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.
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:
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:
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:
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.