Sales tax

This chapter explains sales tax (VAT) as a consumption tax that businesses collect from customers and then remit to the tax authorities. You’ll learn how input tax and output tax work, and how to record sales and purchases that include sales tax.

Learning objectives

By the end of this chapter, you should be able to:

• Describe the principles of the operation of a sales tax
• Calculate sales tax on transactions and record it in the sales tax general ledger account.

Introduction

Sales tax is referred to as value-added tax (VAT) in some jurisdictions. In general, businesses buy items as inputs, add value, and resell the output to customers.

Definitions

Sales tax

The tax paid or payable on the value added. It is a consumption tax and is imposed by the government on the sale of goods and services at the point of purchase.

Businesses registered for VAT collect this tax from customers and remit it periodically (often monthly to quarterly, depending on the jurisdiction) to the relevant tax authorities. The tax rate varies by jurisdiction and may differ across product categories. Some essential items may be exempt or taxed at lower rates.

There are two types of sales tax, namely:

• Input tax
• Output tax

Definitions

Input VAT (Tax)

The tax a business pays on its inputs (i.e., goods purchased from suppliers).

Output VAT (Tax)

The tax a business charges on its outputs (i.e., goods sold to customers).

At the end of each period:

• If output tax exceeds input tax, the excess is remitted to the tax authorities.
• If input tax exceeds output tax, the excess is due back to the business. In practice, the excess is often offset against future tax obligations rather than refunded in cash.

Computation of sales tax

Sales tax is calculated by multiplying the tax rate by the sales amount (exclusive of tax). In examination questions, sales figures may be given either exclusive or inclusive (gross) of tax.

If an amount is inclusive of sales tax, tax has already been added to the selling price. In that case, you need to separate the tax portion from the gross amount.

See the illustrations below.

Illustration 1: Exclusive of sales tax

KDK Ltd makes a sale of $ 1,000.00 exclusive of sales tax. Given a sales tax rate of 15%:

1. What is the sales tax?
2. What are the gross sales?

Compute the sales tax.

Compute the gross sales.

Illustration 2: Inclusive of sales tax

KDK Ltd makes a sale of $ 1,000 inclusive of tax. Given a sales tax rate of 15%:

1. What is the sales tax?
2. What are the gross sales?

Compute the sales tax.

Compute the net sales.

Alternatively, you can compute the net sales (exclusive of tax) first, and then compute the sales tax from the difference.

Accounting treatment for sales tax

Definitions

Output tax

Sales tax charged on sales to customers ( output tax) is not business revenue. The business collects it on behalf of the government, so revenue is recorded net of tax.

The accounting entries to be passed when the sales are cash (credit):

Debit: Cash (receivable)

Credit: Sales (net of taxes)

Credit: Sales tax (output tax)

Input tax

In the same way, tax paid on purchases (input tax) does not form part of the entity’s purchases. The accounting entries to be passed when the purchases are cash (credit):

Debit: Purchases (net of taxes)

Debit: Sales tax (input tax)

Credit: Cash (Account payables)

Sales tax control account

Businesses use a sales tax control account to record both output and input taxes.

• If input tax exceeds output tax, the excess is an asset (a balance due back from the tax authorities).
• If output tax exceeds input tax, the excess is a liability (a balance to be remitted to the tax authorities). Illustration: Sales tax control account

KDK Ltd purchased goods amounting to $1,000 tax exclusive and sold them at $1,100 inclusive of sales tax. The sales tax rate is 15%.

1. What is the input tax?
2. What is the output tax?
3. Will KDK Ltd remit to the tax authorities or otherwise, and how much?
4. Show all the journal entries to be posted that affect the sales tax ledger accounts.

Compute the input tax.

Compute the output tax.

Alternatively, we could use this approach.

Should KDK Ltd remit to the tax authorities or otherwise?

The journal entries to be posted

1. Upon purchase of the goods

2. Upon sale of the goods

Note: When you prepare the T-account for the Sales tax, the closing balance will be the tax credit. See below.