Principles of accounting II

CHAPTER FOUR
4 THE PAYROLL ACCOUNTING SYSTEM
IN ETHIOPIAN CONTEXT

4.1The importance of payroll accounting

The concept of payroll is often referred to the total amount paid to employees of a firm as a
compensation for the service rendered to a firm in a given period of time. The payroll accounting
of a firm has to be given emphasis of significance for the following reasons (as stated on the book
entitled “Accounting principles” by Fees and Warren, page 297)
1. Employees are sensitive to payroll errors and irregularities, and maintaining good
employees moral requires that the payroll be paid on a timely and accurate basis.
2. Payroll expenditures are subject to varies government regulations.
3. The payment for payroll and related taxes has significance on the net income of most
business enterprise.
For the aforesaid reasons the need for accurate system of handling the payroll of a business
enterprise is unquestionable.

4.2 Definition of payroll related terms

Salary or wages:
Salary and wages are usually used interchangeably. However, the term wage is more correctly
used to refer to payments for manual labor that are paid based on the number of hours worked or
the number of units produced. So, they are usually paid when a particular piece of work is
completed or weekly. On the other hand, compensations to employees on monthly basis are
termed as salary.
It must be clear that when we say an employee, we refer to an individual who works primarily to
an organization and whose activities are under the direction and supervision of the employer.
Hence, an employee is different from an independent contractor, a self-employed individual who
works on a fee basis to a firm.

The pay period:

The pay period refers to the length of time covered by each payroll payment. Payment period for
wage workers are usually made on weekly basis. On the other hand, salaried employees’ pay
periods are monthly or semimonthly.

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The pap day:

The day on which wages or salaries are paid to employees, usually the last day of the pay period,
is known as the PAY DAY.

Basic records of a payroll accounting system include:

1. A payroll register (sheet)
2. Individual employees earning records, and
3. Usually, pay checks
These records are generated from a payroll system that is operated manually or using computers.
A payroll register (sheet): The entire list of employees of a business along with each
employee’s gross earning, deductions and net pay for a particular payroll period. The basic
for the preparation of the payroll register can be the attendance sheets, punched (clock)
cards or time cards.
Employee earning record: It is a summary of each employee’s earnings, deductions, and
net pay for each payroll period and of cumulative gross earnings during the year. It is a
separate record kept for each employee. The individual employee’s earning record helps
the employer organization to properly summarize and file tax returns.
Pay check: An instrument for paying salary if the firm makes payment via writing a check
in the name of employee for the net pay or a check for the total net pay.
Gross earnings: It is the total pay of an employee before deductions for the pay periods.
Payroll taxes: Are taxes levied against the employer on the payroll of a firm. It is an
additional payroll related expenses to an employer.
Withholding taxes: these are taxes levied against the earnings of employees of an
organization and withhold by the employer per the regulations of the concerned
government.
Payroll deductions: All the reductions from the gross earnings of employees of an
organizations such as withholding taxes, union dues, fines, credit association pays, .
….etc.
Net pay: The gross earnings after subtracting all the deductions. Sometimes it is known as
the take home pay.

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4.3 Possible components of payroll register

1) Employee number: Numbers assigned to employees for identification purpose when a
relatively large number of employees are included in the payroll register.
2) Name of employees: list of the name of employees.
3) Gross Earnings: the money earned by an employee(s) from various sources. It may
include:
The basic salary or regular earning.
A flat monthly salary of an employee is that paid for carrying out the normal work of
employment and subject to change when the employee is promoted.
Allowance: Money paid monthly to an employee for special reason, which may include:
I) Position allowance: A monthly sum paid to an employee for being a particular
office responsibility, e.g. head of a particular or division.
II) House allowance: A monthly allowance given to cover housing costs of the
individual employee when the employment contact requires the employer to provide
housing but fails to do so.
III) Hard ship allowance: A sum of money given to an employee to compensate for an
inconvenient circumstance caused by the employer. E.g. unexpected transfer to a
different and distant work area or location. It is sometimes known as disturbance
allowance.
IV) Desert allowance: A monthly allowance given to an employee because of assignment
to a relatively hot area.
V) Transportation (fuel) allowance: A monthly allowance to an employee to
cover the cost of transportation up to the work place. If the employer has committed
itself to provide transportation service.
Overtime earning: Overtime work is the work performed by an employee beyond the
regular working hour or day.
Overtime earning is the amount payable to an employee for overtime work done.
In Ethiopia, in this respect, according to Article 33 of proclamation No. 64/1975 the following
matters are discussed about the payment of overtime work.
1. A worker shall be entitled to be paid at a rate of one and one quarter(11/4) times his
ordinary hour rate for overtime work performed before 10 o’clock in the evening(10 p.m.).

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2. A work shall be paid at the rate of one and one half (11/2 ) times his ordinary hour rate for
overtime work performed between 10 o’clock in the evening(10 p.m.) and six o’clock in
the morning(6 a. m.).
3. Overtime work performed on the weekly rest day shall be paid at a rate of two (2) times the
ordinary hour rate of payment.
4. A worker shall be paid at a rate of two and half (21/2) times the ordinary hour rate for
overtime work performed on a public holiday.
Hence, the gross earnings of an employee include the basic salary, allowance and overtime
earnings.
You may sometimes find other of earnings such as Bonus that is paid to employees for
achieving results better than usual.

4) Deductions
These are subtractions made from the earnings of employees that is because it is required by
government or permitted by the employee himself.
In our country, Ethiopia, some of the deductions against the earnings of employees are:
A) Employee income tax
In Ethiopia every citizen is required to pay something in the form of income tax from
his/her earnings of employment. In this case a progressive income tax system that charges
higher rates for higher earnings is applied on the gross earnings of each employee save the
first 150 birr. According to proclamation No. 268/2002 that future amended the income tax
proclamation N o. 107/1994 given below exempts the first 150 birr of the earnings of an
employee from the income tax. The money on which a person does not pay income tax is
an EXEMPTION.
The amended income tax proclamation copied from 4th July 2002 Negarit Gazeta No. 34
states the following about employment income tax and its computation:

Amendment proclamation No.286/2002

A proclamation to amend the income tax proclamation:
WHERE AS, it has become necessary to further amend the Income tax proclamation No.
107/1994, as amended;
NOW THEREFORE, in accordance with Article 9(d) of the Transitional period charter, it is here
by proclaimed as follows;

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1) Short Title
This proclamation may be cited as the “Income Tax Proclamation amendment
No.286/2002.”

2) Amendment
The Income Tax proclamation No. 107/1994 as amended is hereby further amended as
follows:
1) Sub –article of Article 7 is hereby deleted and replaced by the following new sub-
article (b). (1) The first one hundred fifty birr (Birr 150) income from employment
shall be exempt from payment of income tax in all cases.
2) The tax on income from employment over one hundred fifty birr (> birr 150) shall be
charged, levied and collected monthly according to the following schedule.

Rates of Tax(%)
Taxable Monthly Income (In Birr) on Every additional
Income

1 The First 150 birr 0%

2 Over Br.150, but not exceeding Br.650 on the next 500 birr 10%

3 Over Br.650, but not exceeding Br.1400 on the next 750 birr 15%

4 Over Br.1400, but not exceeding Br.2,350 on the next 950 birr 20%

5 Over Br.2,350, but not exceeding Br.3,550on the next 1200 birr 25%

6 Over Br.3,550, but not exceeding Br.5000 on the next 1450 birr 30%
7 Over Br.5000 35%

Generally, taxable income from employment includes salaries, wages, allowances, directors’ fee
and other personal employment, all payments in cash and benefits in kind.

However, according to income tax amendment proclamation No. 30/1992 issued on October 12,
1992 stated that the following categories of payments in cash or benefits on kind are exempted
from tax.
1) Medical costs incurred by employer for treatment of employees.

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Principles of accounting II
2) Transportation allowances paid by employer to its employee.

3) Reimbursement by employer of travelling expenses incurred on duty by employees.

4) Traveling expenses paid to transport employees from elsewhere to place of employment
and to return them upon completion of employment.
B) Pension Contributions
Permanent employees of an organization the employees of which are governed by the existing
regulations of the Ethiopian public servants are expected to pay or contribute 4% of their basic
(monthly) salary to the Government Pension Trust Fund. This amount should be withheld
by the employer from the basic salary of each employee on every payroll and later be paid to
the respective government body.
On the other hand, the employer is also expected to contribute towards the same fund 6% of
the basic salary of every permanent employee of it. It is total amount is that we called earlier
as payroll tax expense to the employer organization. i.e. 6% of the total basic salary of all
permanent employee.
Consequently, the total contribution to the pension Trust Fund of the Ethiopian government is
equal to 10% of the total basic salary of all permanent employees of an organization(4%
comes from the employees and the 6% comes from the employer).
This enables a permanent employee of an organization to be entitled to the pension pay given
that the employee has satisfied the minimum requirements to enjoy this benefits when retired.
Non government organizations are also using this kind of scheme to benefit their employees
with some modifications. This is made in some NGO’s by keeping a fund known as
Provident Fund. Both the employees and the employer contribute towards this fund
monthly. Ultimately, when an employee is retired or drawn out of work a lump sum amount is
given at once.
C) Other deductions
A part from the above two kind of deductions from employees earnings, employee may
individually authorize additional deductions such as deduction to pay health or life insurance
premium, to repay loans from the employer or credit associations, to pay for donations to
charitable organization,…etc
Each of the major other deductions may be put in special column in the payroll register.
Ultimately, the sum of the employees’ income tax, pension contributions, and other deductions
gives the total deductions from the gross earnings of an employee.

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Principles of accounting II

5) The Net Pay

This amount is held in one column of the payroll register representing the excess of gross
earnings over the total deductions of an employee. The column ‘Net pay’ totally tells the
employee home take amount.

6) Signature
Unless some other document is used, the payroll sheet may be designed to allow a column for
signature of the employees after collection of the net pay.
In general, a payroll register should at least show the earnings, deductions and the net payment
with the names of the employees.

4.4 Major Procedures or Activities Involved in Accounting for payroll

1) Gathering the necessary data: All the relevant information about every employee should be
gathered. This activity requires reviewing various documents and to do some arithmetic
work.
2) Including the names of employees along with the gathered data such as earnings,
deductions and net pays in the appropriate column of the payroll register.
3) Totaling and proving the payroll register. It must be proved that the grand total earning
equals the sum of the grand totals of deductions and the net pay in the payroll register.
4) The accuracy and authenticity of the information summarized in the payroll should be
verified by a different person from the one who compiles it.
5) The payroll should be approved by the authorized personnel.
6) Paying the payroll either in cash (this may be after cashing a check issued for the total net
pay of the payroll) or issuing a check of every individual of employee for the net amount
payable to each employee.
7) Recording the payment of the payroll and recognition of the withholding tax liabilities.
8) Recording the payroll tax expenses of the employer.
9) Paying and recording withholding and payroll tax liabilities to the concerned authority, in
our case to the Inland Revenue Administration.

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Principles of accounting II

Demonstration problem
Messebo cement factory pays the salary of its employees according to the Ethiopian calendar
month.
The forth coming data related to the month of Ginbot, 2002.

Ser. Name of Basic Monthly OT hours Duration of OT work Basic salary

No. employee Salary Allowance worked per hour
1 Sara T. 2080 200 10 Up to 10 p. m. 13

2 Petros C. 640 ----- 8 10 p.m. to 5a.m. 4

3 Abdu M. 1280 ----- 6 Weekly rest days 8

4 Leila J. 960 150 ------ ------ 6

5 Kiros W. 520 100 10 Public holiday 3

N.B
Note that the management of the factory usually expects a worker to work 40 hours in a week and
during the month Ginbot all workers have done as they have been expected. Besides, all workers
of this factory are a permanent employees except Petros, the monthly allowance of kiros is not
taxable, and Abdu agreed to have a monthly Br.200 be deducted and paid to the credit association
of the factory as a monthly saving.

INSTRUCTIONS:
Based on the above information,
1) Prepare a payroll register (sheet) for the factory for the month of Ginbot, 2002?
2) Record the payment of salary as of Ginbot, 30 using Ck No. 21 as a source document?
3) Record the payroll tax expenses for the month of Ginbot?
4) Record the payment of the claims of the credit association of the factory that arose from
the Ginbot payroll assuming that the payment was made on Sene1, 2002?
5) Assuming that the withholding taxes and payroll taxes of the month of Ginbot, 2002 have
been paid on Sene3, 2002 via CK No.29, record the required journal entry?

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Principles of accounting II

Computation of earnings, deductions, and net pay:

Overtime earnings=OT Hours worked x (Ordinary hour rate X OT rate)
1) Sara, OT earnings 10 hrs x (13 x 1.25) =Br. 162.5
2) Petros, OT earnings 8hrs x (4 x 1.5) = Br. 48
3) Abdu, OT earnings 6hrs x (8 x 2) = Br.96
4) Kiros, OT earnings 10hrs x (3 x 2.5) = Br.75
Gross earnings = Basic salary + Allowance + OT earnings
1) Sara, (2080+200+162.5) = Br. 2342.5
2) Petros, (640 + 48) = Br. 688
3) Abdu, (1280 + 96) = Br. 1376
4) Leila, (960 + 150) = Br.1110
5) Kiros, (520 + 100 + 75) = Br.695

N.B ITR = Income tax rate

IT = Income tax
OT = Over time

Computation of deductions and net pays:

1) Sara Gross taxable income = Br.2342.5
Employee income tax: Earnings x ITR = IT
150 x 0% = 0.00
500 x 10% = 50.00
750 x 15% = 112.5
942.5 x 20% = 188.5
Total: Br. 2342.5 351.00
Pension contribution: Basic salary x 4%
2080 x 4% = 83.20
Total deductions: ------------------------------------------- -------Br. 434.20
Net pay--------------------------------------------------------------- Br. 1908.30

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Principles of accounting II

2) Petros
Gross taxable income = Br. 688.00
Employee income tax: Earnings x ITR = IT
150 x 0% = 0.00
500 x 10% = 50.00
38 x 15% = 5.70
Total: Br. 688.00 55.70
Pension contribution: Basic salary x 4% = 0.00
(Since he is temporary employee)
Total deductions: ------------------------------------------------Br. 55.70
Net pay ---------------------------------------------------------- Br. 632.30

3) Abdu
Gross taxable income = Br. 1376.00
Employee income tax: Earnings x ITR = IT
150 x 0% = 0.00
500 x 10% = 50.00
726 x 15% = 108.90
Total: Br. 1376 158.90
Pension Contribution: Basic Salary x 4%
1280 x 4% = 51.20
Credit association payment ------------------------------ 200.00
Total deductions: ------------------------------------------ Br.410.10
Net pay --------------------------------------------------- Br. 965.90

4) Leila
Gross taxable income = Br. 1010.00
Employee income tax: Earnings x ITR = IT
150 x 0% = 0.00
500 x 10% = 50.00

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360 x 15% = 54.00
Total: Br. 1010.00 104.00

Pension Contribution: Basic salary x 4%

960 x 4% = 38.40
Total deductions ----------------------------------------- Br. 142.40
Net pay ---------------------------------------------------- Br. 867.60

5) Kiros
Gross taxable income = Br. 595 (Since his monthly allowance is not taxable)
(695-100 = 595)
Gross earnings = Br. 695
Employee income tax: Earnings x ITR = IT
150 x 0% = 0.00
445 x 10% = 44.50
Total: Br.595 44.50
Pension Contribution: Basis Salary x 4%
520 x 4% = 20.80
Total deductions ------------------------------------------- Br. 65.30
Net pay ------------------------------------------------------ Br. 629.70

1) Preparation of payroll register

PAYROLL REGISTER
Messebo cement factory

For the month ended Ginbot 30, 2002

Earnings Deductions Net
Ser. Name B.Sa M.Al Ov.T Gross IT Pe.Con. Ot.ded T.ded Pay
No lowa. Earn.
Sign

1 Sara 2080 200 162.5 2342.5 351 83.20 ---- 434.2 1908.30

2 Petros 640 ----- 48 688 55.70 ----- ------ 55.7 632.30

3 Abdu 1280 ----- 96 1376 158.9 51.20 200 410.1 965.90

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4 Leila 960 150 --- 1010 104 38.40 ----- 142.4 867.80
5 Kiros 520 100 75 695 44.5 20.80 ----- 65.3 629.70
Total 5480 450 383.5 6111.5

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