PastPaperHero | Accounting procedures and entries - Accounting for VAT elements in transactions

Learning Outcomes

This article explains the fundamental principles of Value Added Tax (VAT) as they apply to solicitors' accounts. It outlines the distinction between output and input tax, the treatment of disbursements using both the agency and principal methods, and the corresponding accounting entries. It also clarifies when costs are not disbursements for VAT purposes and how to account for VAT on profit costs, abatements and bad debt relief. After reading this article, you should understand how to correctly account for VAT on professional fees and disbursements in compliance with the SRA Accounts Rules, enabling you to apply these principles to SQE1 assessment questions.

SQE1 Syllabus

For SQE1, you are required to understand the practical application of VAT within the context of solicitors' accounts, including identifying different types of tax, correctly recording VAT elements in transactions, and applying the rules for disbursements. Familiarity with these principles is critical for advising clients and ensuring firm compliance, with a focus on the following syllabus points:

The distinction between output tax and input tax.
The conditions determining whether a payment is a disbursement for VAT purposes.
The accounting treatment and required entries for disbursements using the agency method.
The accounting treatment and required entries for disbursements using the principal method.
The implications of VAT registration for a law firm.
Calculating the VAT element on professional charges and certain disbursements.
The point of supply and when VAT must be recorded on the HMRC VAT ledger.
VAT relief on bad debts and how to adjust the HMRC VAT ledger when debts are written off.
Practical VAT treatment of common items (court fees, Land Registry fees, searches, experts, counsel).

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

A firm pays counsel's fees on behalf of a client. The fee note is addressed to the firm. Can the firm treat this as a disbursement using the agency method for VAT purposes?
1. Yes, always.
2. No, never.
3. Yes, but only if the client specifically instructs the firm to do so in writing.
4. Yes, due to an HMRC concession, provided the firm amends the invoice to show the client's name.
A firm pays a court fee of £150 for a client using money from the client bank account. Court fees are not subject to VAT. What are the correct accounting entries?
1. DR Client Ledger Business Account £150; CR Cash Sheet Business Account £150
2. DR Client Ledger Client Account £150; CR Cash Sheet Client Account £150
3. DR Client Ledger Client Account £150; CR VAT Account £150
4. DR VAT Account £150; CR Cash Sheet Client Account £150
A firm pays a surveyor's fee of £500 + £100 VAT (£600 total). The invoice is addressed to the firm. The firm uses the principal method. What entry is made on the client ledger when the firm pays the invoice?
1. DR Client Ledger Business Account £600
2. DR Client Ledger Business Account £500
3. DR Client Ledger Client Account £600
4. CR Client Ledger Business Account £500

Introduction

Value Added Tax (VAT) is a tax applied to the supply of most goods and services in the UK. For law firms, understanding how to account for VAT is essential for compliance with HM Revenue & Customs (HMRC) regulations and the SRA Accounts Rules. This involves correctly identifying VAT elements in transactions, particularly concerning professional fees and disbursements paid on behalf of clients. This article details the key accounting procedures and entries required.

General Principles of VAT

VAT operates on the basis of output tax charged by businesses and input tax paid by businesses. Most law firms exceed the VAT registration threshold (£85,000 taxable turnover per annum, frozen through at least 2025/26) and must register for VAT.

Key Term: Output Tax
The VAT charged by a VAT-registered business on the taxable supplies of goods or services it makes to its customers. Firms must account for this to HMRC.

Key Term: Input Tax
The VAT paid by a VAT-registered business on goods or services it purchases for business purposes. This can often be reclaimed from HMRC, offsetting the output tax liability.

Key Term: VAT return
A quarterly submission by VAT-registered businesses summarising total output tax charged and input tax incurred in the period. The firm pays HMRC the net amount (output minus input); if input exceeds output, a reclaim may be due.

Key Term: HMRC VAT Ledger
The internal ledger used to record VAT movements. Output VAT is credited when bills are issued; input VAT is debited when the firm incurs VAT on purchases. Quarterly settlement is based on the net position.

Firms account to HMRC quarterly, paying the difference between the output tax collected and the input tax incurred. If input tax exceeds output tax, the firm can reclaim the difference from HMRC. Importantly, VAT is due based on the tax point (usually when the VAT invoice is issued), not when the client pays.

The standard rate of VAT is 20%, applicable to most legal services. Some supplies are zero-rated (e.g., most food, children’s clothing) or exempt (e.g., insurance, postage stamps, many supplies of land). A reduced rate of 5% applies in limited cases (e.g., domestic energy).

VAT on Professional Charges

When a VAT-registered firm issues a bill for its professional services (profit costs), it must charge VAT at the standard rate.

Key Term: Profit Costs
The fees charged by a law firm for the legal services provided to a client, excluding disbursements and VAT.

The accounting entries when issuing a bill for profit costs of £1,000 + VAT (£200) are:

DR Client Ledger Business Account £1,000 (Profit Costs)
DR Client Ledger Business Account £200 (VAT)
CR Profit Costs Ledger £1,000
CR HMRC VAT Ledger £200

These double entries recognise the income and create an output VAT liability. Note that no entry is made in the Cash Sheet at this stage, as payment has not yet been received. When the client pays the bill (£1,200), the entries are:

DR Cash Sheet Business Account £1,200
CR Client Ledger Business Account £1,200

Point of supply and VAT recording: VAT must be recorded when the bill is delivered (the tax point). It is incorrect to defer output VAT entries until receipt of cash.

Abatements (bill reductions) and VAT: if a bill is reduced after delivery, both profit costs and VAT entries are reversed for the abated amount. For example, reducing a £1,000 + VAT bill by £200 + £40 VAT requires:

DR Profit Costs Ledger £200; CR Client Ledger Business Account £200
DR HMRC VAT Ledger £40; CR Client Ledger Business Account £40

Bad debt relief: if a billed amount is written off after being overdue by at least six months, the firm may reclaim the output VAT element from HMRC by debiting the HMRC VAT ledger and crediting the bad debts ledger for the VAT portion. The net amount is written off against bad debts on the client ledger business account.

VAT on Disbursements

Disbursements are costs paid to third parties on behalf of a client. The VAT treatment depends on whether the firm acts as an agent or a principal in making the payment.

Key Term: Disbursement
A cost or expense paid (or to be paid) to a third party on behalf of a client or trust, for which the firm seeks reimbursement. Examples include court fees, counsel's fees, and search fees. Office overheads like postage or standard telephone calls are generally not treated as disbursements for VAT purposes.

HMRC’s approach to disbursements is guided by VAT Notice 700 (para 25.1.1) and case law. For a payment to be treated as a disbursement for VAT purposes (so the firm does not charge additional VAT on it), the firm must have acted as the client’s agent, the supply must be to the client, the client must be responsible for payment to the third party, and the amount must be passed on exactly with appropriate invoicing. Where the firm buys in services as part of its own supply (e.g., certain searches used to produce advice), these are not disbursements for VAT purposes and are treated as part of the firm’s taxable supply.

Items ordinarily not disbursements for VAT purposes include postage, printing/photocopying, phone calls, travel, and many electronic searches used to provide legal advice. By contrast, court fees, Stamp Duty Land Tax and Land Registry registration fees are typically treated as non-taxable disbursements.

Disbursements Not Subject to VAT

Some payments made on behalf of clients are for supplies that are exempt or outside the scope of VAT (e.g., court fees, Land Registry registration fees, Stamp Duty Land Tax). Probate fees are also non-taxable.

When paying such a disbursement (e.g., £150 court fee), the firm simply records the payment. If paid from the client account (assuming sufficient funds):

DR Client Ledger Client Account £150
CR Cash Sheet Client Account £150

If paid from the business account (e.g., insufficient client funds):

DR Client Ledger Business Account £150
CR Cash Sheet Business Account £150

No VAT entries are needed as the supply itself is not subject to VAT. The firm must ensure withdrawals from client account are authorised and only made when sufficient client funds are held for that client.

Disbursements Subject to VAT

Where the disbursement involves a VAT element (e.g., expert witness fees, counsel's fees, surveyor fees, some search fees), the accounting treatment depends on whether the firm is acting as an agent or principal. This is determined primarily by whom the third-party invoice is addressed to.

Agency Method

This method applies when the third-party invoice is addressed directly to the client. The firm acts merely as an agent, paying the cost on the client's behalf. The VAT liability rests with the client.

Key Term: Agency Method
An accounting treatment for VAT on disbursements where the firm acts as an agent for the client. The supply is deemed made to the client, and the firm passes on the exact cost (including any VAT) without adding its own VAT. No entries are made in the firm's VAT account.

Accounting Entries (Agency Method):

If the firm pays a VAT-inclusive invoice of £600 (£500 fee + £100 VAT) addressed to the client:

If paid from client account (sufficient funds):
- DR Client Ledger Client Account £600
- CR Cash Sheet Client Account £600
If paid from business account:
- DR Client Ledger Business Account £600
- CR Cash Sheet Business Account £600

The firm should forward the original VAT invoice to the client if requested, allowing a VAT-registered client to reclaim the input tax. The firm does not separate fee and VAT in its ledgers for agency payments; one VAT-inclusive figure is recorded.

Counsel’s fees concession: In practice, counsel often addresses fee notes to the instructing firm. A long-standing HMRC/Law Society concession allows agency treatment for counsel’s fees even where the invoice is initially addressed to the firm, provided the invoice is amended to show the client as the recipient. Once amended, treat as agency and, if sufficient client funds exist, pay from client account.

Principal Method

This method applies when the third-party invoice is addressed to the firm. The supply is deemed made to the firm, which then re-supplies the service to the client.

Key Term: Principal Method
An accounting treatment for VAT on disbursements where the supply is deemed made to the firm. The firm pays the invoice (including VAT) from its business account, records input tax, and then re-supplies the service to the client by including the net cost and output VAT on its bill.

Accounting Entries (Principal Method):

Stage 1: Firm pays the invoice (e.g., £500 fee + £100 VAT = £600 total)

Payment must be from the business account (even if client funds are available).
Entries:
- DR Client Ledger Business Account £500 (Net amount, part of the firm’s taxable supply to the client)
- DR HMRC VAT Ledger £100 (Input Tax)
- CR Cash Sheet Business Account £600 (Total paid)

Stage 2: Firm bills the client (recharges the disbursement)

The firm includes the net cost (£500) on its bill to the client and adds VAT (£100) to this amount (along with VAT on its profit costs).
Entries when billing:
- DR Client Ledger Business Account £500 (Recharged disbursement net cost)
- DR Client Ledger Business Account £100 (VAT on recharged disbursement—output VAT)
- CR HMRC VAT Ledger £100 (Output Tax)
- Corresponding entries for profit costs and their VAT are also made at this time.

This two-stage approach ensures that input tax is recorded at payment and output tax at billing. The firm then settles the quarterly net VAT.

Search fees: Since late 2017 and HMRC’s 2020 guidance changes, many electronic search fees are treated as part of the solicitor’s taxable supply if the firm uses the information to advise the client. In that case, pay the search from business account, record input VAT (if charged), and include the net search fee on the bill with output VAT. Some searches (e.g., certain local land charges via HMLR) may be non-taxable, but the default assumption should be that online searches used to produce advice are not disbursements for VAT purposes.

Worked Example 1.1

Your firm acts for Property Co Ltd. You pay a Land Registry fee of £270 on their behalf from the client account, which holds sufficient funds. Land Registry fees are not subject to VAT. What are the accounting entries?

Answer:
Land Registry fees are disbursements not subject to VAT. As sufficient client funds are held, the payment is made from the client account. DR Client Ledger Client Account £270 CR Cash Sheet Client Account £270

Worked Example 1.2

Your firm acts for Innovate Ltd, a VAT-registered company. You instruct an expert witness who invoices the firm £1,000 + £200 VAT (£1,200 total). The invoice is addressed to your firm. You pay the invoice. Later, you bill Innovate Ltd £3,000 profit costs + VAT, plus the recharged expert fee. What are the entries when you pay the expert's invoice?

Answer:
As the invoice is addressed to the firm, the principal method applies. Payment must be from the business account. DR Client Ledger Business Account £1,000 (Net cost of expert fee) DR HMRC VAT Ledger £200 (Input Tax reclaimed by the firm) CR Cash Sheet Business Account £1,200 (Total paid to expert)

Worked Example 1.3

You receive a counsel’s fee note for £800 + £160 VAT (£960 total), addressed to your firm. The matter relates to a commercial client who is VAT-registered. The client asks that you treat counsel’s charge as a disbursement. How can you do this, and what are the entries if you pay from client funds?

Answer:
Under the counsel’s fees concession, amend the invoice to show the client as the recipient so it meets agency conditions. Then treat as agency: DR Client Ledger Client Account £960 CR Cash Sheet Client Account £960 No entries in HMRC VAT ledger; send the original (amended) VAT invoice to the client.

Worked Example 1.4

You order a mining search and pay £10 + £2 VAT via an online provider. You use the search result to advise the client. Later you bill profit costs of £300 + VAT and show the search separately. What entries arise at payment and billing?

Answer:
The search is part of your taxable supply (not a disbursement for VAT purposes). At payment: DR Client Ledger Business Account £10; DR HMRC VAT Ledger £2; CR Cash Sheet Business Account £12. At billing: include the £10 as a separate line within your taxable supply. DR Client Ledger Business Account £10; DR Client Ledger Business Account £2 (output VAT on that line); CR HMRC VAT Ledger £2. Also record profit costs and their VAT.

Worked Example 1.5

A surveyor invoices your firm £500 + £100 VAT for a valuation used in probate; you pay from business account. When you bill the client, you include £500 for the survey and £100 output VAT on that item, plus your profit costs and VAT. Later, the client pays the bill from client funds you hold. How do the entries proceed?

Answer:
Payment: DR Client Ledger Business Account £500; DR HMRC VAT Ledger £100; CR Cash Sheet Business Account £600. Billing: DR Client Ledger Business Account £500; DR Client Ledger Business Account £100; CR HMRC VAT Ledger £100 (output VAT). On receipt from client account to clear the bill: transfer from client to business account using cash transfers (not detailed here), then DR Cash Sheet Business Account for the amount received and CR Client Ledger Business Account to clear the debt.

Exam Warning

A common error is confusing the agency and principal methods. Remember the key determinant: who is the invoice addressed to? If it's the client -> Agency Method (usually paid from client account if funds available, VAT is client's responsibility). If it's the firm -> Principal Method (must be paid from business account, firm reclaims input tax and charges output tax). Also note the concession for counsel's fees allowing agency treatment even if invoiced to the firm, provided the invoice is amended.

Avoid treating overheads (e.g., travel, postage, routine phone calls) as disbursements. These are part of the firm’s taxable supply and must carry VAT as part of profit costs. For searches, check current HMRC guidance: where the firm uses search data to advise, treat the cost as part of the firm’s taxable supply.

Revision Tip

Create a simple flowchart or table summarising the VAT treatment of different types of disbursements (VAT-exempt vs VAT-subject) and the two methods (Agency vs Principal), including the trigger (invoice recipient) and the key accounting steps/ledger entries for each. This visual aid can help solidify understanding for the exam.

Key Point Checklist

This article has covered the following key knowledge points:

VAT-registered firms must charge output tax on their professional fees and account for it to HMRC.
Firms can generally reclaim input tax paid on goods and services used for business purposes and record it on the HMRC VAT ledger.
Disbursements are costs paid to third parties on behalf of clients; not all expenses qualify as disbursements for VAT purposes.
The VAT treatment of disbursements depends on whether the supply is subject to VAT and whether the firm acts as agent or principal.
Disbursements not subject to VAT (e.g., court fees, Land Registry registration fees, SDLT) are simply recorded as payments without VAT entries.
If a disbursement is subject to VAT and the invoice is addressed to the client, the agency method is used: the VAT-inclusive cost is passed on, paid from client funds if available, with no entry in the firm's VAT account.
If a disbursement is subject to VAT and the invoice is addressed to the firm, the principal method is used: the VAT-inclusive cost is paid from the business account, the firm records input VAT, and the net cost plus output VAT is recharged to the client upon billing.
Counsel’s fees may be treated under the agency method if the invoice is amended to show the client as the recipient.
Many electronic searches used to advise clients are not disbursements for VAT purposes; treat as part of the firm’s taxable supply (principal method).
VAT must be recorded on the HMRC VAT ledger when bills are issued (tax point), not on receipt of payment.
Bad debt VAT relief may be claimed for written-off debts after six months by adjusting the HMRC VAT ledger.
Mixed receipts must be allocated promptly to the correct bank account; only billed items are business money.

Key Terms and Concepts

Output Tax
Input Tax
Profit Costs
Disbursement
Agency Method
Principal Method
VAT return
HMRC VAT Ledger

Accounting procedures and entries - Accounting for VAT eleme...