What Is a Value-Added Tax (VAT)?

A value-added tax (VAT) is a consumption tax placed on a product whenever value is added at each stage of the supply chain, from production to the point of sale. The amount of VAT that the user pays is on the cost of the product, less any of the costs of materials used in the product that have already been taxed.

Value-added taxation is based on taxpayers' consumption rather than their income. In contrast to a progressive income tax, which levies greater taxes on higher-level earners, VAT applies equally to every purchase.

How a Value-Added Tax Works

A VAT is levied on the gross margin at each point in the manufacturing-distribution-sales process of an item. The tax is assessed and collected at each stage, in contrast to a sales tax, which is only assessed and paid by the consumer at the very end of the supply chain.1

Say, for example, ABC is  manufactured and sold in the country of. Here is how the VAT would work:

1. ABC manufacturer buys the raw materials for AED 10.00, plus a VAT of AED 0.50-payable to the government -for a total price of AED 10.50.
2. The manufacturer then sells  to a retailer for AED 20.00 plus a VAT of AED 1 for a total of AED 21. However, the manufacturer renders only AED 0.50 to Government, which is the total VAT at this point, minus the prior VAT charged by the raw material supplier. Note that the AED 0.50 also equals 5% of the manufacturer's gross margin of AED 10.
3. Finally, the retailer sells  to consumers for AED 30 plus a VAT of AED 1.50 for a total of AED 31.50. The retailer renders AED 0.50 to Government, which is the total VAT at this point (AED 1.50), minus the prior AED 1 VAT charged by the manufacturer. The AED 0.50 also represents 5% of the retailer's gross margin.

The standard way to implement a value-added tax involves assuming a business owes some fraction on the price of the product minus all taxes previously paid on the good.

By the method of collection, VAT can be accounts-based or invoice-based. Under the invoice method of collection, each seller charges VAT rate on his output and passes the buyer a special invoice that indicates the amount of tax charged. Buyers who are subject to VAT on their own sales (output tax) consider the tax on the purchase invoices as input tax and can deduct the sum from their own VAT liability. The difference between output tax and input tax is paid to the government (or a refund is claimed, in the case of negative liability).

By the timing of collection, VAT (as well as accounting in general) can be either accrual or cash based. Cash basis accounting is a very simple form of accounting. When a payment is received for the sale of goods or services, a deposit is made, and the revenue is recorded as of the date of the receipt of funds-no matter when the sale had been made. Cheques are written when funds are available to pay bills, and the expense is recorded as of the cheque date-regardless of when the expense had been incurred. The primary focus is on the amount of cash in the bank, and the secondary focus is on making sure all bills are paid. Little effort is made to match revenues to the time period in which they are earned, or to match expenses to the time period in which they are incurred.

Accrual basis accounting matches revenues to the time period in which they are earned and matches expenses to the time period in which they are incurred. While it is more complex than cash basis accounting, it provides much more information about your business. The accrual basis allows you to track receivables (amounts due from customers on credit sales) and payables (amounts due to vendors on credit purchases). The accrual basis allows you to match revenues to the expenses incurred in earning them, giving you more meaningful financial reports.