Settlement Discount Granted and VAT

by Yoli
(Durban, South Africa)

Q: How will the VAT input and output be treated when settlement discount is granted?

A: For those who aren't familiar with this term, VAT is short for Value-Added Tax. This is a tax on the "value" a business "adds," which is usually the same as the profit you make. It is a sales tax and is added to the price that you're selling an item at.

VAT input is recorded whenever there is an expense or asset purchased. VAT input means you're claiming money from the tax authorities (you're recording a debtor/receivable).

Likewise VAT output is recorded when you make income. VAT output means you owe more money to the tax authorities (you're recording a creditor/payable).

Because settlement discount granted is an expense, we record VAT input. Settlement discount is the same as a cash discount by the way and is a discount granted for paying off a debt early.

Here's an example to show what happens when we have a settlement discount.

Let's say VAT is 10% and we sell an item usually worth $100 ($110 with VAT included) for only $88.

The entries would be:

Dr Bank $88
Dr Discount granted $20
Dr VAT input $2
Cr Sale $100
Cr VAT output $10

VAT output is recorded because of the income, the sale. VAT input is also recorded because of the expense, the discount granted.

The discount of $22 ($110 - $88) is divided 100:10 into 100% expense (discount) of $20 and 10% VAT input ($2). The $22 is essentially 110% (100% + 10%).

Hope that makes sense...