Value Added Tax in Bookkeeping

VAT is a simple concept that has somehow managed to get very complicated in practice. Its complexities once led to a celebrated court case to establish whether a jaffa cake is a cake or a biscuit. If you enjoy a jaffa cake with your afternoon tea, you will be pleased to know that you are eating a cake which is zero-rated, rather than a chocolate-covered biscuit which carries VAT at the standard rate. This is because it has the characteristics of a cake, especially in that it starts life soft and tends to get harder in time.
A chocolate-covered biscuit, on the other hand, starts life hard and tends to get softer in time. It took the best legal brains in Britain a long time to establish that.

Value added tax

The subject of VAT is so large that this chapter only has room for a few key points. There is much more.
What follows relates to the laws of the United Kingdom.

VAT is chargeable on transactions made in the UK when the goods or services are supplied ‘in the course or furtherance of any business’. ‘Business’ is taken to encompass activity conducted in a business-like way, which means that some charities have to register for VAT and account for it on their business income. Supplies made outside the UK are outside the scope of UK VAT.

The concept is that every time a VAT-registered business makes a sale, VAT is added to the amount charged to the purchaser. The purchaser must pay this to the seller, but if it is a VAT-registered business the seller can recover it. Each VAT-registered business must periodically pay to HMRC the difference between VAT that it has charged (outputs) and VAT that it has paid (inputs). If the inputs are greater than the outputs, a payment to the business is made by HMRC. This continues up a chain provided that all the parties are VAT-registered businesses. It stops when a sale is made to a consumer or a business that is not VAT-registered. This person or business pays the VAT and has no way of recovering it. It is a bit like the children’s game of pass the parcel. It is all good fun until the music stops. Features of VAT in the UK include:

Exempt supplies

Certain business supplies are exempt from VAT.

Zero-rated supplies

Zero-rated supplies are within the scope of VAT but the rate charged is nil. The supplier may recover its VAT inputs. Examples of zero-rated supplies are books and newspapers, exports, passenger transport and children’s clothing. If a business makes only zero-rated supplies, it must tell Customs but, with their permission, need not register.

Reduced-rate supplies

VAT is charged on the supply of certain goods and services at the reduced rate, which at the time of writing is 5%. The supply of domestic fuel and power is an example of a reduced-rate supply.

If a supply is not zero-rated, subject to the reduced rate, exempt or treated as outside the scope of VAT (such as salaries), then it is standard-rated. At the time of writing the standard rate in the UK is 17.5%. VAT commenced in April 1973 with a standard rate of 10%. It was cut to 8% on 29 July 1974 and then raised to 15% on 18 June 1979. It was raised again to the present rate of 17.5% on 1 April 1991.


A business that only makes exempt supplies cannot register and cannot reclaim the VAT on its inputs.

A business that only makes zero-rated supplies must register and can reclaim the VAT on its inputs.

Other businesses that supply goods or services in a business capacity must register if their turnover is above the registration threshold. They may choose to do so (and recover their VAT inputs) if their turnover is below the registration threshold.

It is a legal requirement that, if requested to do so, a seller charging VAT must provide the purchaser with a proper VAT invoice that shows its VAT registration number. If this is not provided, the purchaser should not pay the VAT to the seller and must not reclaim it as a VAT input. The good news is that although the legal issues may be troublesome, the bookkeeping should be straightforward and probably will not cause any difficulties.

It is essential that there is a VAT account in the Nominal ledger.

Many businesses choose to have two, one for inputs and one for outputs, and some businesses have a more
complicated structure of VAT accounts. The examples that follow assume that there is just one VAT account.

The bookkeeping system must be designed so that the VAT element of sales (outputs) is identified and posted to the VAT account. Similarly, the VAT element of purchases (inputs) is identified and posted to the VAT account. It follows that the balance of the VAT account is a running total of the amount owing to or from the Customs and Excise part of Her Majesty’s Revenue and Customs (HMRC). As an example of what should be done, VAT columns should be incorporated in the cash book and the VAT element of purchases and sales should be posted to the VAT account. The following repeats the payments side of the cash book shown in Chapter 3. However, VAT at 17.5% has been charged
on all items except the bank charges.

VAT account in the nominal ledger

The following entries illustrate the postings. Clapham and Crayfish Ltd makes a sale on credit of £10,000 to Dashwood and Dorkins Ltd on 3 May. VAT of £1,750 is added to the invoice making a total of £11,750. This appears in the books for Clapham and Crayfish as follows.

Sales account in Value Added Tax

The appropriate identifying posting reference must be shown. Hopefully you will remember from the second chapter
that VAT is a liability account in the balance sheet, and that a credit balance indicates that money is owing.

Mirror postings will be made in the books of Dashwood and Dorkins Ltd with £1,750 posted as a debit to the VAT account. This sum may be deducted from the credits when the VAT return is completed and the payments to Customs and Excise is made.