Sales tax

This chapter explains sales tax 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 sales tax 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 tax

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

Output 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 net sales (exclusive of tax)?

Compute the sales tax.

Compute the net sales.

Accounting treatment for sales tax

Output tax is not revenue: the business collects it on behalf of the government. Input tax is not part of purchases: it is recoverable from (or offset against) the tax authorities. So sales and purchases are both recorded net of tax.

Sale with sales tax

	Debit	Credit
Cash (receivable)	X
Sales (net of tax)		X
Sales tax (output tax)		X

Purchase with sales tax

	Debit	Credit
Purchases (net of tax)	X
Sales tax (input tax)	X
Cash (payables)		X

Returns and discounts

• A sales return reverses the original sale, including its tax: debit sales returns (net) and debit sales tax (the tax portion), credit receivables (gross). A purchase return reverses the input tax the same way.
• Sales tax is calculated on the price after deducting a trade discount, not on the original list price. A trade discount itself isn’t posted to the accounts - only the discounted (net) amount is recorded, with sales tax calculated on that net amount.

Pitfall: Don’t record a trade discount as an expense - it’s deducted before sales tax is calculated and never appears as its own line in the accounts. A settlement (early-payment) discount is different: under IFRS 15, revenue is recorded net of the discount if the customer is expected to take it, and in full otherwise, with revenue reduced if the discount is later taken. It is never recorded as an expense.

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).
• When the business pays the balance owed to the tax authorities: debit sales tax, credit cash.
• When the business receives a refund: debit cash, credit sales tax.
• The closing balance on the account equals the opening balance, plus output tax, minus input tax, minus payments made, plus refunds received (for a liability balance).

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

(a) Upon purchase of the goods

(b) Upon sale of the goods

Note: in the sales tax T-account, input tax ($150) is debited and output tax ($143.48) is credited, leaving a debit balance of $6.52. This is an asset: an amount receivable from the tax authorities (a tax credit against future liabilities). See below.