Accounting 101

Basic VAT

No introduction to accounting would be complete without a chapter on VAT!

We’ve heard something about VAT in the earlier chapters, looking at where invoices have VAT charged on them, and being able to claim VAT back on costs.  But what is VAT, when does it apply, and how does it work?

That’s what we’ll look at now.

7.1 What is VAT?

VAT stands for ...

Which businesses have to register for VAT?

There is a limit set by HMRC. Once a business' VATable sales go over the limit in the previous 12 months or the next 30 days, the business must register for VAT.

HMRC change the limit every year, and at the moment (as from 1st April 2016) it's £83,000.

If a business makes less VATable sales than that then it can apply to be registered for VAT early - this is called voluntary registration. But a business that isn't making VATable sales can't register for VAT.

All about VATable sales

When you go shopping, you will almost certainly pay VAT on most of the goods and services you buy. The government's aim with imposing VAT is to collect extra tax from the end consumer - but it's businesses that are responsible for collecting the tax and paying it over to HMRC.

So, can you answer Jennie's question?

 

And who has to register for VAT?

  • All individuals
  • All businesses
  • Some businesses

7.2 How businesses collect and pay VAT to HMRC

VAT on sales: output VAT

 

When a business is registered for VAT, it has to charge VAT at the appropriate rate on all its VATable sales. The VAT a business charges to its customers is called output VAT.

 

 

This VAT is added to the business's sales invoices, as we saw in chapter 4, and the customer has to pay the business the total amount of the invoice, including the output VAT.

The amount of output VAT to charge on the invoice is worked out by multiplying the basic amount charged for each item by the VAT rate that applies to that item, and then adding the VAT up for all the items.

VAT on sales: output VAT - an example

There is one line on this invoice with a service charged at 20%, and then another with a product (books) which is zero-rated and charged at 0%.

The total amount of VAT due is worked out as:

£50 per hour x 5 hours x 20% = £50

VAT on costs: input VAT

When a business buys goods or services from a VAT-registered business, then that business will have charged output VAT to them. If the purchasing business is registered for VAT too, and if the VAT on the goods and services they bought is not "blocked" as HMRC calls it, then they are entitled to claim that VAT back from HMRC. VAT that has been charged to a business, which that business can reclaim, is called input VAT.

 

When a business is registered for VAT, it can reclaim some - but not all - of the VAT that it’s charged by its suppliers. The VAT it can reclaim is called input VAT.

 

 

At regular intervals, usually once a quarter, the business must add up all the output VAT from within that quarter, and then add up all the input VAT too. They take the input VAT away from the output VAT, and pay the balance to HMRC.

Match the VAT type

  • VAT a business charges to its customers
    output VAT
  • VAT a business has been charged, and can reclaim
    input VAT

7.3 Different ways of adding up input and output VAT

Invoice accounting and VAT

There are two main ways a business can add up its output and input VAT.

 

The first way is called invoice accounting, or the standard method of accounting for VAT.  In this case, the business adds up all the output VAT that has been charged on invoices with an invoice date during the quarter in question, whether or not those invoices have been paid.  Input VAT is also worked out by adding up all the input VAT on bills received that are dated during the quarter, whether or not the bills have been paid. (Input VAT can also be included in respect of bank payments with no bill, and expenses.)

So why doesn't everyone just use invoice accounting?

Cash accounting and VAT

The second way a business can add up its VAT is by cash accounting.

This means that the business adds up its output VAT based on the money it has received from customers against VAT invoices in that quarter, irrespective of when the invoices were dated. Input VAT is claimed based on what was paid in the quarter, not when the bills were dated.

FreeAgent calculates both invoice and cash accounting for VAT automatically, so long as the user chooses the correct VAT settings.

What type of accounting does Billy's Bobbles Ltd use for VAT?

Billy's Bobbles Ltd is registered for VAT and calculates its VAT based on the money it has received from customers in the quarter and the money it has paid in bills during the quarter. 

  • Invoice accounting
  • Cash accounting
  • Standard method

True or false?

Angela runs a small boutique clothing retail store. She doesn't offer any credit arrangements for her customers.

  • She should use cash accounting, because that way she can reclaim her input VAT sooner.

7.4 The VAT return in FreeAgent

The FreeAgent VAT return explained

Watch the video to find out how to access the VAT return in FreeAgent and learn about each section of the form. 

Identify the different elements of the VAT return: Question 1

Click on the box that contains the total of the sales that the business made in the quarter.

Identify the different elements of the VAT return: Question 2

Click on the box that contains the amount that the business must pay over to HMRC.

7.5 The VAT report in FreeAgent

All about the VAT report in the FreeAgent app

Behind each VAT return in FreeAgent is a VAT report. This lists all the transactions that make up the figures on the VAT return.

HMRC do carry out “VAT inspections”, when they turn up and check a business’s record-keeping and make sure that they have paid the right amount of VAT at the right time. The VAT report will be crucial for a business going through a VAT inspection.

On the next page you’ll see two extracts from a VAT report for a business that is invoice accounting for VAT.

FreeAgent and VAT for businesses using cash accounting

If the business is cash accounting for VAT, when the business raises a sales invoice, the VAT element can’t yet go to code 819 VAT Charged, because that’s what populates box 1 on the VAT return - and the output VAT on this invoice shouldn’t go on to the VAT return until the customer pays the invoice.

So FreeAgent takes the VAT element of the invoice as a credit to code 823, Deferred VAT.

When the user enters a receipt against that invoice (an Invoice Receipt bank transaction), you may remember that FreeAgent posts the entries for that receipt as Debit Bank, Credit Trade Debtors.

But FreeAgent does something else as well when the business is cash accounting and the user records an invoice receipt, which is to post a pair of automatic journal entries to move the VAT element of the invoice from code 823 Deferred VAT to code 819 VAT Charged.

Those entries will debit code 823 (to reduce the amount of liability in there), and credit code 819 (to increase the amount owed to HMRC).

Let's see that happening in 'Show Transactions' in the app.

You’ll see that for the invoice receipt, because the business is cash accounting, four entries have been created. The total amount of the receipt, £1,200, has been posted to reduce the amount owed by customers (Trade Debtors) and increase the amount in the bank account. The VAT amount on the receipt, £200, has been moved to code 819 VAT Charged, so that it appears on the VAT return now that the invoice has been paid.

For bills and bill payments when the business is cash accounting, exactly the same thing happens, only the entries will be the opposite way round in terms of debits and credits.

When the user creates a bill, the amount of input VAT that will be reclaimable once the bill has been paid goes to code 823 Deferred VAT, because the input VAT can’t be reclaimed until the bill has been paid when the business is cash accounting.

When a bill payment is put against that bill by the user, FreeAgent posts the full amount of the bill payment as a debit to Trade Creditors, to reduce the amount that the business owes to its suppliers, and a credit to the bank account, to reduce the amount that the business has in the bank because it has spent some on paying this bill.

But it also automatically posts journal entries to move the amount of VAT from code 823 to code 818, now that the VAT can be reclaimed.

Here’s what that looks like in 'Show Transactions' in the app.

M Says...

Select the correct answer from the list.

  • 819 VAT Charged, because all output VAT goes there immediately.
  • 823 Deferred VAT, because the VAT will not be payable to HMRC until the invoice has been paid.
  • 819 VAT Charged, because the VAT is payable to HMRC even if the invoice has not been paid.
  • 823 Deferred VAT, because all output VAT goes there initially.
If a business is cash accounting for VAT, which code in FreeAgent does the VAT element of an invoice go to when that invoice is marked as sent, and why?

7.6 The VAT flat rate scheme for small businesses

Calculating flat rate VAT

I said earlier that there are two main ways that a business can calculate the VAT it must pay to HMRC; invoice accounting and cash accounting.

That’s if they’re paying HMRC the difference between their output VAT and input VAT.

There’s a different way that the smallest businesses in the UK can calculate their VAT payable to HMRC, which is called the VAT flat rate scheme.

How this works is that instead of having to add up all their output VAT and then take off all their input VAT, the business would instead add up all their sales for the quarter, including the output VAT charged to HMRC - because the business still has to charge output VAT to its customers in the normal way when it’s using the flat rate scheme.

They would add up their sales, including output VAT, using either invoices issued, or cash received from customers, in the quarter.  This figure is called the business’s flat rate turnover and it will include all sales except those that are outside the scope of VAT.  Zero-rated and exempt sales do also form part of the flat rate turnover, which means that a business can pay more VAT to HMRC by using the flat rate scheme.

Once the flat rate turnover has been worked out, the business applies its flat rate percentage to the turnover figure.  The flat rate percentages are set by HMRC and vary with what the business actually does - its trade.  FreeAgent users who are using the flat rate scheme choose their trade from a drop-down menu when they are setting up their business.

This figure, the flat rate turnover multiplied by the relevant percentage, will be - subject to a couple of exceptions, which we’ll look at in a moment - what the business pays to HMRC.  Hardly any input VAT can be reclaimed when the business is using the flat rate scheme.  The idea of the scheme is to simplify record-keeping for the smallest businesses, because they don’t have to remember what they can claim input VAT on.

The reason why the flat rate percentages vary with a business’s trade is because some trades are likely to have more input VAT to reclaim if they do not use the scheme.  The aim of the scheme is not to save - or cost - a business money, so HMRC sets the percentages to compensate for the average amount of input VAT that that business would usually be able to reclaim.

Profit on the flat rate scheme

Input VAT on the flat rate scheme

Normally it’s not possible to reclaim VAT on the flat rate scheme.  There are two main exceptions to this rule.

The first is that if a business buys a capital asset that cost more than £2,000 including VAT, they can reclaim input VAT on this capital asset.  FreeAgent deals with this automatically.  They do then have to remember, if they sell this asset, to pay HMRC the full output VAT which they charge on the sale - not the flat rate amount.

The second exception is that any business, whether or not it is using the flat rate scheme, can reclaim input VAT on certain costs that it incurs before registering for VAT.  These are stock and assets that the business bought in the four years before it registered and which it still has, and services such as accountants’ fees or solicitors’ fees that the business incurred in the six months before registration.  VAT on services that have been used up in full, such as electricity or mileage, can’t be reclaimed in this way.

Test your knowledge!

  • Nothing.
  • £100.
  • £60.
  • £72.
A customer, who is using the VAT flat rate scheme with a percentage of 12%, issues an invoice for £500 + 20% VAT. How much VAT will he pay to HMRC for that invoice?