Settlement Discount Granted and VAT

by Yoli
(Durban, South Africa)

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

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 (the "value" is basically the difference between how much you sell something for and the cost of buying or making that thing).

VAT is basically a sales tax and is added to the price that you're selling an item at.

VAT is a tax that is charged in many countries around the world and at differing rates in each country. Some countries do not charge VAT but rather have a General Sales Tax (GST).

Now recording VAT is not so straightforward - you have 2 accounts when you're recording VAT, VAT Input and VAT Output.

VAT Input is recorded whenever you spend on things - i.e. 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). Usually the VAT Output is much greater than the VAT Input, which means the business has a tax liability and owes VAT overall.

Settlement discount is the same
as a cash discount and is a discount granted for paying off a debt early.

Settlement discount granted is an expense (the opposite of this is settlement discount received, which is an income for your business).

Because settlement discount granted is an expense, we record VAT Input on it.

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 a total of only $88 (also including VAT).

The entries would be:

Dr Debtors $110
Cr Sales $100
Cr VAT Output $10
($110 - $100)

This is the first entry, when we record the income and debt owed to us.

Here's the second entry:

Dr Bank $88
Dr Discount granted $20
($22 x 100/110)
Dr VAT Input $2 ($22 x 10/110)
Cr Debtors $110

In this second entry we cancel out the debt owed (debtors).

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 overall $22 discount is essentially 110% (100% + 10%).

Hope that makes sense...

Michael Celender

Related Questions & Tutorials:

Return to our page of Full Accounting Questions and Answers

Comments for Settlement Discount Granted and VAT

Click here to add your own comments

Settlement Discount and VAT Question and Answer
by: Othelia

On the 15 Feb 20.8 Gromit Dealers sold goods on credit to Vice Traders for R8,050 (vat inclusive of 15%). 0n 28 Feb 20.8 Vice Traders settled their account and Gromit Dealers granted a 5% settlement discount.

Hi Othelia,

This is a very difficult question involving multiple calculations. I'll list the journal entry first and then try to explain all the calculations.

Here's the initial journal entry when recording the sale:

Dr Debtors R8,050
Cr Sales R7,000 (R8,050 x 100/115)
Cr VAT Output R1,050 (R8,050 x 15/115)

The easiest thing to start with here is the debtors, which is the full amount (R8,050). Then calculate the sales figure. We know that the R8,050 sale includes VAT (so this is the 100 + 15 figure = 115%).

The actual sales figure to be recorded is the 100/115 figure of this amount. And the VAT Output on the sale is the 15/115 figure.

Here's the second journal entry when recording the settlement of the debt:

Dr Bank R7,647.50 (R8,050 x 95/100)
Dr Discount granted R350 (R8,050 x 5/100 x 100/115)
Dr VAT Input R52.50 (R8,050 x 5/100 x 15/115)
Cr Debtors R8,050

First we cancel out the debtors in full.

The next thing I would journalize is the money received, which is calculated as R8,050 - (R8,050 x 5%). Or R8,050 x 95/100.

The final things to work out are the discount amount (expense) and the VAT on this (VAT input).

The overall discount is R8,050 x 5% = R402.50. But this is made up of the discount allowed expense and the VAT Input (which you can claim for this expense).

So you have to split this figure into the actual discount amount (100/115) and the VAT portion (15/115).

Hope that helps break down what is a very difficult question and concept!

Good luck!

Michael Celender
Accounting Basics for Students

by: Kwazi

Thank you so much Michael, this is really helpful.

You're welcome.

- Michael
Founder of Accounting Basics for Students

VAT for cash discount
by: Nadeem

As per my knowledge, VAT is charged on net of discount amount. That should be 88*10%= 8.8

Allowance for settlement discount granted
by: Anonymous

If I am asked to calculate net turnover do I also add allowance for settlement discount granted?

settlement discount vat input/output
by: Anonymous

So when receiving a settlement discount is it VAT output then?

Yes, because settlement discount received is an income we then record VAT output (a liability account - meaning we owe VAT).

Michael C.
Founder of Accounting Basics for Students

Click here to add your own comments

Return to Ask a Question About This Lesson!.

© Copyright 2009-2021 Michael Celender. All Rights Reserved. 
Click here for Privacy Policy.