How VAT works: input tax and output tax

VAT is a tax on sales of goods and services. A business that is registered for VAT adds it to its prices and passes it on to HMRC.

Output tax

The VAT a business charges on its sales. It is owed to HMRC, so it is never the income of the business.

Input tax

The VAT a business pays on its purchases and expenses. A registered business can claim it back, so it is not a cost.

Net

The price before VAT.

Gross

Net plus VAT: what the customer pays.

At the end of each VAT period the input tax is set against the output tax.

• Output tax is more than input tax: the business pays the difference to HMRC.
• Input tax is more than output tax: HMRC pays the difference to the business.

The rates of VAT, the turnover at which a business has to register and the dates a return is due all change, so they are not given here. They are on GOV.UK. Every amount of VAT in this guide is given as a figure.

The VAT account is an account in the general ledger. It gathers every VAT figure in the books. Its balance is what the business owes HMRC, or what HMRC owes the business.

A sale on credit is posted in three lines.

• Debit Trade receivables with the gross amount: the customer owes all of it.
• Credit Sales with the net amount: only the net is the income of the business.
• Credit VAT with the VAT: it is owed to HMRC.

A purchase on credit is the mirror image: debit Purchases with the net, debit VAT with the VAT, and credit Trade payables with the gross.

Everything on the debit side reduces what is owed to HMRC. Everything on the credit side increases it.

A credit balance is a liability: VAT owed to HMRC. A debit balance is an asset: VAT that HMRC owes the business.

1. Enter every sales invoice split into net, VAT and gross: credit sales in the sales day book, cash sales in the cash book.
2. Enter every purchase the same way: credit purchases in the purchases day book, expenses paid straight from the bank in the cash book.
3. Enter credit notes in the returns day books. Their VAT goes the other way, because a credit note cancels part of a sale or a purchase.
4. At the end of the period, total each VAT column and post it to the VAT account.
5. Work out the output tax: the VAT on sales, less the VAT on credit notes sent to customers.
6. Work out the input tax: the VAT on purchases, less the VAT on credit notes from suppliers. Leave out any VAT that cannot be claimed.
7. Take the input tax from the output tax. The business pays HMRC the difference, or is repaid it if the input tax is the bigger figure.
8. Post the payment: debit VAT, credit Bank. The balance for the period is cleared.

A receipt from a credit customer has nothing in the VAT column of the cash book. The VAT was recorded when the invoice went into the sales day book, and entering it again would count it twice.

Tidewell Pottery sells mugs and bowls to gift shops. One sale is £640.00 net with VAT of £128.00, so the shop owes £768.00. One purchase of clay is £270.00 net with VAT of £54.00, so the supplier is owed £324.00.

On those two invoices alone, output tax is £128.00 and input tax is £54.00, so Tidewell owes HMRC £74.00. A whole quarter works the same way, with totals in place of single invoices.

Output tax is £3,480.00 plus £620.00, less £90.00 on credit notes to customers: £4,010.00. Input tax is £1,940.00 plus £215.00, less £65.00 on credit notes from suppliers: £2,090.00.

£4,010.00 less £2,090.00 is £1,920.00, the same as the balance on the account. Tidewell pays HMRC £1,920.00: debit VAT, credit Bank.

In the next quarter Tidewell buys a new kiln. Output tax is £3,700.00 and input tax is £5,150.00. Input tax is the bigger figure, so HMRC repays £1,450.00.

Zero rated

A taxable sale on which the VAT is nil. The seller still claims the input tax on its own costs.

Exempt

A sale that carries no VAT by law, such as insurance or interest on a loan. There is no VAT in the price, so there is nothing to claim.

Outside the scope

A payment that is not a sale of goods or services, such as wages, drawings or tax paid to HMRC.

Blocked

VAT the law does not let a business claim, such as the VAT on entertaining customers, or on a purchase with no valid VAT invoice.

VAT that cannot be claimed does not go to the VAT account. It becomes part of the cost of the thing that was bought.

• Crediting Sales with the gross amount. Output tax is not income, so Sales takes the net.
• Debiting Purchases with the gross amount when the VAT can be claimed. The purchase is recorded net.
• Entering VAT in the cash book when a credit customer pays, or when a credit supplier is paid. The day book has already recorded it.
• Posting the VAT on a credit note to the same side as the invoice. A credit note to a customer is a debit to VAT. A credit note from a supplier is a credit.
• Claiming VAT with no valid VAT invoice, or on a blocked purchase such as a meal for a customer.
• Posting the payment to HMRC to an expense account. It is a debit to the VAT account, where it clears the balance.

• The balance on the VAT account at the end of the period agrees with the amount due on the VAT return. Both are built from the same books.
• A credit balance is shown as a current liability in the statement of financial position.

When the two figures disagree, the size of the difference is a clue.

• The same as one entry: that entry was left out, or was posted to another account.
• Twice one entry: that entry is on the wrong side.
• The same as the last VAT bill: the payment to HMRC never reached the VAT account.