Sales Tax
A business registered for sales tax adds tax to its sales (output tax) and pays tax on what it buys (input tax). It pays the state the output tax less the input tax, so the tax is borne by the final consumer, not the business. Sales and purchases are therefore recorded net of tax, and the tax goes to a sales tax account, whose balance is the amount owed to (or by) the state. Be ready to work from a net price to a gross price and back again.
1 Introduction
In this chapter we will explain the principles of the operation of a sales tax (for example value added tax, or VAT, as it is called in many countries).
We will also explain how to calculate the sales tax on transactions, and the effect on the accounting entries.
You do not need to know the rules or rates of any particular country: a question always gives you the rate. Rates differ between countries, and the examples in this chapter use more than one rate (16% and 17.5%), so always work with the rate you are given.
2 The principles of sales tax
In the first lecture the tutor works the farmer, knitter and shop illustration with his own prices ($10, $15 and $40) and a rate of 20%, where the page uses $20, $40 and $80 at 17.5% — the method is exactly the same, and a question will always tell you the rate.
If a business is registered with the state for sales tax, then they are required to add the tax to the price of all their sales. They are acting as tax collectors for the state, and the tax that they have charged on their sales is payable to the state periodically (in some countries it is accounted for monthly and in some countries three-monthly). The tax charged on their sales is known as output tax.
However, the business will have suffered (i.e. will have been charged) sales tax on their purchases. The tax they have suffered is known as input tax.
At the end of each period, the excess of the output tax collected by the company over the input tax suffered by the company is payable to the state.
If in any period the input tax exceeds the output tax then the difference will be repaid by the state.
Follow a woollen jumper from the sheep to the customer. A farmer sells the wool to a knitter for $20, the knitter sells the jumper to a shop for $40, and the shop sells it to a customer for $80 (all prices before tax). Each of them is registered and must add sales tax at 17.5%.
Stage | Net | Output tax | Input tax | Paid to |
$ | $ | $ | $ | |
Farmer sells the wool to the knitter | 20.00 | 3.50 | — | 3.50 |
Knitter sells the jumper to the shop | 40.00 | 7.00 | 3.50 | 3.50 |
Shop sells the jumper to the customer | 80.00 | 14.00 | 7.00 | 7.00 |
Total collected by the state | 14.00 |
Each business pays the state its output tax less its input tax, and keeps exactly the amount it would have kept with no tax at all (the farmer $20, the knitter $40 − $20 = $20, the shop $80 − $40 = $40). The customer pays $94 — the $80 price plus $14 of tax — and is the only person who bears the tax. The state receives the same $14 (17.5% of $80), collected a little at each stage as value is added.
Small businesses below a size set by the state usually do not have to register. A business that is not registered does not add tax to its sales — and it cannot reclaim the tax it is charged on its purchases, so that tax is simply part of the cost of what it buys. The same applies to any input tax that a registered business is not allowed to reclaim: it is included in the cost of the expense or asset. A question will always tell you if a business is not registered or if tax cannot be reclaimed.
3 The calculation of sales tax
The rate of sales tax is determined by the state and differs from country to country. Also, many countries have different rates of sales tax depending on the nature of the item being sold.
Some businesses quote their selling price without sales tax, and then add the relevant percentage. Other businesses (particularly shops selling to the general public) quote a selling price including sales tax.
It is important in the examination to be able to identify the net sales price, the gross sales price, and the amount of sales tax.
You are given | To find | Working (rate 17.5%) |
The net (tax exclusive) price | The tax | Net × 17.5% |
The net price | The gross (tax inclusive) price | Net × 1.175 (that is, net + tax) |
The gross price | The net price | Gross ÷ 1.175 |
The gross price | The tax | Gross × 17.5/117.5 (or gross − net) |
The tax is always a percentage of the net price. Taking 17.5% of a gross figure is the classic mistake. Sales tax is one of the few places where you should be ready to work to the nearest cent.
Alpha sells goods at a net (or tax exclusive) price of $150.
The rate of sales tax is 16%.
What is the gross (or tax inclusive) selling price?
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Beta sells goods at a gross (or tax inclusive) price of $120.
The rate of sales tax is 16%.
What is the net (or tax exclusive) selling price, and what is the amount of the sales tax?
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Gamma sells goods at a gross (or tax inclusive) price of $220.
The rate of sales tax is 17.5%.
What is the net (or tax exclusive) selling price, and what is the amount of the sales tax?
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4 The accounting entries
4.1 Input tax
When a company makes purchases, the amount charged will include sales tax, but the tax suffered will be recovered from the state.
The entry is therefore:
Account | Debit | Credit |
Purchases | with the net cost | |
Sales tax | with the amount of the tax | |
Payables / Cash | with the gross cost |
The same applies to anything the business buys — electricity, a machine, a van: the expense or asset is recorded at the net cost and the tax is debited to the sales tax account. (If the input tax cannot be reclaimed, the gross amount is debited to the expense or asset instead.)
4.2 Output tax
When a company makes sales, the amount charged includes sales tax, but the tax collected will be paid to the state.
The entry is therefore:
Account | Debit | Credit |
Receivables / Cash | with the gross amount | |
Sales | with the net amount | |
Sales tax | with the amount of the tax |
Revenue is therefore always the net amount: the output tax is not the business’s income, it is collected for the state.
4.3 The sales tax account
The balance on the Sales Tax account (often called the sales tax control account) will represent the amount of sales tax owing to or from the state.
Balance at the end of the period | Meaning | Entry when settled |
Credit balance (output tax more than input tax) | Owed to the state — a current liability | Dr Sales tax, Cr Cash |
Debit balance (input tax more than output tax) | Owed by the state — a current asset | Dr Cash, Cr Sales tax |
(Note that more commonly a debit balance is not repaid, but is left on the account to reduce the payment to the state in the following period.)
Delta’s purchases and sales for December are as follows:
Net | Sales tax | Gross | |
Purchases on credit | 432,000 | 75,600 | 507,600 |
Sales on credit | 624,000 | 109,200 | 733,200 |
Record these transactions in the ledger accounts.
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Siti Rahman runs a shop in Kuala Lumpur and is registered for sales tax at 17.5%. In the quarter to 31 March:
Cash sales, including sales tax, were $47,000.
Goods for resale were bought on credit for $20,000 plus sales tax.
A delivery van was bought for $11,750, including sales tax.
Staff entertainment cost $470 including sales tax; the tax on entertainment cannot be reclaimed.
Required: Calculate the output tax, the input tax that can be reclaimed, and the amount payable to the state for the quarter. At what amounts are the sales, purchases, van and entertainment recorded?
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5 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Sales Tax
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