Our “Dummies Guide to Debit and Credit” was well received, so we have decided to add a few more useful pieces to the series including this “Dummies guide to VAT”.
To fully comprehend the following please take the time to read our previous series:
Dummies Guide to Debit and Credit: Introduction
Dummies Guide to Debit and Credit: What is profit and Loss compared with Balance Sheet?
Dummies Guide to Debit and Credit: Transaction Types
VAT as another transaction Type
If we add VAT into the equation we see another load of transactions. VAT stands for Value Added Tax and for those entities that are registered into the scheme they add a percentage (now at 20%) to each sale, in exchange for the capacity to claim the taxable amount off their eligible supplies. In effect they become a tax agent on behalf of the government, collecting taxes that are due while deducting the taxable amount off their expenses. Usually this is declared every quarter but can be every month. (For further details see www.hmrc.gov.uk)
These extra journals need an additional nominal code structure to track what is owed and allowed to be reclaimed. As VAT is a tax it will be a liability as normally you will owe money to HMRC. In this case I am adding a layer to our chart of accounts (types of transactions) and included three categories of liability. One is VAT collected on Sales, the other VAT reclaimed on purchases and the last is the overall VAT liability.
If our business owner had been VAT registered then the journals would have looked like this:
His first transaction in month 2 was to buy £50 worth of supplies. If his supplier was VAT registered then the overall amount would now be £60 (£50 for the materials and £10 VAT @ 20%). The amount owed to the supplier has risen to £60 but the amount debited as an expense is still £50. What is added is third line for the negative liability (HMRC owes them) for £10.
Month 2
| Debit | Clic | ||
| Debtor | Credit | 60 | |
| Expense | Liability | ||
| VAT on Sales | |||
| 10 | VAT on Purchases | ||
| VAT liability | |||
| Asett | 100 | Income | |
| Debit | 50 | Capital | 100 |
In the next month he makes a sale for £100 but the amount he charges the customer is £120 which is £100 for the item(s) and £20 for the VAT. The income level is still the same at £100 but the amount owed in debtors has increased to £120. The third line is now £20 credited to the VAT on Sales so that increases what is owed to HMRC
Month 3
| Debit | Clic | ||
| Debtor | 120 | Credit | 60 |
| Expense | Liability | ||
| VAT on Sales | 20 | ||
| 10 | VAT on Purchases | ||
| VAT liability | |||
| Asett | 100 | Income | 100 |
| Debit | 50 | Capital | 100 |
In the next month the amount of VAT owing is calculated. To work out the amount owed two transactions are required. One is to clear out the VAT on Sales so that is ready for the next quarter and declare the liability owed.
| 20 | VAT on Sales | ||
| 10 | VAT on Purchases | ||
| VAT liability | 20 |
The other clears the VAT on purchases and reduces the overall liability.
| VAT on Purchases | 10 | ||
| 10 | VAT liability | 20 |
The End result is debiting £20 against a credit of £10 which leaves an amount of £10 to be paid to HMRC.
Month 4
| Debit | Clic | ||
| Debtor | 120 | Credit | 60 |
| Expense | Liability | ||
| VAT on Sales | 0 | ||
| 0 | VAT on Purchases | ||
| VAT liability | 10 | ||
| Asett | 100 | Income | 100 |
| Debit | 50 | Capital | 100 |
Even though the customer has not paid and he has not settled his debt to the supplier, they still have to pay HMRC. Our business owner reduces his asset, or cash in bank to clear his debt of £10 to HMRC even though our business owner has not received that amount from the customer.
Month 5
| Debit | Clic | ||
| Debtor | 120 | Credit | 60 |
| Expense | Liability | ||
| VAT on Sales | 0 | ||
| 0 | VAT on Purchases | ||
| VAT liability | 0 | ||
| Asett | 90 | Income | 100 |
| Debit | 50 | Capital | 100 |
The VAT accounts are now cleared to begin recording transactions for the next quarter.
Payment of the VAT
This exercise is based on the standard scheme which is calculated on the invoices sent out and received regardless of whether they have been paid. For businesses that have problems collecting money from debtors, they can claim “Cash VAT accounting scheme” which is set to money received or paid out which helps with cashflow but you lose the control of clearing VAT on Sales and Purchases accounts which means you know that the VAT return calculations are correct. With VAT cash accounting those amounts will never clear down due to time delays in paying invoices.
So, for VAT each time a sale is made a liability is allowed for the tax collected from the client. This liability is reduced by the VAT on the purchase which is reclaimed. At the end of the quarter the debt is cleared from the VAT liability be reducing that amount from the bank account. These journals help to keep track of what is owed and how it affects the value of the business.
Go to our downloads section for our interactive widgets for 3 month cashflow and petty cash book with VAT available for subcribers. Read further articles on the advantages of using VAT and what type of VAT should I apply for?
We help set up accounting software packages for both windows and Mac formats. Go to our Services page for more information. For help with Making Tax Digital for those on Mac or PC click here.
