What is Sales Tax?
Sales tax is a tax charged on the sale of goods and services and is usually administered by and paid over to the tax authorities. The tax is an indirect tax which is charged as a percentage of the selling price of the goods or services at each stage of its life. Each country has its own rules and regulations regarding sales taxes and may refer to it using different names such as GST (goods and services tax) or VAT (Value added tax).
The principles of how the tax operates are best seen by way of an example.
Sales Tax Examples
Suppose a supplier sells raw materials to a manufacturer, who then sells its finished products to a retailer, who finally sells it to a consumer. At each stage in the life of the product the seller charges sales tax to the purchaser.
For the purpose of this example the rate of tax used is 20%.
Supplier Sells Raw Materials to Manufacturer
If the supplier sells the raw materials to the manufacturer at a cost of 250 before sales taxes, then the tax is calculated as follows:
Tax rate = 20% Net price = 250 Tax = Net price x Sales tax rate Tax = 250 x 20% = 50 Total price = Net price + Sales tax Total price = 250 + 50 = 300
The supplier has collected tax of 50 from the manufacturer and must now account for this to the tax authorities.
Manufacturer Sells Product to Retailer
The manufacturer now sells the finished product to a retailer for say 460 before sales taxes.
Tax rate = 20% Net price = 460 Tax = Net price x Sales tax rate Tax = 460 x 20% = 92 Total price = Net price + Sales tax Total price = 460 + 92 = 552
The manufacturer has now collected tax of 92 from the retailer, but has paid over tax of 50 to the supplier of the raw materials. The manufacturer must now account for the net amount collected of 42 (92 – 50) to the tax authorities.
Retailer Sells the Product to a Consumer
Suppose the retailer now sells the product to a customer for 1,150.
Tax rate = 20% Net price = 1,150 Tax = Net price x Sales tax rate Tax = 1,150 x 20% = 230 Total price = Net price + Sales tax Total price = 1,150 + 230 = 1,380
Our retailer has collected tax of 230 from the consumer, but has paid tax of 92 to the manufacturer. The retailer must now account for the net amount they have collected of 138 (230 – 92) to the tax authorities.
Sales Tax Example Summary
All of the transactions in the above sales taxes example are summarized in the table below.
|Supplier sale to manufacturer||50|
|Net collected by supplier||50||50|
|Manufacturer sale to retailer||92|
|Net collected by manufacturer||42||42|
|Retailer sale to consumer||230|
|Net collected by retailer||138||138|
|Total paid to tax authorities||230|
In this example, the total tax paid to the tax authorities is 230. It should be noted that the supplier, manufacturer, and the retailer have simply collected sales tax, deducted the amount they have paid, and transferred the net amount to the tax authorities. The sales tax has no impact on their revenues and expenses. The tax authority has received sales taxes of 230, and this has been paid entirely by the end consumer, who is the final person in the sales chain.
Sales tax collected on sales is sometimes referred to as output tax, whereas the tax paid on purchases is referred to as input tax. So for example, in relation to the manufacturer above, the input tax on the purchase of raw materials is 50, and the output tax on the sale to the retailer is 92.
Accounting for Sales Tax
As an example of accounting for sales tax, consider the bookkeeping journal entries required for the manufacturer discussed above.
Sales Tax on Purchases
The manufacture has purchased raw materials from a supplier costing 250 before sales taxes, and the tax at 20% is calculated as 50. the bookkeeping journal entry is as follows:
|Sales tax account||50|
Sales taxes are posted as a debit to the sales tax account. This represents an amount recoverable from the tax authorities and is an asset of the business which is included in the balance sheet. Only the net amount of 250 is posted to the income statement purchases account. The gross amount of 300 posted to the accounts payable account, represents the amount due to the supplier and is a balance sheet liability.
Sales Tax on Sales
Next the manufacturer sells the product to the retailer for 460 plus tax of 92 and reflects this in the accounting records as follows:
|Sales tax account||92|
The tax is posted as a credit to the sales taxes account. This represents an amount payable to the tax authorities and is a liability of the business. Only the net amount of 460 is posted to the income statement revenue account. The gross amount of 552 posted to the accounts receivable account, represents the amount due from the retailer, and is a balance sheet asset.
Following the posting of the purchase and sales transactions, the sales tax account now has a net credit balance of 42 (92 – 50), which represents the liability the business has to the tax authorities. When the net amount collected is paid to the tax authorities, the following journal is posted to clear the account.
|Sales tax account||42|
Following the payment, the balance on the tax account is now zero.
How to Figure Out Sales Tax
Sales taxes can be calculated on either the net sales (excluding tax) or the gross sales (including tax) amount.
Tax based on Net Sales
As seen in the example above, the tax is simply a percentage of the net sales amount. The net sales tax formula is as follows.
For example, if the tax rate is 20% and the net sales amount is 340, then the tax is calculated as follows.
Tax rate = 20% Net price = 340 Tax = Net sales x Tax rate Tax = 340 x 20% = 68
Tax based on Gross Sales
On the other hand if the gross amount of the sale is known, the formula for calculating sales tax below can be used.
For instance if the tax rate is 20% and the gross sales amount is 408, then the tax is calculated as follows:
Tax rate = 20% Gross sale = 408 Tax = Gross sales x Tax rate / (1 + Tax rate) Tax = 408 x 20% / (1 + 20%) = 68
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.