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VAT on Purchases in Xero when using the VAT Flat Rate Scheme

The Short Answer

Mark all expenses as NO VAT if you are on the VAT Flat Rate Scheme.


Clients often ask us the best way to record the VAT on their expenses when they are on the VAT Flat Rate Scheme and using Xero. On the VAT Flat Rate Scheme it is not possible to recover the VAT on purchases, but the invoices still include VAT on them so this can create confusion.

Our advice is that it is best to mark such expenses as if there was no VAT charged (by marking a payment/invoice as ‘No VAT”), though it is actually fine to mark them as including the VAT it just means your profit and loss will look a bit different.

If that’s all you need to know you can stop reading now. If you want to know why it doesn’t make any difference read on.


Our Example

To explain how this works we are going to assume a really simple company that only has two transactions one sale of £10,000 + VAT and one month of Caprica expenses of £80 + VAT. We will assume that the company is registered for the VAT Flat Rate Scheme on a rate of 14.5%

The Sales Side (applies to both scenarios)

When the sale is accounted for it must include VAT (if VAT registered of course). So we would process it from the bank reconciliation like this:

Untitled

When we click ‘OK’ Xero will adjust a number of accounts.

  • Increase the Profit and Loss ‘Sales’ account by £10,000
  • Increase the VAT liability account by £2,000
  • Increase the Bank account by £12,000

Scenario 1 – Marking a Purchase as No VAT

In this case we will show what happens when you mark the purchase as NO VAT. Like this:

No fees

When we click ‘OK’ Xero will adjust the following accounts

  • Increase the Profit and Loss ‘Audit and Accountancy Fees’ account by £96
  • Decrease the bank account by £96
  • It will not touch the VAT account

Recording the FRS Profit

As part of the process for preparing year end accounts it is necessary to post a manual journal into Xero to record the VAT FRS profit. We do this for all our Xero clients on the VAT Flat Rate Scheme.
You may remember that we recorded a VAT liability of £2,000 when we posted to the sales transaction. This is overstating the liability though. As we are the VAT Flat Rate Scheme we only actually owe HMRC £12,000 x 14.5% = £1,740. So there is actually £260 of FRS profit sitting in the VAT liability account at the moment.

To fix this we would post a journal that does the following:

  • Increase the Profit and Loss ‘FRS Profit’ account by £260
  • Decrease the VAT liability account by £260

So we end up with a Profit and Loss that looks like this:

Sales – £10,000
FRS Profit – £260
Audit & Accounting Fees – (£96)
Profit before tax – £10,164


Scenario 2 – Marking a Purchase as 20% VAT

In this scenario we will show what happens when you mark the purchase as 20% VAT. Like this:

 

20pc
When we click ‘OK’ Xero will adjust the following accounts

  • Increase the Profit and Loss ‘Audit and Accountancy Fees’ account by £80
  • Decrease the VAT liability account by £16
  • Decrease the bank account by £96

By telling Xero that this cost included VAT, Xero is now recording the expense net of VAT as a cost and reducing the amount owed to HMRC.

Recording the FRS Profit

This time our adjustment to the FRS Profit account is going to be different. We already know that the VAT on the accounting fees is not recoverable. So the amount that is owed to HMRC is exactly the same as in Scenario 1.

We owe 14.5% of £12,000 or £1,740.

However, in Scenario 2 our VAT Liability account is showing that we owe £2,000 – £16 = £1,984. Consequently our liability is overstated by £244.

To fix this we would post a journal that does the following:

  • Increase the Profit and Loss ‘FRS Profit’ account by £244
  • Decrease the VAT liability account by £244

So we end up with a Profit and Loss that looks like this:

Sales – £10,000
FRS Profit – £244
Audit & Accounting Fees – (£80)
Profit before tax – £10,164


Both scenarios end up with the same end profit

As you can see both scenarios ended up with the same level of profit before tax. The difference between the two is that in Scenario 1 the FRS Profit is £16 higher and the Accounting Fees are £16 lower (which cancel each other out).

As a result both scenarios are ‘correct’. HMRC and Companies House are happy for you to take either approach.

My personal preference would be Scenario 1, this is for two reasons:

  • The accounting fees did cost £96 not £80, so it’s better to have a clear picture of what your purchases actually cost you
  • It’s easier to mark everything as NO VAT – you won’t have to think about what the invoice says each time you reconcile an expense

The Conclusion – Be consistent!

We don’t mind which approach clients wish to take. What is important though is that the company is consistent. Pick an approach and stick with it.

3 Comments.
  1. Ryan

    Thanks for this helpful information. I’m now using “No VAT” for most accounts. I have a question about one of the other fields that appears in two Xero forms.

    When I enter an expense there is a checkbox that defaults to ticked that says “Include Tax [x] Line item amounts are: Tax Exclusive ( ) Tax Inclusive (o)”.

    Similarly, when you “Spend Money” it asks if the amounts are “tax exclusive (default), tax inclusive, or no tax” (for some reason the default is different from the receipt form).

    If my business is on the VAT flat rate scheme and most accounts are marked as “No VAT”, what are the correct settings to use in the above forms? Does it depend on the type of purchase/expense or is it safe to always use one option? (except in the case for capital expenditure goods).

    For example, if I have a travel expense, should I be choosing the “no tax” option if all the line items are for accounts that are “No VAT”?

    Thanks for your help.

    • [email protected]

      Hi Ryan thanks for commentating.

      By picking the tax rate as ‘NO VAT’ for the individual line item you are effectively making the Tax Exclusive / Tax Inclusive options totally redundant. So I would generally ignore that, except as you way with capital goods.

      So the answer is it doesn’t matter. As long as you have No VAT on the line item / receipt.

  2. Dan

    One benefit of Scenario 2 is that it tells you when there is no longer any point being on the FRS – if the profit is sub zero (or close to zero), then you should look at switching back, even if you haven’t hit the turnover limit. Also, if you switch, you don’t have to go back and edit any of the transactions for that quarter.

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