Sales Tax, The day books and Control Accounts

1 Introduction

This chapter shows how the day books and journal are used to feed information into the double-entry system and into the receivables and payables ledgers.

2 Sales tax

Many countries have a sales tax where an amount is added to goods sold and this amount must later be paid over to the Government. Usually businesses are required to register for sales tax once their turnover (sales) reaches a certain amount. Once registered, they have to charge sales tax to their customers on any taxable supplies they make.

Supplies are classified for sales tax, and the classification decides both the tax charged on the sale and whether the input tax on the related purchases can be reclaimed:

• Standard-rated supplies. Tax is charged at the normal rate. Input tax on the related purchases is reclaimable.

• Reduced-rate supplies. Tax is charged at a lower rate. Input tax is reclaimable.

• Zero-rated supplies. Tax is charged at 0%, so no tax is added to the sale, but the supply is still taxable - input tax on the related purchases is reclaimable.

• Exempt supplies. No tax is charged and the supply is outside the tax. Input tax on the related purchases cannot be reclaimed.

The amount of the sales before the tax is added is called the net amount, and after tax is added is called the gross amount. Similarly, most purchases will include an amount of sales tax.

The tax on sales is called output tax.

The tax on purchases is called input tax.

Once registered, tax has to be charged on taxable supplies and this is periodically paid over the government. However, once registered, traders can reclaim input tax from the government. Only the net amount of input and output tax is paid to, or reclaimed from, the government.

Sales tax is accounted for in a sales tax account:

It is vital to realise that for a registered trader, tax charged on sales is not part of sales or income and that tax charged on purchases is not part of expenses. The sales tax account shows the liability to or from the government.

3 Sources of information on sales tax

When you are asked where the sales tax figures come from, the answer is the business's own records plus the tax authority:

• Sales invoices issued - the source of output tax.

• Purchase invoices received - the source of input tax.

• The sales and purchases day books, whose sales tax columns total the output and input tax for the period.

• The cash book and petty cash book sales tax analysis columns, for cash sales and cash purchases that never reach a day book.

• The sales tax account in the general ledger, which brings all of the above together and shows the balance owing to or from the government.

• The tax authority itself - its published rates, its notices and guidance, and the registration and return deadlines it sets.

Information a sales tax invoice must show. A registered customer can only reclaim input tax if they hold a valid tax invoice, so the invoice has to carry:

• the seller's name, address and sales tax registration number;

• an invoice number and the tax point (the date that decides which return the tax falls into);

• the customer's name and address;

• a description of the goods or services supplied;

• the net amount, the rate of tax, the amount of tax and the gross amount - separately.

4 Sales tax calculations

It is important to be able to work out gross and net amounts and the amount of tax, and this can best be done by a cost structure.

If sales tax is at 20%, then the cost structure would be:

Once that is established then you can easily move between any of the sales figures using proportions.

1   Net amount = 280: therefore

  sales tax = 280 x 20/100 = 56, and

  gross amount = 280 x 120/100 = 336

2   Tax = 40: therefore

  net amount = 40 x100/20 = 200, and

  gross amount = 40x 120/20 = 240

3   Gross amount = 840: therefore

  sales tax = 840 x 20/120 = 140, and

  net amount = 840 x 100/120 = 700

For example, if $12 is paid including sales tax at 20%, $2 is the sales tax and $10 the net cost (12 x 20/120 = 2).

If there are bulk or quantity discounts, the sales tax is calculated on the amount after the discount.

The amount of sales tax charged on sales is known as output tax (a tax on goods leaving the business). Businesses suffer sales tax on their purchases as suppliers have to charge sales tax on their sales; that tax is known as input tax (it is the tax on goods coming into the business).

At the end of each tax accounting period, the net of the sales output and input taxes is paid to or received from the government.

5 Other ways sales tax is accounted for

The treatment taught above - output tax netted against input tax, neither touching sales or expenses - applies to a registered trader making taxable supplies. Two other situations are examinable.

An unregistered trader. A business below the registration threshold, or making only exempt supplies, charges no output tax and cannot reclaim input tax. The tax on its purchases is simply part of the cost: a $480 invoice is debited to Purchases at $480, and a $1,200 computer is capitalised at $1,200. There is no sales tax account at all.

Irrecoverable input tax. Even a registered trader sometimes cannot reclaim the tax - for example on purchases used to make exempt supplies, or on items the tax authority specifically blocks. That tax is absorbed into the expense or into the cost of the asset in exactly the same way.

Reporting the sales tax balance. The sales tax account is a general ledger account like any other and its balance goes into the statement of financial position:

• a credit balance (output tax exceeds input tax) is a current liability - tax owed to the government;

• a debit balance (input tax exceeds output tax, which happens to a business making mainly zero-rated supplies) is a current asset - tax repayable by the government.

6 The sales tax return

At the end of each tax period the trader sends the authority a return. The layout differs from country to country but the components are always the same:

A properly kept sales tax account produces the return almost on its own: the credits are box 2, the debits are box 4, and the balance is box 5. This is why the account is sometimes called the sales tax control account.

7 The cash flow effect of sales tax

Sales tax is not an expense of the business, but it moves a great deal of cash through it. Between charging the tax on a sale and paying it over on the return, the business is holding the government's money - that is a source of short-term finance. The opposite is also true: a business that pays its suppliers quickly but collects from its customers slowly finances the output tax out of its own pocket, because the tax falls due on the invoice date, not the date the customer pays.

Illustration. A trader makes standard-rated sales of $60,000 net in a quarter and standard-rated purchases of $40,000 net. Tax is 20%.

The business collected $12,000 from customers during the quarter but only had to hand over $4,000, and not until after the quarter ended. If the return is due a month after the quarter end, the business has had the use of that money for up to four months. Longer credit taken from suppliers works the other way: the input tax cannot be reclaimed any sooner, but the cash has not gone out either.

Changes in sales tax legislation. You may be asked what a change would do to the business:

• A rise in the rate increases the cash collected and the cash paid over, so the amount of government money the business holds at any moment goes up - helpful for cash flow, but it also raises the gross price to customers, which may reduce sales volume.

• A change in the registration threshold can bring a small business into the system - it must then charge tax on its sales, but can also start reclaiming input tax.

• Reclassifying a supply from standard-rated to exempt is bad news: the business stops charging output tax but also loses the right to reclaim the input tax on the related purchases, which then becomes a real cost.

• A change in the length of the tax period, or in the payment deadline, changes only the timing - but timing is exactly what cash flow is.

8 Penalties

Tax authorities enforce the deadlines. You should know the shape of the penalties even though the amounts are not examinable:

• Late registration - a penalty based on the tax that should have been charged from the date registration became compulsory, which the business usually cannot now recover from its customers.

• A late return - a fixed penalty, or a surcharge that escalates if it happens again within a set period.

• Late payment - interest on the tax outstanding from the due date, plus a surcharge.

• An incorrect return - a penalty based on the tax understated, reduced if the error is disclosed voluntarily and increased if the error was deliberate.

• Failure to keep proper records, or to issue valid tax invoices - a separate penalty in its own right.

9 The day books

For convenience, the diagram of the accounting system is produced again:

The purchase day book (PDB)

This book records all the invoices received by a business from its credit suppliers.

Before invoices are listed here, they should be approved for payment as the invoices will progress from here to the ledgers and eventual payment.

The PDB is simply a list. A simple PDB would be as follows:

Notes

1. Despite its name the purchases day book does not have to be totalled every day.
   

2. The total of the net amount, sales tax amount and gross amount columns should add across (known as cross casting). If they don’t, an error has been made somewhere.
   

3. The total of the gross amount column is how much extra we owe suppliers because of these invoices.
   

4. The total of the net amount column is the cost of how much extra has been purchased.
   

5. The total of the sales tax amount is simply the total of the sales tax relating to these invoices. This can be recovered from the government.
   

The posting that would be made to account for these purchases transactions are:

In the general ledger

These entries reflect that $3,300 is owed to suppliers for goods of $2,750 and sales tax of $550.

In addition, in the Payables Ledger, each of the suppliers is credited with the gross amount of their invoices

Note: the Payables Ledger is not part of the double entry system: it is a memorandum entry. If everything has been done properly, the sum of the detailed accounts in the payables ledger will agree with the payables Control Account in the general ledger.

This system fulfils the following functions:

1. The control account provides an instant answer as to what is owed to suppliers in total
   

2. The detailed ledger accounts in the Payables Ledger give information about exactly what is owed to whom
   

3. Ensuring the control account and the sum of the ledger balances agree will reduce the chance of an error having occurred in the postings.
   

The sales day book (SDB)

This book records all the invoices issued by a business to its credit customers before they are sent out to customers.

The SDB is simply a list. A simple SDB would be as follows:

Notes

1. Despite its name the sales day book does not have to be totalled every day.
   

2. The total of the net amount, sales tax amount and gross amount columns should add across (known as cross casting). If they don’t, an error has been made somewhere.
   

3. The total of the gross amount column is how much extra we are owed by customers because of these invoices.
   

4. The total of the net amount column is the pre-tax sales value of the extra sales.
   

5. The total of the sales tax amount is simply the total of the sales tax relating to these invoices. This will be paid to the government (after off-setting any input sales tax).
   

The posting that would be made to account for these sales transactions are:

In the general ledger

These entries reflect that $1,224 is owed by customers for goods of $1,020 and sales tax of $204.

In addition, in the Receivables Ledger, each of the customers is debited with the gross amount of their invoices

Note: the Receivables Ledger is not part of the double entry system: it is a memorandum entry. If everything has been done properly, the sum of the detailed accounts in the receivables ledger will agree with the receivables Control Account in the general ledger.

This system fulfils the following functions:

1. The control account provides an instant answer as to what is owed by customers in total
   

2. The detailed ledger accounts in the Receivables Ledger give information about exactly who owes what.
   

3. Ensuring the control account and the sum of the ledger balances agree will reduce the chance of an error having occurred in the postings.

10 Control account reconciliations

The receivables and payables control accounts should always agree with the sum of the balances on the receivables and payables ledgers respectively. If they don’t, then an error must have been made and needs to be corrected.

Correcting control account and ledger errors is a common exam requirement.

For example, a receivables control account balance is $3,825. The three receivable account balances in the receivables ledger are as follows:

Something must have gone wrong because the control account balance does not agree with the total of the individual balances.

Investigation of the entries shows the following errors:

1. An invoice for $425 in the day book was posted to C Ltd’s account as $452.
   

2. An invoice for $500 in the day book was posted as $200 to B’s account
   

3. The sales day book was under cast (ie added up by too little) by $400
   

Solution

It is vital to understand which entries come from where.

Individual lines in the day book affect postings to the receivables (or payables) ledger

Totals in the day book affect postings to the receivables (or payables) control account.

11 Reconciling the payables ledger to suppliers' statements

The reconciliation above is an internal one: the control account against the business's own list of balances. It will find a casting or posting error, but it cannot find an invoice the business never received, because nothing in the business's own records knows about it.

That is what a supplier statement reconciliation is for. Each month suppliers send a statement of account showing what they think is owed. Comparing it with the balance on that supplier's account in the payables ledger checks the business's record against an independent outside document - and it is the only check in the whole system that does. It is done before the supplier is paid, so that the business pays what it really owes, and before the year end, so that payables are not understated.

The differences fall into three groups:

• Timing differences, which are genuine and need no correction, only explanation: invoices and credit notes the supplier has issued but which have not yet reached the business (goods in transit), and payments the business has sent that the supplier has not yet received or recorded (cash in transit).

• Errors by the business: an invoice posted at the wrong amount, posted to the wrong supplier, or omitted; a credit note posted as an invoice; a discount taken but not recorded. These are corrected in the business's ledger.

• Errors or disputes on the supplier's side: goods returned for which no credit note has yet been issued, an invoice for goods never received, a disputed price. These are taken up with the supplier and are not put through the ledger until settled.

Illustration. At 31 March the balance on ABC Ltd's account in the payables ledger is $4,120. ABC Ltd's statement of account shows $5,480 owing. Investigation shows:

• A cheque for $760 sent on 28 March is not on the statement.

• A credit note for $150 for goods returned on 24 March is in the payables ledger but the supplier has not yet issued it.

• An invoice for $640 was posted to the payables ledger as $460.

• An invoice for $270 dated 20 March, for goods received on 22 March, was never entered in the payables ledger at all.

The two sides now agree at $4,570, and every difference has been explained. Notice which items went on which side. The cheque and the credit note are timing differences on the SUPPLIER's records, so they are taken off the statement and nothing is posted for them. The two invoice errors are the business's own, so they are added to the ledger balance and they do have to be posted.

Correcting entries. Only the business's own errors are journalled:

The payables balance to report. The figure that goes into the statement of financial position is the corrected balance on the payables control account - not the total of the suppliers' statements, and not the uncorrected ledger balance. Invoices for goods received before the year end but not yet entered must be brought in, otherwise both payables and purchases are understated and profit is overstated.

12 Returns day books

In addition to sales and purchases day books, some businesses keep sales returns day books and purchases returns day books. Credit notes issued to customers or received from suppliers are listed there.

They act as ‘negative’ day books. Therefore the following postings are made:

Sales returns day book:

Total:     Dr Sales, Cr Receivables control account

Individual lines:   Cr individual customers’ accounts

Purchase returns day books

Total:     Cr Purchases, Dr Payables control account

Individual lines:   Dr individual suppliers’ accounts