B1: 1.03 An introduction to VAT

On this course we will be using examples of businesses that are registered for VAT and we will demonstrate how they should prepare documents and record financial transactions in their books and ledgers. Whilst this is not a VAT course, it is important that you understand some of the basics of how this tax works.

What is VAT?

VAT, or Value Added Tax, is a tax charged by businesses on their sales. Generally, when a business’ annual sales reaches the VAT threshold (currently £85,000) they must register for VAT and charge VAT on their sales at the appropriate rate. In the UK we have three different VAT rates as shown below and the amount charged depends on the type of goods or services supplied to the customer.

VAT ratesApplied to the sales of…
Standard rate (20%)Most goods and services
Reduced rate (5%)Some goods and services including children’s car seats and home fuel bills
Zero rate (0%)Some goods and services including most food, children’s clothing and the sale of new residential property
VAT rates

In addition to the above, there are some goods and services that are known as exempt from VAT. This means that no VAT is charged on their sale. Examples of sales that would be exempt from VAT would include most financial services and postal charges.

Note: On this course we will almost always be dealing with purchases and sales of goods where either the Standard Rate of 20% is to be used or where no VAT is to be charged

How does VAT work?

Charging VAT on sales

When a business provides goods or services it will calculate how much is to be charged to the customer. The amount before VAT is included is normally referred to as the Net (or Nett) amount. VAT, at the appropriate rate for the goods or services sold is then calculated and added to the Net amount to calculate the Gross amount (which might also be called the Total). This Gross figure is the amount to be paid by the customer.

Calculating VAT on sales of goods or services

Let’s say a VAT registered builder’s merchants makes a sale of timber for £2,600 plus VAT at the standard rate. The Net, VAT and Gross amounts are as follows:

Net amount2,600.00
VAT at 20%£2,600 x 20%520.00
Gross amount£2,600 + £520£3,120.00
VAT calculations for a standard rated sale of £2,600

When calculating VAT, most businesses will round their calculations down to the nearest penny. For example, if a business made a net sale of £15.08 and VAT of 20% is to be charged, we would multiply £15.08 by 20%, which works out at £3.106. We would then round this number down to the nearest penny; i.e. £3.10

Reclaiming VAT on costs

At the same time a business charges VAT on its sales, it will also be paying VAT on its costs (since the businesses its buys from therefore be charging VAT on their sales). The business will therefore keep a record of the amount of VAT it has incurred on its costs.

Sometimes a business might receive invoices from suppliers which do not specify the VAT included in the total amount paid or demanded (nb. this should only happen where the invoices or receipts are for relatively small sums). Where the accountant is certain that VAT at the standard rate has been charged by the supplier, we can calculate the amount of VAT included in the charge by using something called the VAT fraction. For a VAT rate of 20% the VAT fraction is 1/6th.

Using the VAT fraction

Let’s say a business has a receipt from a stationers for £18 and we know that VAT of 20% is included in this amount but there is no breakdown of the amount between Net and VAT.

To calculate the VAT we would multiply the gross amount of £18.00 by 1/6th (or alternatively simply divide the gross amount by 6).

To calculate the Net amount we would multiply the Gross amount of £18.00 by 5/6ths (or alternatively deduct the VAT we calculated from the Gross amount).

For our example; the VAT would be calculated as £18 x 1/6 i.e. £3 and the Net would be £18 x 5/6 i.e. £15

[Note: You must not calculate the VAT by multiplying the gross by the standard rate of 20%. If you do you will have calculated 20% of both the Net and the VAT charged on the purchase and the figure calculated for VAT will be too high.]

Calculating the VAT to be paid to, or reclaimed from HM Revenue & Customs

At the end of a VAT period (usually every three months) a business’ accountant will calculate the total VAT it has charged on its sales and the total VAT incurred on its costs. A VAT return will then be prepared and submitted to HM Revenue & Customs including this information.

  • If the VAT on sales for the period exceeds the VAT on costs the business will have to pay the difference to HM Revenue & Customs
  • If the VAT on sales for the period is lower than the VAT on costs the business will claim a refund of the difference from HM Revenue & Customs

A word of warning

Although the basics of VAT are relatively straightforward, you should be aware that VAT is a complex tax and there are many additional rules for particular circumstances. HM Revenue & Customs have prepared numerous guides (called notices) which provide more detailed information, a good starting point is their VAT Guide known as VAT Notice 700 which can be accessed from HMRC’s website.