VAT is basically a consumption tax that is levied on goods and services at every stage of the supply chain; typically where value is added, from the initial production to the point of sale. The VAT that the user pays depends on the underlying cost of the product, adjusted for any cost of materials in the product that has already been taxed at any previous stage.
VAT is based on consumption as compared to income. It is charged equally on every purchase that is made, as opposed to progressive income tax, which levies taxes on a progressive basis. It is considered to be a simple and a more standardized traditional sales tax, with lesser compliance-related issues.
How VAT works?
VAT is imposed on the gross margin of the product, across all the processes. For example, it is going to be imposed on manufacturing, distributing, as well as selling of an item. The tax is subsequently assessed and collected at every stage. This is slightly different from the sales tax system, which requires taxes to be assessed and paid only by consumers at the end of the supply chain.
Input VAT Vs Output VAT
Output VAT is the VAT that is calculated and charged on the sale of own goods and services. On the other hand, the Input VAT is the VAT that is paid as a price on goods and services that have been procured by the company. In other words, Input VAT is levied on purchases, whereas Output VAT is levied on sales of goods and services.
Example of VAT
The concept of VAT is illustrated in the following example:
Macy Co. produces leather bags and sells it at their outlet. For this purpose, they procure the leather, hand it to a third-party manufacturer, and then sell it at their outlet. The applicable VAT rate is 10%.
Let’s assume that for a bag, the leather cost amounts to $2. With 10% VAT that is applicable, the rate charged from the supplier of Macy Co. amounts to $2.20.
Subsequently, the manufacturer processes the leather and then passes it on to the retailer at $5. This would also see a VAT markup equivalent to $0.5. Therefore, the total cost of the bag is now $5.50.
At the retail outlet, the bag sells for $10 plus VAT. Therefore, the cost of the bag to the consumer would be $10.10.
Is VAT an expense?
VAT is not considered to be an expense. This is because it is not a cost incurred as a result of the operations or production of the company. In fact, this is a tax that is imposed by the government. Organizations are just a carrier that deals with the money that belongs to the government. It is imperative to understand that there is an underlying need to categorize VAT as a liability (or an asset) that needs to be settled by the government.
Accounting Treatment of VAT
VAT is recorded as a tax liability in the financial statements of the company. It is not expensed, and therefore, it does not impact the profit and loss and loss statement. If VAT is payable at a given year-end, it is charged in the financial accounts as a paid liability.
When dealing with VAT, the journal entries differ depending on the type of transaction involved. Journal entries that are required for VAT are given below:
When goods are purchased – and both purchase cost and VAT has to be paid
In order to record the aforementioned transaction, the following journal entries are made:
| Account | Debit | Credit |
| Purchase | xxx | |
| VAT Input | xxx | |
| Cash (or Bank) | xxx |
Purchases are debited in the profit and loss account because they are an expense, and they increase the assets of the company. In the same manner, VAT input can either be a Current Asset or a Negative Current Liability. The decision of Current Asset or Negative Current Liability depends on the output tax that is charged. In case the output tax is equivalent to the input tax paid, then it will be automatically written off. In the case where the input tax is higher than the output tax, it will result in a tax asset, and if the output tax is lower than the input tax, it will result in tax liability (i.e., VAT liability).
When goods are sold – and the company receives both the Sale Value and the VAT output received
In order to record the aforementioned transaction, the following journal entries are made:
| Account | Debit | Credit |
| Cash (or Bank) | xxx | |
| Sales | xxx | |
| VAT Output | xxx |
Just like the normal course of VAT, sales are recorded as credits in the income statement. In the same manner, Current Asset is also increased because there is an influx in the bank account (or Current Asset account). In the same manner, the amount that has been received in the form of VAT is also going to be credited because this amount is a current liability, which needs to be paid to the government.
When VAT is paid to the government
In the case where VAT is settled and the payment is made to the government, the following journal entries are required:
In order to record the aforementioned transaction, the following journal entries are made:
| Account | Debit | Credit |
| Net VAT Payable (Excess of Output over Input) | xxx | |
| Bank | xxx |
The journal entries above represent that the organization merely settles the amount that is owed to the government. In most circumstances, this transaction holds true. However, if the input tax exceeds the output tax, then it acts as a tax asset, that can be adjusted for in the near future.
