Chapter 3: Payroll Accounting

Chapter 3
Accounting For the Payroll System in an Ethiopian Context

3.1 The Importance of Payroll and Payroll Accounting

The term Payroll often refers to any document prepared to pay remuneration to the employee for the
service rendered to an organization in a given period of time. Payroll accounting is an accounting
that is concerned with preparation of payroll and recording and reporting of remunerations. The
payroll accounting of a firm has significance and has to be given emphasis for the following
reasons:
1. Employees are sensitive to payroll errors and irregularities, and maintaining good employee
moral requires that the payroll be paid on a timely, accurate basis.
2. Payroll expenditures are subject to various government regulations
3. The payment for payroll and related taxes has significant effect on the net income of most
business enterprises (salary is the largest expense in most businesses)
3.2 Definition of payroll related terms
1. Salary or Wages: Salary and wages are usually used interchangeably. However, the term
wages 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 for a period less than a month. On the other hand,
compensations to employees on monthly or annual basis are termed as salaries. 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.
2. The Pay Period: The length of time covered by each payroll payment. Pay periods for
wageworkers are usually a weekly or biweekly period. That is, wage is paid either weekly or
biweekly. On the other hand, for salaried employees, the pay periods are a month, semi-month,
quarter, semi-annual, or a year.
3. The Pay Day: The day on which wages or salaries are paid to employees. PAY DAY is usually
the last day of the pay period.

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 Chapter 3: Payroll Accounting

4. A Payroll Register (Payroll Sheet): the entire list of employees of a business along with each
employee’s gross earnings, deductions and net pay (or the take home pay) for a particular
payroll period. The basis for the preparation of the payroll register can be the attendance sheets,
punched (clock) cards or time cards.
5. Employee Earnings 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 employees' earnings record helps the employer
organization to properly summaries and file tax returns.
6. Pay Check: An instrument for paying salary if the firm makes payment via writing a check in
the name of each employee for the net pay or a check for the total net pay.
7. Gross Earnings: The total pay to an employee before deductions for the pay period.
8. Payroll Taxes: Are taxes levied against the employer on the payroll of a firm. It is the portion
of pension or social security contribution made by the employer. It is an additional payroll
related expense to an employer.
9. Withholding Taxes: These are taxes levied against the earnings of employees of an
organization and withheld by the employer as per the tax laws of the concerned government
10. Payroll Deductions: All the reductions from the gross earnings of an employee such as
withholding taxes, union dues, fines, credit association pays, etc.
11. Net Pay: The net earnings after subtracting all the deductions. It is sometimes known as take
home pay. The amount collected by an employee on the payday.
In the above definitions of payroll related terms, the three are considered the basic records of a
payroll accounting system. These are: (1) A payroll sheet, (2) Individual employees' earnings
records, and (3) Pay checks. These records are generated from a payroll system that is operated
either manually or using computers

3.3 Components of a Payroll Register

1. Employee number – numbers assigned to employee for identification purpose. It might be
alpha-numeric character when a relatively large number of employees are included in the
payroll register.
2. Name of employees – full name of each employee included in the list of payroll sheet.

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 Chapter 3: Payroll Accounting

3. Earnings – a benefit in cash or in kind earned by an employee from various sources of

employment. It may include:
A. The basic salary or Regular Earning – a flat monthly salary of an employee that is paid for
carrying out the normal work of employment and subject to change when the employee is
promoted.
B. Allowances: money paid monthly to an employee for special reason, which may include:
 Position Allowance - a monthly sum paid to an employee for bearing a particular office
responsibility, e.g. head of a particular Department or Division.
 House Allowance– a monthly allowance given to cover housing costs of the individual
employee when the employment contract requires the employer to provide housing but fails
to do so.
 Disturbance Allowance – a sum of money given to an employee to compensate for an
inconvenient circumstance caused by the employer. For instance, unexpected transfer to a
different and distant work area or location.
 Desert Allowance – a monthly Allowance given to an employee because of assignment to a
relatively hot region. It is sometimes known as Hardship Allowance
 Transportation (Fuel Allowance) – a monthly Allowance to an employee to cover cost of
transportation up to the work place if the employer has committed itself to provide
transportation service
C. Overtime Earnings
Overtime work is the work performed by an employee beyond the regular working hours or days.
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 is discussed about
payment for overtime work.
I. A worker shall be entitled to be paid at a rate of one and one quarter (1 ¼) times his ordinary
hourly rate for overtime work performed before 10 O'clock in the evening (10 p.m.). (From
6:00 am to 4:00 pm)
II. A worker shall be paid at the rate of one and one half (1 ½) times his ordinary hourly 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.)

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III. Overtime work performed on the weekly rest days shall be paid at a rate of two (2) times the
ordinary hourly rate of payment.
IV. A worker shall be paid at a rate of two and half (2 1/2) times the ordinary hourly rate for
overtime work performed on a public holiday.
Hence, the gross earnings of an employee may, therefore, include the basic salary, allowances and
overtime earnings. You may find sometimes other form of earnings such as Bonus that is paid to
employees for achieving results better than usual.

4. Deductions
These are amounts to be subtracted from the earnings of employees because they are required by
government (mandatory deductions) or permitted by the employee himself (voluntary deductions.
Mandatory deductions include employment income tax and pension contribution. In our country,
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
earning 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 600 Birr.
According to proclamation No. ----/2008 that has become into effect beginning Hamle 1, 2008 E.C.
exempts the first Br 600 of the earnings of an employee from income tax. The money on which a
person does not have to pay income tax is an exemption. According to the new proclamation,
employee income tax has to be computed based on Schedule “A” as follows:

Employment Income per Month Tax Deductable

TB Over Birr To Birr Rate
1st 0 600 0 Exempt (0%)
2nd 600 1,650 10% 60
3rd 1,650 3,200 15% 142.5
4th 3,200 5,250 20% 302.5
5th 5,250 7,800 25% 565
6th 7,800 10,900 30% 955
7th Above 10,900 35% 1,500

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Generally, taxable income from employment includes salaries, wages, allowances, director’s fees
and other personal emoluments, all payments in cash and benefits in kind.
Pension Contribution
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 7% of their basic
(monthly) salary to the government pension Trust Fund. This amount should be with held 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 11% of the
basic salary of every permanent employee of it. It is this total amount that we called earlier as
payroll taxes expense to the employer organization (i.e. 18% of the total basic salary of all
permanent employees).
Consequently, the total contribution to the pension Trust Fund of the Ethiopian government is equal
to 18% of the total basic salary of all permanent employees of an organization (i.e. 7% comes from
the employees and the 11% 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 benefit when retired.

Non-government organizations are also using this kind 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.
B. Other Deductions (Voluntary Deductions)
Apart from the above two kinds of deductions from employees earnings, employees may
individually authorize additional deductions such as deductions to pay health or life insurance
premiums; to repay loans from the employer or credit association; to pay for donations to charitable
organizations; 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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The column “Total Deductions” shows the total amount to be deducted from the earnings of
employees.
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' total tells the excess of grand total
earnings over grand total deductions made from the earnings of employees. It is the grand total take-
home pay.
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 pays along with the names of employees.

3.4 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 columns of the payroll register.
3. Totaling and proving the payroll register. It must be proved that the grand total earnings equal
the sum of the grand totals of deductions and net pays in the 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 is 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 for every individual 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 taxes expense of the employer.
9. Paying and recording withholding and payroll tax liabilities to the concerned authority, in our
case to Inland Revenue Administration, on time.

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 Chapter 3: Payroll Accounting

3.5 Demonstration Problem

Ethio Relief Agency pays the salary of its employees according to the Ethiopian Calendar month. The forth
coming data relates to the month of Hider, 1998.

Name of Basic Allow OT Hrs Duration of BS per

S.No. Employee Salary ance worked OT work hour
01 Senait Bahiru 9,600 100 10 6 AM to 10 PM 60
02 Petros Challa 1,600 __ 8 10 PM to 6 AM 10
03 Abdu Mohammed 6,000 __ 6 Weekly Rest Days 37.5
04 Leilla Jemal 4,000 50 __ __ 25
05 Kirkos Wolde 12,000 500 10 Public Holidays 75

Additional Information:
Note that management of the agency usually expects an employee to work 40 hours in a week and
during Nahase 2008 all employees have worked as they have been expected. Besides, all workers of
this agency are permanent employees except Petros Chala and the monthly allowance of Kirkos
Wolde is not taxable; Abdu Mohammed agreed to have Br 200 be deducted from his earning and
paid to the Credit Association of the Agency as a monthly saving.
Instructions: Based on the above information:
A. Compute of earnings, deductions and net Pays.
B. Prepare a payroll register (or Sheet) for the agency for the month of Nahase, 2008
C. Record the payment of salary as of Nahase 30, 2008 using Ck. No. 41 as a source documents
D. Record the payroll tax expense for the month of Nahase 2008. Memorandum No.006
E. Record the payment of the claim of the credit Association of the agency that arose from
Nahase's payroll assuming that the payment was made on Meskerem 1, 2008
F. Record the payments of withholding taxes and payroll taxes of the month of Nahase, 2008
assuming that they have been paid on Meskerem 5, 2008 via Ck. No. 50

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 Chapter 3: Payroll Accounting

A. Computations Of Earnings, Deductions And Net Pays

Overtime Earning:
Overtime Earning = OT Hrs Worked @ (Ordinary Hourly Rate @ OT Rate)
1. Senayit Bahiru
 10 Hrs @ (60 @ 1.25) = Br 750
2. Petros Challa
 8 Hrs @ (10 @ 1.5) = Br 120
3. Abdu Mohammed
 6 Hrs @ (37.5 @ 2) = Br 450
4. Kirkos Wolde
 10 Hrs @ (75 @ 2.5) = Br 1,875
Gross Earnings:
Gross Earnings = Basic Salary + Allowance + OT Earning
1. Senayit Bahiru
 Br 9,600 + 100 + 750 = Br 10,450
2. Petros Challa
 Br 1,600 + 0 + 120 = Br 1,720
3. Abdu Mohammed
 Br 6,000+ 0 + 450 = Br 6,450
4. Leilla Jemal
 Br 4,000 + 50 + 0 = Br 4,050
5. Kirkos Wolde
 Br 12,000 + 500 + 1,875 = Br 14,375

DEDUCTIONS AND NET PAY:

1. Senayit Bahiru
Gross Income (Gross Ea rning) = Br 10,450 and Taxable Income = Br 10,450
Deductions:
 Employee Income Tax:
(10,450 x .3) - 955= 2,180

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Or using the long process, Employee Income Tax on Taxable Income of Br 10,450 is
computed as follows:
Over Birr To Birr On Tax rate
0 600 600 0 0
600 1,650 1,050 10% 105
1,650 3,200 1,550 15% 232.5
3,200 5,250 2,050 20% 410
5,250 7,800 2550 25% 637.5
7,800 10,900 2650 30% 795
Total tax amount 2,180

 Pensions Contribution = Basic Salary @ 7% = Br 9,600 x .07% = Br 672

Net Pay:
Gross Taxable Income..........................................
Br 10,450.00
Less: Deductions
Employee Income Tax
...............................................
2,180
Pension Contribution
...............................................
672
Voluntary Contribution
0.00
Total Deduction........................... 2,852
Net Pay................................................................
Br 7,598
2. Petros Challa
Gross Income = Br 1,720 and Taxable Income = Br 1,720
Deductions:
 Employee Income Tax:
(1,720 x .15) -142.5 = 115.5
 Pensions Contribution = Br 0.00, he is a Contractual worker
Net Pay:

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 Chapter 3: Payroll Accounting

Gross Taxable Income..........................................

Br 1,720.00
Less: Deductions
Employee Income Tax
...............................................
115.5
Pension Contribution
...............................................
0.00
Voluntary Contribution
0.00
Total Deduction........................... 115.5
Net Pay................................................................
Br 1,604.5
3. Abdu Mohammed
Gross Income = Br 6,450 and Taxable Income = Br 6,450
Deductions:
 Employee Income Tax:
(6,450 x .25) -565 = 1047.5
 Pensions Contribution = Br 6,000 x .07% = Br 420
 Voluntary Contribution = Br 200.00 payable to Credit Association
Net Pay:
Gross Taxable Income..........................................
Br 6,450.00
Less: Deductions
Employee Income Tax
...............................................
1047.5
Pension Contribution
...............................................
420.00
Voluntary Contribution
200.00
Total Deduction........................... 1667.5
Net Pay................................................................
Br 4,782.5
4. Leilla Jemal

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 Chapter 3: Payroll Accounting

Gross Income = Br 4,050 and Taxable Income = Br 4,050

Deductions:
 Employee Income Tax:
(4,050 x .2) -302.5 = 507.5
 Pensions Contribution = Br 4,000 x 0.07% = Br 280
Net Pay:
Gross Taxable Income..........................................
Br 4,050.00
Less: Deductions
Employee Income Tax
...............................................
507.5
Pension Contribution
...............................................
280
Voluntary Contribution
0.00
Total Deduction........................... 787.5
Net Pay................................................................
Br 3,262.5

5. Kirkos Wolde
Gross Income = Br 14,375 and Taxable Income = Br 14,375 – 500 = Br 13,875
Deductions:
 Employee Income Tax = (13,875 x .35) – 1,500 = Br 3,356,25
 Pensions Contribution = Br 12,000 @ .07% =Br 840
Net Pay:
Gross Taxable Income.......................................... Br 13,875.00
Less: Deductions
Employee Income Tax...... 3,356.25
Pension Contribution.............. 840
Voluntary Contribution...........0.00
Total Deduction........................... 4,196.25
Net Pay................................................................ Br 9,678.75

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 Chapter 3: Payroll Accounting

B. Preparing a payroll register (or Sheet)

ETHIO RELIEF AGENCY
Payroll Register (Sheet)
For Month of Nahase 2008
Pay Day: Nahase 30,2008
Earnings Deductions
Seri. Name of Basic Allow. Over- Gross Income Pension Other Total Ded. Net Pay
No Employee Salary time Earning Tax Ded. Ded.
01 Senayet B. 9,600.00 100.00 750.00 10,450.00 2,180 672 __ 2,852 7,598
02 Petros Ch. 1,600.00 __ 120.00 1720.00 115.5 __ __ 115.5 1,604.5
03 Abdu M. 6,000.00 __ 450.00 6,450.00 1047.5 420 200 1667.5 4,782.5

04 Leila J. 4,000.00 50.00 __ 4,050.00 507.5 280 __ 787.5 3,262.5

05 Kirkos W. 12,000.00 500.00 1,875.00 14,375.00 3,356.25 840 __ 4,196.25 10,178.75

Totals 33,200.00 650.00 3,195.00 37,045.00 7,206.75 2,212 200.00 9,618.75 27,426.25

Proving the Payroll:

Total Earnings:
Basic Salary........................................................................ Br 33,200.00
Allowance........................................................................... 650.00
Overtime............................................................................. 3,195.00
Total Earnings................................................ Br 37,045.00

Deductions:
Employee Income Tax.......................................................... Br 7,206.75
Pension Contribution............................................................ 2,212
Other deductions................................................................... 200.00
Total Deductions.......................................................... Br 9,618.75
Total Net Pays.............................................................. 27,426.25
Total Deductions & Net pay........................... Br 37,045.00

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 Chapter 3: Payroll Accounting

C. Recording the Payment of Salary on Nehase 30, 2008

Salary Expense............................................................................... 37,045.00
Employee Income Tax Payable..................................... 7,206.75
Pension Contribution Payable....................................... 2,212
Credit Association Payable............................................ 200
Cash............................................................................... 27,426.25
Ck. No. 41
D. Recording the Payroll Tax Expense for Nehase, 2008
Ethio - Relief Agency incurred payroll tax expense of Br 3,476 during Nehase, 2008. This is
determined as the product of the basic salary of all permanent employees and 11%. This is because
the agency has to contribute 11% of the basic salary of every permanent employee to the
government pension trust fund. Thus,
 Payroll Tax Expense = Total Basic Salary of all permanent Employees @ 9%
 Payroll Tax Expense = (9,600 + 6,000 + 4,000 + 12,000) @ 11% = Br 3,476
By the amount of Br 3,476 the agency's expense, payroll taxes expense, and pension contributions
payable increase. Therefore, the following journal entry is made as of Nehase 30, 2008:
Payroll Tax Expense.......................................................................
3,47
6
Pension Contribution Payable....................................... 3,47
6

Memorandum No. 006

The source document is an internal office memorandum that indicates the incurrence of this
expense.
E. Recording the payment of the claim of the credit Association
Credit Association Payable......................................... 200
Cash........................................................... 200
F. Recording the payments of withholding taxes and payroll taxes of the month
Look at the account balances before payment:
Employee Income Tax Payable Pension Contribution Payable
7,206.75 (2) 2,212 (2)

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3,476.00 (3)
5,688
From the above accounts you can see that the agency has a total liability of Br 12,894.75. That is the
sum of Br 7,206.75 Employee Income Tax payable and Br 5,688 Pension Contribution payable
(7,206.75 + 5,688= 12,894.75). Note also that the total pension contribution payable is equal to 18%
of the basic salary of all permanent employees. That is, Br 31,600 x 18% = Br 5,688. T hen, the
payment is recorded as follows:
Employee Income Tax Payable................................... 7,206.7
5
Pension Contribution Payable.................................... 5,688
Cash.......................................................... 12,894.7
5
Ck. No. 50
After the payment of these liabilities have been posted, the above two accounts will have zero
balances.

EXERCISES
Exercise 3.1:
Payroll data of a government hotel, Andinet Hotel, for the month of Hamle, 2008 are given below:
Over time in hours
Name Basic Regular Upto 10PM – Rest Holy
Salary HourlyRate Allowanc 10PM 6AM Days Days
e
Abera Br 600 Br 3 Br 200 10 – 4 –
Abebu 420 2.10 – 20 10 – 5
Belete 980 4.90 100 – 5 – 8

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Additional information: Abebu is contractual employee and the allowance to Abera is free of
income tax.
Required:
1. Prepare payroll register
2. Record on page 10 of a two column general journal:
a) The payment of salary on Hamle 30,
b) The recognition of payroll tax expense, and
c) The payment of the amounts owed, in connection with the month Hamle, 2008 payroll,
to the government on Nehase 5, 2008.
Exercise 3.2: A permanent employee of a government organization with a basic monthly salary of
Br640.00 and monthly Allowance of Br100.00 has worked 20 overtime hours during days in the weekends
of the current month. This employee usually works 160 hours in a month to earn his basic salary. Based on
the above information answer the following questions:
1. What is the ordinary hourly rate of this employee?
2. How much is the gross earnings of this employee?
3. Determine the amount of employee income tax and pension contribution!!
Exercise 3.3: W/t Kedija, the employee of CMN Agency, government owned, has worked 10
hours, 8 hours and 12 hours, during the holidays, after mid night on working days and weekends
respectively in a given month. In the same month, she has earned a regular monthly salary of 1,120
BIRR as the result of working 140 regular working hours. Determine her gross overtime earnings
for the month.
Exercise 3.4: Using the following payroll data of Paradise Restaurant, government owned, for the
month of Sene 988:
Employee Name Basic Salary OT Earning
DerbeReta Br 200.00 Br 50.00
RahelAmde 400.00 200.00
Michael Girma 300.00 400.00
1. Compute the (a) Income tax deduction from each employee; (b) Pension contribution by each
employee; and (c) Employer’s payroll tax expense
2. Prepare journal entries to record the (a) Payment of salary to employees; (b) Employer’s payroll
tax expense; and (c) Payment of the deductions and payroll taxes to the government at the
beginning of the following month
3. Assuming that the ordinary hourly rate of Rahel is Br 2 and all of her overtime hours were
performed during weekly rest days, how many overtime hours did she work?

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