What is value added tax-VAT?
Value-added tax (VAT) is a tax that is charged at each level or point of sale where value addition is made in a product. The tax is levied on each step, like a producer of raw materials sells his products to a factory, factory transfers the finished good to wholesalers, the wholesalers sell it to a retailer, and ultimately the retailers sell this product to an end consumer who uses it.
The consumer pays VAT to the retailer from whom he has purchased a product. All the buyers in the prior stage have reimbursed the VAT by succeeding buyers in the whole process. The VAT system is most common in European countries. So, it means that it’s an expense for the consumer and not for the manufacturer and seller.
Calculation of VAT
Value-added tax is charged as a percentage of the total cost of a product. For instance, if the cost of a product is $1500 and the percentage at which VAT is charged is 10%. The consumer will pay $1650. The merchant in this case will keep $1500. The remaining amount i.e., $150 will be paid to the government.
How To Account for VAT in accounting
VAT is usually categorized into two categories. i.e., Input VAT and Output VAT. VAT input is recorded when there is a purchase of goods. Contrary to that, during a sale, a company records VAT output. The figures of input and output VAT are calculated and the excess of output over input is paid to the government’s account. It’s useful to keep records of goods bought that incorporate VAT because it will then be allowed to subtract the value of Input tax from Output tax to reach those figures which a business has to pay to regulatory bodies.
Journal Entries for VAT
The accurate treatment of VAT by following the requirements of International Account Standards (IAS) is compulsory for every company. You have to pass the following journal entries.
- Raw materials are purchased from the market by paying the cost and input tax on these materials. The entry will be:
| Particulars | l/f | Debit | Credit |
| Purchase Account | XXX | ||
| Input VAT Account | XXX | ||
| Cash/Creditor | XXX |
- Finished goods are sold to customers and output VAT is also collected from respective customers. The entry will be:
| Particulars | l/f | Debit | Credit |
| Cash/Accounts receivables | XXX | ||
| Sale Account | XXX | ||
| Output VAT payable account | XXX |
- Now we will have to calculate the amount that will be paid to the government. This amount is calculated as a difference between input tax paid and output tax received from customers. Two situations may arise here.
- Input tax greater than output tax
- Output tax collected from the customer is great than the input tax. In this case, following journal entry will be passed.
| Particulars | l/f | Debit | Credit |
| VAT payable Account(net) | XXX | ||
| Bank Account | XXX |
The debit impact of this transaction is the removal of liability from the books of accounts. On the other hand, the credit impact is an outflow of cash from business and payment to the Government.
Example
- TPL ltd. company has purchased raw materials from its suppliers costing @10,000(exclusive of VAT). Assume that rate of VAT is 10%.
| Particulars | l/f | Debit | Credit |
| Purchase Account | 10,000 | ||
| Input VAT Account | 1,000 | ||
| Cash/Creditor | 11,000 |
- TPL ltd. company has sold goods at price of $12,000 (exclusive of VAT) to one of its customers. Assume that rate of VAT is 10%.
| Particulars | l/f | Debit | Credit |
| Cash/Accounts receivables | 13,200 | ||
| Sale Account | 12,000 | ||
| Output VAT payable account | 1,200 |
- At the end of the period, excess output VAT over input was paid to the government.
| Particulars | l/f | Debit | Credit |
| VAT payable Account(net) | 200 | ||
| Bank Account | 200 |
Conclusion
Value-added tax is added at all stages of the good flow. For instance, the manufacturer purchases raw material from a supplier and pays VAT. Then, the manufacturer adds certain value by converting raw material to finished goods. At this stage, the manufacturer sells the goods to the whole seller and collects VAT from them.
In the next stage, the whole seller sells goods to the retailer and collects VAT from them. In the end, the retailer sells goods to the consumer and collects VAT.
Hence, VAT is an expense only for the consumers. And not for the manufacturer, whole seller, and retailers.
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