Value-added tax (VAT) is indirect tax which is collected by every manufacturer, supplier or retailer or any other party who is part of the supply chain together with the invoice price of the product or service and deposited with the government.

VAT is collected in increments at different stages of the supply chain. The first party in the supply chain collects VAT by applying the rate to the value of raw materials and deposits the whole amount with government. The second party collects VAT by applying the VAT rate to the value of the semi-proceed goods, which is higher than the value of raw materials because it now includes labor and manufacturing overheads. However, it can take credit of the VAT he already paid to the supplier of raw materials and deposit only the differential with the government. Each person bears VAT equals to the VAT rate multiplied by value added where value added equals the difference between the market value of its product and the price it paid for the inputs.

## Output VAT vs Input VAT

The VAT which each party collects at its sales is called output VAT and the VAT that it paid on its inputs i.e. raw materials, etc. is called input VAT.

$$\text{Ouput VAT}=\text{Sales Invoice Value}\times \text{VAT Rate}$$

$$\text{Input VAT}=\text{Purchases}\times \text{VAT Rate}$$

The amount that must be paid to the government at each stage equals the difference between output VAT and input VAT. It can also be calculated by applying the VAT rate to the gross margin if all outputs and inputs are taxable at a uniform VAT rate.

$$\text{VAT deposited}=\text{Output VAT}\ -\ \text{Input VAT}$$

$$\text{VAT deposited}=\text{VAT rate}\ \times \text{Gross Profit}$$

## Journal entries example

Let’s consider the supply chain of Seosh, a shoe company. On 1 January 2017, it purchased 100,000 square feet of premium leather from Tannerife, a tannery at a price of $100 per square ft. VAT is applicable at 10% and because it is being collected on purchases, it is the input VAT. The VAT would equal$10 per square ft (=$100 × 10%). The invoice amount per square ft. would be$110 (i.e. raw materials value of $100 plus VAT of$10). The $10 on account of VAT is collected by Tennerife from Seosh and paid to the government. At the time of recognition of the purchase, Seosh must pass the following journal entry: Account Dr Cr Raw materials ($100×100,000) $10,000,000 Input VAT (10%×$100×100,000) $1,000,000 Accounts payable$11,000,000

Seosh produces 2 pairs of shoes per square ft of leather. Let’s assume each pair is sold for $150. Cost of and VAT paid related to rubber and other materials amounted to$5,000,000 and $500,000 respectively which is also debited to Input VAT account. Since 100,000 square ft of leader will yield 200,000 pairs of shoes each of which is sold for$150, sales equal $30,000,000. The VAT that must be collected from customers amounts to$3,000,000 i.e. 10% of the $30 million. Because it is received on sales, it is the output VAT. This would be recorded using the following journal entry in Seosh’s books: Account Dr Cr Accounts receivable (2×100,000×$150×1.1) $33,000,000 Sales (2×100,000×$150) $33,000,000 Output VAT$3,000,000

Seosh’s liability i.e. the amount it must pay the government is the difference between the output VAT and input VAT. Seosh’s shall make the following journal entry at the time of payment of the VAT to government:

Account Dr Cr
Output VAT $3,000,000 Input VAT ($2,000,000 on leather + $500,000)$2,500,000
Cash $500,000 The net VAT obligation of Seosh is$500,000. This can also be calculated by applying the VAT rate to the gross profit. Gross profit in case of Seosh is $5 million (=$30 million - $20 million -$5 million) and its 10% equals \$500,000.