Sales tax is levied on suppliers of goods or services by government or relevant tax authority that is ultimately collected from end consumers.
As it is an indirect tax, anyone selling further is liable to pay tax on its sales but the charge is shifted to next purchaser and collected from the buyer. Therefore, first seller and any intermediate seller are simply collection agents for government. This continues until goods or services reach the final consumer.
In simple words, entities are liable to pay tax on goods sold but can adjust or deduct the sales tax they have paid as part of purchase price while purchasing goods. Therefore sales tax payable can be different from actual sales tax liability.
Sales tax payable is calculated using the formula:
Sales tax = Sales tax collected on goods sold – Sales tax paid on goods purchased
1 Understanding sales tax liability and sales tax payable
A basic concept that require clear understanding is that almost every seller is also a buyer of goods and/or services.
For example, on sales of goods and services subject to tax, Entity A is liable to pay sales tax. Sales tax on goods sold is also called output tax. As it is an indirect tax, the charge is shifted to next buyer by adding the relevant tax amount in the price of goods/services sold.
Suppose Entity A want to sell its product for $50 to its customer. If sales tax is 10% then actual amount that will collected from customer will be 55 [50 + (50 x 0.1)]. Entity A has taken $5 from customer on behalf of government, therefore, Entity A is liable for $5 towards government.
In order to make such sales, Entity A must have purchased some goods or services. Just like Entity A charged and collected sales tax from its buyers, the supplier of Entity A will collect tax from Entity A. Sales tax on purchased is also called input tax.
Suppose Entity A has purchased some units for a total price of $33 out of which $3 were tax. In short, Entity A have paid some of the sales tax as part of purchase price already. Entity A will be awarded a tax credit for $3 which simply means it can be deducted from sales tax liability.
So far Entity A is liable to pay $5 tax on its sales but has paid $3 already when goods were purchased. Therefore, sales tax payable is $2 (5 – 3)
2 Calculating Sales tax
In example of Entity A above we can understand that in order to calculate sales tax payable we need to know few things:
- sales tax rate
- Amount of sales to calculate output tax
- Amount of purchases to calculate input tax
Sales tax rate can be different from one jurisdiction/country to another. Different products can have different rates associated with them. There may be additional conditions regarding sales tax like the status of buyer, quantity of units sold may change sales tax calculation. Usually countries have a specific percentage to be applied. Sales tax rates can change from period to period. Thus can add some complexity to calculation of tax liability.
Sales and purchases amounts can be expressed exclusive of tax i.e. without tax or inclusive of tax with tax. It is important to know how prices are expressed as it affects the way sales tax liability (output tax) and sales tax credit (input tax) are calculated.
3.1 Amounts exclusive of sales tax
If amounts of sales and purchase are expressed without adding tax amount i.e. exclusive of tax then output and input tax figures can be calculated by simply multiplying a tax rate with sales and purchases figure respectively.
Output tax = Sales exclusive of tax X Tax rate
Input tax = Purchases exclusive of tax X Tax rate
Example: Sales tax calculation for exclusive of tax amounts
Shounter is calculating output tax and input tax on his transactions. During the month total sales he made were 500,000 and purchases amounted to 350,000. Figures are exclusive of tax.
If tax rate is 10% what is:
- Output tax
- Input tax
Solution:
Output tax = 500,000 x 0.1 = 50,000
Input tax = 350,000 x 0.1 = 35,000
3.2 Amounts inclusive of sales tax
If amounts of sales and purchases are expressed with tax amounts that is inclusive of sales tax then output and input tax figures can be determined by multiplying a tax fraction to sales and purchases figure.
Tax fraction can be expressed as following:
| Sales tax rate |
| (100 + sales tax rate) |
For example if sales tax rate is 14% then tax fraction will be:
| 14 |
| (100 + 14) |
In this case calculation will be:
Output tax = Sales inclusive of sales tax X Tax fraction
Input tax = Purchases inclusive of sales tax X Tax fraction
Example: Sales tax calculation for inclusive of tax amounts
Shounter is calculating output tax and input tax on his transactions. During the month total sales he made were 500,000 and purchases amounted to 350,000. Figures are inclusive of tax.
If tax rate is 12% what is:
- Output tax
- Input tax
Solution:
As the amounts are inclusive of tax so tax fraction will be applied instead of tax rate which is: 12/112
Output tax: 500,000 x 12/112 = 53,571
Input tax: 350,000 x 12/112 = 37,500
3.3 Calculating sales tax payable and sales tax refund
Once output tax and input tax amounts are determined we can compare the figures if we have sales tax payable or sales tax refundable. If output tax is greater than input tax then we have the difference as payable. If output tax is lesser than input tax then we have the difference as refund. Refund can be awarded in cash or as a credit towards future tax liability.
output tax > input tax = payable
output tax < input tax = refund
Example: Calculating sales tax payable/refund
Latok Plc has made exclusive of tax sales amounting to 1,000,000. During the period purchases were 880,000 inclusive of tax. Sales tax rate for the period is 10%
Calculate sales tax payable/refundable
Solution:
Output tax = 1,000,000 x 0.1 = 100,000 [tax rate is applied as figure is tax exclusive]
Input tax = 880,000 x 10/110 = 80,000 [tax fraction is applied as figure is tax inclusive]
As output tax > input tax therefore difference is payable.
Sales tax payable = 100,000 – 80,000 = 20,000
4 Accounting for Sales tax
The accounting journal entries and treatment is very similar to usual sale and purchase transaction with only one addition i.e. sales tax account. On sales, sales tax liability will arise whereas at the time of purchases any sales tax paid will reduce sales tax liability.
Usually a single sales tax account is maintained to record the transactions. But entities may choose to keep two separate sales tax accounts for sales and purchase.
4.1 Accounting for Output tax
Sales are always recorded exclusive of tax in entity’s accounting books and sales tax on such sales is recorded as liability. One important thing to remember is that cash received or receivables are always recorded inclusive of tax.
Once the sales tax amount is determined using tax rate or tax fraction. The complete journal entry is following:
| Cash/Bank/Receivables a/c | ### | |
| Sales a/c | ### | |
| Sales tax a/c | ### |
Example: Accounting for Output tax
Izmis Ltd. made a fortune last year by selling 2 million units of candies named “caves”. Total sales were 240,000 inclusive of tax. Tax rate applicable was 20%. All sales were made on credit.
Give the journal entry to record above sales and related sales tax.
Solution:
Sales are inclusive of tax therefore, tax fraction will be applied: 20/120
= 240,000 x 20/120 = 40,000
| Receivables a/c | 240,000 | |
| Sales a/c | 200,000 | |
| Sales tax a/c | 40,000 |
4.2 Accounting for Input tax
Just like sales figure, purchases are always recorded exclusive of sales tax. Sales tax paid is treated as reduction in sales tax liability or receivable. Also, the payment made in cash, by cheque or payables recorded are always inclusive of tax.
The journal entry is following:
| Purchases a/c | ### | |
| Sales tax a/c | ### | |
| Cash/Bank/Payables a/c | ### |
Example: Accounting for input tax
Saral Inc. purchased 100 units costing $1,000 each and paid sales tax at 15%. The price is exclusive of tax. Purchase was cash based.
Give journal entry to record the purchase in the books of Saral
Solution:
| Purchases a/c | 100,000 | |
| Sales tax a/c | 15,000 | |
| Cash a/c | 115,000 |
4.3 Accounting for sales tax payable and refund
At the end of the period or when entity is liable to file tax return, entity will determine the balance of sales tax account and take the steps. If sales tax account has a credit balance then it means entity has sales tax payable. If the account has a debit balance then it means entity is entitled to sales tax refund.
In short it is the closing balance of the sales tax account that will determine if entity has sales tax payable to be paid or refund to be claimed.
Example: Accounting for sales tax payable / refund
Momhil has had a good month and made profitable sales. Momhil is required to file sales tax return every month. Following data is available regarding sales and purchases during the month:
Sales
| July 1 | Sales exclusive of tax | 5,000 |
| July 10 | Sales inclusive of tax | 10,000 |
| July 15 | Sales exclusive of tax | 8,000 |
| July 20 | Sales inclusive of tax | 5,000 |
| July 25 | Sales inclusive of tax | 12,000 |
Purchases:
| July 2 | Purchases exclusive of tax | 12,000 |
| July 8 | Purchases inclusive of tax | 7,000 |
| July 12 | Purchases exclusive of tax | 5,000 |
| July 20 | Purchases exclusive of tax | 8,000 |
| July 28 | Purchases inclusive of tax | 2,000 |
Determine if entity has sales tax payable or refund for the month of July if the sales tax rate is 10%
Solution:
For above transactions the sales tax account will be as following. Remember the workings are done for understanding purposes and are not usually done within the T-account.
| Sales tax a/c | |||||
| July 2 | 12,000 x 0.1 | 1200 | July 1 | 5,000 x 0.1 | 500 |
| July 8 | 7,000 x 10/110 | 636 | July 10 | 10,000 x 10/110 | 909 |
| July 12 | 5,000 x 0.1 | 500 | July 15 | 8,000 x 0.1 | 800 |
| July 20 | 8,000 x 0.1 | 800 | July 20 | 5,000 x 10/110 | 455 |
| July 28 | 2,000 x 10/110 | 182 | July 25 | 12,000 x 10/110 | 1091 |
| Balance | 437 | ||||
| 3755 | 3755 | ||||
The above account shows a credit balance as credit side is greater than the debit side meaning entity has tax payable. When entity will pay it the journal entry will be following:
| Sales tax a/c | 437 | |
| Cash a/c | 437 |
5 Discounts and Sales tax
Sales tax amount is calculated net of discount figures of sales and purchases.
To calculate output tax, first deduct the trade discount (if not already) and cash discount from sales amount and then apply the sales tax rate on the resultant. Same goes for purchases in calculating input tax.
Trade discount is usually taken care of in the invoice and transactions are recorded after taking its effect. However, students often get confused if cash discount or settlement discount is to be deducted from sales figure or not for calculating sales tax.
Confusion is quite genuine as sales tax amount is calculated at the time of transaction and at point we hardly know if cash discount will be taken or given in future. Therefore, we simply assume that cash discount will be taken or given. Moreover, no adjustments are made even if situation is otherwise in the future.
Example: Discounts and Sales tax
Yashkuk Plc sold 276 containers of granite. Total worth of units is 100,000 exclusive of tax. Yashkuk gave 10% trade discount. Yashkuk sold the units to buyer on 5/7, n30 terms.
Sales tax rate applicable for the period is 10%.
Calculate the output tax amount in the books of Yashkuk Plc
Solution:
Original price of units were 100,000 on which 10% was given that renders 90,000 (100,000 x 0.9)
As sales tax is applicable therefore it has to be calculated. However, entity is offering 5% discount if buyer pays the money within 7 days with total credit period of 30 days from the date of sale. We assume that customer will take the cash discount therefore further reducing the value for sales tax purposes ONLY
= 90,000 x 0.95 = 85,500
Applying tax rate to determine output tax: 85,500 x 0.1 = 8,550
Transaction will be recorded as following:
| Receivables | 98,550 | |
| Sales a/c | 90,000 | |
| Sales tax a/c | 8,550 |
You can see from the journal entry above the sales revenue is recorded at 90,000 and not 85,500. We reduced the sales figure ONLY for computing sales tax amount. The receivables will be recorded at 90,000 plus sales tax.