Flat Rate VAT - Accounting Implications

We've had a few inquiries from clients as to how flat rate VAT works in AccountsPortal.

Before we go into that detail, it may be a good idea to go through the background to flat rate VAT first. The HMRC website is a great place to start.

Some important points to bear in mind:

  • You can only register for the Flat Rate Scheme (FRS) if your annual taxable turnover is less than £150,000. Your annual taxable turnover is the total of all the vatable items that you sell during the year.
  • You can stay on the FRS as long as your total business income is less than £225,000 per annum.
  • You still need to show VAT on each sales invoice (note that this is not your flat rate!).
  • You pay VAT as a fixed percentage of your VAT inclusive turnover. The actual percentage depends on your business - see FRS percentages for more information. You get a 1% discount in your first year of FRS registration.
  • You cannot claim back VAT on purchases (unless they are in respect of capital assets worth more than £2,000).
  • One of the main reasons for the FRS is simplicity of record keeping, although in practise this is not always the case!

The way that our system works flat rate vat is based on a methodology that calculates the difference (i.e. the profit or loss) from using the Flat Rate Scheme (FRS) compared to Standard VAT.  Our method of calculation allows allows the user to know exactly if its worthwhile being on the FRS scheme or not. Generally, if you have a lot of sales and few expenses, then it will be of benefit to use the FRS. Conversely, if you have a higher proportion of vatable expenses, then it may make more sense to not use the FRS.

By way of a simple example, lets assume that you raise an invoice for £1,000 plus 17.5% VAT, so the total invoice is £1,175.

Scenario 1

Assume that your company is registered on standard VAT (i.e. not on the FRS). In this case, the standard journal entry would be something like:

Dr Accounts Recievable 1,175
Cr Sales 1,000
Cr VAT 175

Therefore, at the end of the vat period, you would have to pay £175 to HMRC

Scenario 2

Now, lets assume that the company is registered at a 10% flat rate. You again raise an invoice for £1,000 at 17.5%, so the total invoice is still £1,175. But, because you are registered under the FRS, when it comes to the end of the vat period, you only owe HMRC £1,175 x 10% = £117.50. The remaining £57.50 (i.e. the £175 from scenario 1 minus £117.50 from scenario 2) is actually a 'profit' made from using the FRS.

So, the journal becomes:

Dr Accounts Receivable 1,175
Cr Sales 1,000
Cr Sales (Profit from FRS) 57.50
Cr VAT 117.50

In effect, the sales (and gross profit, etc) has been increased by £57.50. Notice that as long as the company's flat rate is below the invoice rate (in this case 10% is below 17.5%), then it will 'profit' from using the FRS. As mentioned above, it gets a bit more complicated when you take expenses into account - because you can claim back the vat back on these if you are standard rate registered, but you cannot claim the vat if you are on the FRS.

Whew! Like I said, although the FRS appears to be more simple, the reality can be very different!

Always speak to your accountant before registering for VAT or changing from one vat scheme to another - its critical to understand the picture as a whole before making any decisions.

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