VAT: What it is and how it works
Value Added Tax (VAT) is often a somewhat mystical concept.
In this tutorial we offer a simple explanation that gets to the heart of what it is, how it works and how we deal with the accounting side of VAT.
What is VAT?
The simplest way to explain VAT is by way of an example.
In a world with no VAT Mr Farmer sells his produce to Mrs Deli down the road. Mrs Deli uses this produce in the food she sells to Joe Soap, the Software Consultant, who often has a bite to eat at the Deli.
Here’s what the accounting will look like: Mr Farmer sold his goods to Mrs Deli for R20, Mrs Deli then took these goods and turned them into lunch which she sells to Joe Soap for R100.
Inject VAT into this scenario and this is what it would look like:
Mr Farmer sells his produce to Mrs Deli for R22.80 (R20 with 14% tax added on top of it) because he is what they call a “VAT Vendor” which is basically someone who signed up to collect taxes on behalf of SARS.
So he adds VAT as a percentage on top of his selling price. Mrs Deli hands over R22.80 in cash rather than the R20 in the world without VAT. When Mrs Deli sells lunch to Joe Soap, since she is also a VAT vendor, she charges him R114 rather than R100.
Why would anyone sign up for a job as SARS’ little helper?
Well, there are two reasons for this. One is that VAT vendors are allowed to deduct the VAT that they are paying in producing their goods or services from the amount that they have to pay over to SARS.
The second reason is because of the law. Businesses whose income exceeds a certain amount must register for VAT. At the time of writing, the tax threshold here in South Africa was R1million turnover per annum.
Let us look at Mrs Deli’s business to see how this works. First she buys ingredients and pays R22.80 in cash. (The R2.80 that she pays is called Input VAT.) She then uses these ingredients to make lunch. She sells a meal to Joe Soap and makes an income of R114. (The R14 she charges him is called Output Vat.)
At the end of every VAT period, in most cases this is bi-monthly, Mrs Deli needs to add up all the Output VAT and Input VAT. Then she needs to pay the difference over to SARS.
There are few other complications such as and inclusions, exclusions but this should help you understand enough to go on to the next section.
How does VAT affect accounting?
Lets look at another basic sale and see how Vat impacts the accounting.
Company A sells widgets to company B for R5,000. They pay via EFT.
What are the accounts involved?
Sales and Bank.
The business accounts would look something like this:
Let’s do the same transaction but now let’s introduce VAT:
The difference between the two scenarios are that in the second instance the amount the customer is charged and pays is R700 more than in the first example (5,000 vs 5,700).
In both cases the company’s Sales are the same. This is because even though the customer owes R5,700 only R5,000 belongs to the business. The 700 that the business collects belongs to SARS.
A third account is added to the list of accounts affected. The transaction now affects Sales, Debtors and Vat Control. The VAT Control Account keeps a running balance of the difference between VAT Outputs and Inputs. VAT Control Account is a liability. This means that this amount is owed to someone outside of the business. R700 is now owed to SARS.
Let’s add another transaction to this scenario. The company bought the widgets from Supplier A for R2,850 and paid via EFT. Our supplier is a VAT vendor. So the invoice shows R2,500 + R350 VAT.
The new transaction also affects three accounts. Cost of Sales, Bank and VAT Control.
Let’s start with the Bank. We actually pay our supplier R2,850 in cash. So our Bank Account decreases by R2,850.
Cost of Sales is only affected with R2,500 because the R350 that was included in the payment to Supplier A will be deducted from the amount owing to SARS.
The VAT Control Account showed R700 owing to SARS before this transaction. Since we’ve added this transaction, this amount has decreased to R350. R700 less the R350 from our suppliers payment.
If these were the company’s only two transactions they would pay SARS the R350 in Cash and their accounts would look like this:
Below is an example of a report used for calculating vat and filing VAT Returns:
Typically, if you are using business operating software, these reports are automatically generated while you capture receipts, payments, customer invoices and supplier invoices.
These reports group inputs and outputs together and calculate how much is due to you or is payable to SARS.
Quickfire VAT Facts
You can only claim VAT on invoices that charge VAT.
If you claiming vat on an invoice you need to keep this document and make sure that the supplier has put your VAT number on their invoice.
VAT adds a very slight complexity to the basic accounting you’ve been learning so far. As in all things, sticking to the basics will help you navigate this easily.
Remember VAT is simply collecting money on behalf of SARS. In return, you get to get claim VAT on some of your business expenses.
This means you need to keep track of all sales as well as all expenses you can claim.