while the net amounts credited to the VAT and sales accounts combined will also total 840 thus maintaining the integrity of the double-entry system. The entries in the three ledgers will be as follows: Sales Ledger: G Charman 2018 2018 April 5 Sales 480 April 24 Returns inwards 48 M05_WOOD5008_01_SE_C05.docx.doc 5 4/5/2011
H Morris 2018 2018 April 24 Sales 360 Purchases Ledger: H Wilde 2018 2018 April 7 Returns outwards 24 April 1 Purchases 240 April 22 Purchases 180 B Dean 2018 2018 April 19 Returns outwards 12 April 12 Purchases 60 General Ledger: Sales 2018 2018 April 30 Total for month 700 Purchases 2018 2018 April 30 Total for month 400 Returns inwards 2018 2018 April 30 Total for month 40 Returns outwards 2018 2018 M05_WOOD5008_01_SE_C05.docx.doc 6 4/5/2011
April 30 Total for month 30 VAT 2018 2018 April 30 VAT on purchases 80 April 30 VAT on sales 140 April 30 VAT on returns inwards 8 April 30 VAT on returns 6 outwards April 30 Balance c/d 58 146 146 May 1 Balance b/d 58 The outstanding balance on the VAT account represents what the business owes to HM Revenue and Customs. It represents the VAT collected less the VAT that has been paid and can be offset against the VAT owing. Until the payment is actually made, the amount for VAT owing would appear as a current liability on the statement of financial position. If the amount was paid on 17 May, the entry would appear as follows: VAT 2018 2018 May 17 Cash book 58 May 1 Balance b/d 58 If the balance brought down had been a debit balance, the business could claim back VAT from HM Revenue and Customs as it would have paid more for VAT than the business had collected from VAT on sales. Given that the value of sales normally exceeds purchases this situation is unlikely to be anything other than short-lived, and most businesses would not bother to claim the amount back as in the long run the business will pay more in VAT than it claims back. You should now attempt review questions 5.1 to 5.4. M05_WOOD5008_01_SE_C05.docx.doc 7 4/5/2011
Other items in the VAT account WOOD: Business Accounting Basics, 01 Non-current assets VAT is likely to be included on the non-current assets that the business purchases as well as other expenses related to the running of operations. Some businesses will be able to reclaim the VAT paid on the purchase of non-current assets by offsetting it against VAT payable on sales, in the same way that VAT paid on purchases is used. Example 5.3 If a machine costs 5,000 (net of VAT), the VAT added on would total 1,000 (20% of 5,000). If the business can reclaim the VAT back on this purchase the entries in the ledger accounts would be as follows: Where VAT can be reclaimed on purchases of non-current assets: Machinery Bank 5,000 Cash book Machinery (plus VAT) 6,000 VAT VAT on machinery 1,000 Where VAT cannot be reclaimed on purchases of non-current assets: Machinery Bank 6,000 M05_WOOD5008_01_SE_C05.docx.doc 8 4/5/2011
Cash book Machinery (plus VAT) 6,000 We can see that whether the VAT can be reclaimed or not the total of the two debits equals the credit entry. Instructions will normally be provided as to whether or not the business is allowed to reclaim VAT when purchasing non-current assets. Cash sales and cash expenses Especially for smaller businesses, there may be small amounts that may be entered into the VAT account. VAT collected on cash sales should be treated in the same way as the VAT collected from debtors on credit sales. Likewise, VAT that can be reclaimed on expenses (petty cash payments and others) would be debited to the VAT account in the same way as VAT on purchases is accounted for. One complication that may be encountered is where the VAT has already been added in the amount. The problem here is that simply subtracting 20% from the total given will NOT give the correct amount. If this is thought about then it is obvious if an amount is increased by adding 20% VAT on top of the original total, the new total is higher, and 20% of this new, higher total, will not be the same. The correct procedure used would be to multiply the total figure as follows: VAT total = 20 x Gross total 120 M05_WOOD5008_01_SE_C05.docx.doc 9 4/5/2011
Example 5.4 If cash sales for a period totalled 618.60 and already included VAT, then we can work out how much VAT was due on this as follows: VAT total = 20 x 618.60 = 103.12 120 You should now attempt review questions 5.5 to 5.11. VAT and discounts Trade discounts do not appear in ledger accounts. However, cash discounts (for prompt payment) will appear and the inclusion of VAT in these invoices with discounts will complicate matters. VAT will always be calculated on the assumption that the cash discount is taken i.e. the lowest possible total. Even if the payment arrives too late to qualify for the discount, the VAT will be calculated assuming the discount is taken. Example 5.5 A business sells goods worth 750 but allows a trade discount of 20%. A cash discount is offered for prompt payment at a rate of 5%. What would be the invoice total for this sale? Stage 1: Deduct the trade discount. 750 less 20% equals 600 (750 150). Stage 2: Deduct the cash discount. 600 less 5% equals 570 (30 being the cash discount). Stage 3: Calculate the VAT. M05_WOOD5008_01_SE_C05.docx.doc 10 4/5/2011
570 20% equals 114. Stage 4: Calculate the invoice total (adding the VAT on before the cash discount is deducted). 600 + 114 = 714. If the cash discount is taken then the debtor would pay 714 less the 30 discount, i.e. 684. The trade discount has no effect as it is not included in the accounting aspect of the sale. A common mistake is to add the VAT on to the amount after the cash discount is deducted. It is important to remember that the invoice total will be before the cash discount is taken. You should now attempt review questions 5.12 to 5.16. Chapter review By now you should understand the following: How VAT is calculated How to enter VAT in the double-entry system thus calculating the liability for VAT for a business How to calculate VAT when the invoice is already inclusive of VAT How to calculate VAT on an invoice subject to trade and cash discounts. Handy hints The following hints will help you avoid errors. Ensure that you are familiar with the rate of VAT to be used in any question. VAT is a liability so remember that any VAT a business collects will be credited to the VAT account and any paid will be debited. Remember that to calculate VAT when it is inclusive you cannot simply deduct 17.5% it will not get you back to the pre-tax value. M05_WOOD5008_01_SE_C05.docx.doc 11 4/5/2011
When dealing with discounts, remember that when calculating the VAT it is necessary to base it on the assumption that cash discounts will be taken, but the VAT will be added on top of the invoice before the discount is deducted. Key terms VAT(Value Added Tax) A tax placed on most goods and services in the UK, currently normally levied at 20% Zero rated goods/servicesgoods and services which are not subject to VAT, such as children s clothing REVIEW QUESTIONS For each question, assume that VAT is levied at the rate of 20%. 5.1 From the following day book extracts, construct a VAT account for the month of July 2007. Net figures (before addition of VAT) for July 2007 Sales for month 1,750 Purchases for month 1,125 Returns inwards for month 230 Returns outwards for month 178 5.2 From the following day book extracts, construct a VAT account for the month of October 2008. Net figures (before addition of VAT) for October 2008 Sales for month 12,560 Purchases for month 8,790 Returns inwards for month 456 Returns outwards for month 670 5.3 From the following day book extracts, construct a VAT account for the month of March 2003. Net figures (before addition of VAT) for March 2003 Sales for month 895 Purchases for month 785 M05_WOOD5008_01_SE_C05.docx.doc 12 4/5/2011
Returns inwards for month 18 Returns outwards for month 9 Additional information: (i) VAT owing as at 1 March 2003 was 26. (ii) VAT paid on 9 March 2003 was 145. 5.4 Consider the following account: VAT 2003 2003 May 31 VAT on purchases 289 May 1 Balance b/d 56 May 31 VAT on returns inwards 12 May 31 VAT on sales 546 May 31 Balance c/d? May 31 VAT on returns outwards 7 609 609 June 1 Balance b/d? (i) What does the balance on May 1 represent? (ii) Calculate the balance for June 1. (iii) Where will the balance for June 1 appear in the final accounts? 5.5 Bradleigh Payne s books show the following information for February 2005: VAT on sales for the month was 867.54. VAT on returns inwards was 12.54. VAT on purchases for the month was 342.54. Cash expenses paid during the month totalled 108.60 which included reclaimable VAT at 17.5%. Calculate the amount of VAT due for the month of February 2005. 5.6 From the following day book extracts, construct a VAT account for the month of May 2019. Net figures (before addition of VAT) for May 2019 Sales for month 1,123.50 Purchases for month 765.75 Returns inwards for month 98.00 M05_WOOD5008_01_SE_C05.docx.doc 13 4/5/2011
Returns outwards for month 103.00 Additional information: Cash sales inclusive of VAT for May totalled 484.20. 5.7 From the following day book extracts, construct a VAT account for the month of June 2007. Net figures (before addition of VAT) for June 2007 Sales for month 7,450 Purchases for month 5,780 Returns inwards for month 874 Returns outwards for month 1,010 Additional information: (i) Cash sales inclusive of VAT for June totalled 984. (ii) Non-current assets were purchased during June which include VAT of 350 which can be reclaimed. 5.8 From the following day book extracts, construct a VAT account for the month of March 2005. Net figures (before addition of VAT) for March 2005 Sales for month 3,240 Purchases for month 2,850 Returns inwards for month 214 Returns outwards for month 180 Additional information: (i) VAT owing as at 1 March 2005 was 320. (ii) Cash sales inclusive of VAT for March totalled 1,272. (iii) Petty cash expenses incurred in March totalled 123 inclusive of VAT (which can be reclaimed). 5.9 From the following day book extracts, construct a VAT account for the month of April 2006. M05_WOOD5008_01_SE_C05.docx.doc 14 4/5/2011
Net figures (before addition of VAT) for April 2006 Sales for month 5,240 Purchases for month 3,950 Returns inwards for month 412 Returns outwards for month 380 Additional information: (i) VAT owing as at 1 April 2006 was 220.73. (ii) Cash sales inclusive of VAT for April totalled 870. (iii) Petty cash expenses incurred in April totalled 342 inclusive of VAT (which can be reclaimed). (iv) Fixed assets were purchased during April which includes VAT of 450 which could be reclaimed. (v) VAT paid on April 18 totalled 299. 5.10 The following extracts are taken from the day books of David Conlon for the three months ended 30 June 2004. Sales day book Details Net VAT Total Total for period 785.00 157.00 942.00 Purchases day book Details Net VAT Total Total for period 562.00 112.40 674.40 Sales returns day book Details Net VAT Total Total for period 68.00 13.60 81.60 Purchases returns day book Details Net VAT Total Total for period 44.00 8.80 52.80 M05_WOOD5008_01_SE_C05.docx.doc 15 4/5/2011
Additional information: (i) As at 1 April 2004 there was a debit balance in the VAT account of 117. (ii) A payment for VAT of 183 was made on 24 May 2004. (iii) VAT reclaimable on expenses totalled 58 for the three months to 30 June 2004. From the above information, construct a VAT account for the three months ending 30 June 2004. 5.11 From the following transactions, construct the sales, purchases and both returns day books for the month of May 2001. Transfer the totals for the month to the VAT account. 2001 May 1 Bought goods on credit 300 from A Davidson, 200 from C Platt May 8 Sold goods on credit to M Cousins worth 800 May 12 Bought goods on credit from G Guy totalling 250 May 15 Sold goods on credit to F Connelly for 550 May 18 Returned goods to Platt for 36 May 22 Sold goods on credit to M Cousins for 280 May 25 Connelly returned goods worth 120 May 28 Granville returned goods worth 82 5.12 For the following sales transactions calculate the following: (i) Sales invoice totals with VAT at 17.5% (ii) Amount due if the cash discount is taken. (a) Sales of 1,500 with a cash discount of 5% (b) Sales of 1,000 with a trade discount of 20% and a cash discount of 2.5% (c) Sales of 2,000 with a trade discount of 10% and a cash discount of 1.25% (d) Sales of 640 with a trade discount of 25% and a cash discount of 3% 5.13 Calculate the VAT on each of the following transactions: (a) Cash sales inclusive of VAT totalling 274.92 (b) Net sales totalling 1,345.00 (c) Petty cash expenses inclusive of VAT totalling 38.70. 5.14 Twelve tube alloys are sold to Moir Ltd for 40 each. A trade discount of 20% is allowed on the order and a cash discount of 5% is offered. However, Moir Ltd returns four of these. Calculate the value of the credit note to be issued to Moir Ltd. M05_WOOD5008_01_SE_C05.docx.doc 16 4/5/2011
5.15 Twenty-five Stembolts are sold for 8 each. A trade discount of 25% is offered on the sale. A discount of 2.5% is allowed for prompt payment. Calculate the value of the invoice for the total transaction. 5.16 Chris Cureton s books show the following information for January 2005: Cash sales were 413.70 including VAT at 17.5%. VAT on credit sales for the month was 1,898.66. Equipment purchased on 15 January 2005 included reclaimable VAT of 450. Calculate the amount of VAT due for the month of January 2005. M05_WOOD5008_01_SE_C05.docx.doc 17 4/5/2011