Chapter 4 Accounting for Ethiopian Payroll system

Introduction

Individuals may receive various types of income such as wages or salary from
employment, rent from letting houses or buildings, interest from
lending/saving money, and profit from their trading activities or business.
These individuals are required to pay income tax. They are ordered to do so by
income tax proclamations, regulation and directives. The law specifies how and
when these individuals have to pay the required tax. This article deals
especially with the aspect of the law which applies to individuals who earn
income from employment. According to the law, individuals who obtain income
from their employment are required to pay tax.

Importance of payroll accounting

Accounting for payroll is particularly important because:

1- Payroll often represents the largest expense that a company incurs.

2- Both federal and state governments require that detailed payroll records
be kept and
3- Employees are sensitive to payroll errors or irregularities. To maintain
good employee morale payroll must be paid on a timely and accurate
basis.

Definition of payroll related terms

1. Salary and Wages: Salary and wages are usually used interchangeably.
However, the term wages are more correctly used to refer to payments to
unskilled-manual labor. It is usually paid based on the number of hours
worked or the number of units produced. Therefore, wages are usually
paid when a particular piece of work is completed or weekly. On the
other hand, salaries refer to payments to employees who render
managerial, administrative or similar services, and they are usually paid
to skilled labor on a monthly or yearly basis.

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 2. The Pay Period: A pay period refers to the length of time covered by
each payroll payment.
3. The Pay Day: The pay day- is the day on which wages or salaries are
paid to employees. This is usually on the last day of the pay period.
4. A Payroll Register (sheet): is the list of employees of a business along
with each employee’s gross earnings; deductions and net pay (take home
pay) for a particular pay period. The payroll register (sheet) is prepared
based on attendance sheets, punched (clock) cards or time cards.
5. Pay Check: A business can pay payroll by writing a check for the
amount of the net pay. A check is prepared in the name of each employee
and handed to employees. Alternatively, a check for the total net pay can
be prepared for employees to the paid by cash at the organization.
6. Income tax: are taxes collected from the earnings of employees by the
employer organization as per the regulations of the government. These
have to be submitted (paid) to the government because employer
organization is only acting as an agent of the government in collecting
these taxes from employees.
7. Payroll tax expenses: refers to the employer portion of the pension
contribution (11% of the basic salary) contributed by the employer
organization to the employee)
8. Payroll Deductions: are deductions from the gross earnings of an
employee such as employment income taxes (withholding taxes), labor
union dues, fines, credit association pays etc.
9. Net Pay: Net Pay is the earning of an employee after all deductions have
been deducted. This is the take home pay amount collected by an
employee on the payday.

Employment income

Employment income refers to any payment received or to be received by an

employee from his employer(s) by virtue of rendering services to the employer(s)

and not virtue of personal consideration.

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Employment income is one of the heads or schedules of income in Ethiopian

income tax legislation. Employment income is also known by the name

schedule ‘A’ income, personal income, or income from employment.

For the purpose charge of employment income tax in Ethiopia, article #12(1)

of the tax proclamation #979/2008 defines the term employment income

as follows: employment income shall include any payments or gains

(benefits) in cash or in kind received from employment by an individual,

including but not limited to: salary/wages, allowance, bonuses,

commissions, gratuity or other remunerations received by an employee

in respect of current, future or past employment.

However, for comprehensive understanding, readers are strongly advised to

refer to tax administration proclamation No. 983/2008, income tax

regulation No. 410/2017, Directive No.1/2011 and circulars on severance

tax in addition to the aforementioned tax proclamation.

Components of the Payroll Register

 Employee Id
 Employee Name
 Gross earnings (the sum of Basic salary, Allowances & OT)
 Deductions (Income tax, PC, and Others)
 Net pay

Basic Salary
Basic Salary is a flat monthly salary of an employee for carrying out the normal
work of employment and subject to change when the employee is promoted.
Overtime work earning

Overtime work is the work performed by an employee beyond the regular

working hours. Overtime earnings are the amount paid to an employee for
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overtime work performed. Article 33 of proclamation No. 64/1975 discussed
the following about how overtime work should be paid:

A worker shall be entitled to the paid at a rate of

i. one and one-quarter (1 ¼) times his ordinary hourly rate for overtime
work performed before 10:00 P.M in the evening.
ii. One and one half (1 ½) times his ordinary hourly rate for overtime work
performed between 10:00 P.M and six (6:00 A.M) in the morning.
iii. Two times the ordinary hourly rate for overtime work performed on
weekly rest days
iv. two and one half (2 ½ ) times the ordinary hourly rate for overtime work
performed on a public holiday.

All in all, the gross earnings of an employee may include the basic salary,
allowance and overtime earnings.

Allowances
Allowances are money paid monthly to an employee for special reasons, like:
- Position allowance (Responsibility allowance)- a monthly paid to an
employee of earning a particular office responsibility.
- Housing allowance- a monthly allowance given to cover housing
costs of the individual employee when the employment contract
requires the employer to provide housing but the employer fails to
do so.
- Hardship 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.
- Transportation (fuel) allowance: - a monthly allowance to an
employee to cover cost of transportation up to her workplace if the
employer has committed itself to provide transportation service.

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Employment income tax shall not include exempted income for tax and
retirement benefit purpose. Except hardship and transportation (though
there is a limit), all allowances are taxable incomes.

Employment Income Deduction

Deductions are subtractions made from the earnings of employees required by
the government or permitted by the employee himself.

Employment Income Tax:

The employee's income tax system divides taxable income into different tax bands.

These are a range of income bands with different tax rates. Below is a schedule

that specifies tax bands and their tax rates.

Employment Income Income Tax rate (%) Deductible amount

≤ 600 Exempt threshold 0

601 – 1650 10% 60

1651 – 3200 15% 142.50

3201 – 5250 20% 302.50

5251 – 7800 25% 565.00

7801 – 10900 30% 955.00

≥10,900 35% 1500.00

According to the above tax rate schedule, employees who earn up to 600 Birr a

month are below the threshold for paying employment income tax. It is presumed

that this exemption has removed hundreds of thousands of low income employees

from the tax roll. However, employees who earn 601 Birr per month and above are

liable to pay employment income tax. In order to impose a heavier tax burden on
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those employees who earn more, the government uses a progressive employment

income tax system. Tax on income from employment has six bands or groups of

rates. These are 10%, 15%, 20%, 25%, 30% and 35%. The minimum tax rate

applied to income from employment is 10% while the maximum is 35%. These

bands of rates in the above schedule are used to compute the tax due.

Pension contribution (PC)

Permanent employees of both governmental and private organization in
Ethiopia are expected to pay or contribute 7% of their basic salary to the
governments’ pension trust fund. An employee will be considered as a
permanent employee if he/she engaged in their employment for more than 45
days from day of employment.

This amount is withheld by the employer from each employee on every payroll
and later be paid to the respective government body. The employer is also
expected to contribute towards this same fund 11% of the basic salary of every
permanent government employee.

Therefore, the total contribution to the pension fund of the Ethiopian

government and private employee is equal to 18% of the basic salary of all of its
permanent employees. That is, 7% comes from the employees and 11% comes
from the employer.

This enables a permanent employee of private and government organization to

be entitled to the pension pay when retiring provided the employee satisfies the
minimum requirements to enjoy the benefits.

Other Deductions
Apart from the above two kinds of deductions, employees may individually
authorize additional deductions such as deductions to pay life insurance
premiums, to repay loan from the employer, to pay for donation to charitable
organization, contributions to "ldir" etc.

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Income Exempt from Tax (tax free earning)
As per the income tax Proclamation, Regulation and Directives of Ethiopia, the
following categories of payments in cash or benefits in kind shall be excluded
from computation of income taxable under employment income tax.
(a) Amounts paid by employers to cover the actual cost of medical treatment of
employees;
(b) Allowances in lieu of means of transportation granted to employees under
contract of employment;
(c) Hardship allowance;
(d) Amounts paid to employees in reimbursement of traveling expenses
incurred on duty;
(e) amounts of travelling expense paid to employees recruited from elsewhere
than the place of employment on joining and completion of employment or in
case of foreigners traveling expenses from or to their country, provided that
such payments are made pursuant to specific provisions of the contract;
(f) Allowances paid to members and secretaries of boards of public enterprises
and public bodies as well as to members and secretaries of study groups set up
by the Federal or Regional Government;
(g) Income of persons employed for domestic duties;
Examples
1. Assume that Mr. Abebe is an employee of ABC Co. with a basic salary of
Br. 6,400. The regular working hours per week is 40 hours. Mr. Abebe is
entitle to get a position allowance and transportation allowance of Br.
1,500 and Br. 600 respectively. Beside this he has been working for
additional 15 hours; of which, 5 hours on weekly rest day, 6 hours on
public holiday and the remaining after 10:00 pm. Assuming that Mr.
Abebe is a permanent employee:
Required:
a. Compute the gross earning of Mr. Abebe for the month of May
b. Compute the total payroll deduction of Mr. Abebe for the month of May
Solution
Gross earning= Basic salary + Allowances + overtime earning
Overtime earning?
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1st determine regular pay per hour i.e
Regular pay per hour = Monthly basic salary = Br. 6,400 = Br.
40/hour
Monthly working hours 40hoursX4
Over time earning = Regular pay per hour X OT duration rate X OT hour
worked
OT duration rate 5hour week end 2 times, 6 hour public holiday 2.5 times and
after 10:00pm 1.5times. Therefore,
Overtime earning = Br. 40/hour X 2times X 5hours
+
= Br. 40/hour X 2.5times X 6hours
+
= Br. 40/hour X 1.5 times X 4 hours
Overtime earning = Br. 1,240
Gross earning= Basic salary + Allowances + overtime earning
= Br. 6,400 + (Br. 1,500+600) + Br. 1,240
= Br. 9,740
Total payroll deduction = Payroll Tax + Pension + Other(if any)
i. Payroll tax
Taxable Income = Gross Earning – Exempted earning
= Gross Earning – Transportation Allowance
= Br. 9,740 – Br. 600
= Br. 9,140
Therefore, Tax= (Br. 9,140 X 30%) - Br. 955
= Br. 1,787
ii. Pension = Basic salary X 7%... Employee
= Basic salary X 11%..Employer
Pension = Br. 6,400 X 7%= Br. 448 Employee
Pension = Br. 6,400 X 11%= Br. 704 Employer

Total payroll deduction = Tax + Pension

= Br. 1,787 + Br. 448
= Br. 2,235
Net Pay = Gross earning – Total payroll deduction

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 = Br. 9,740 – Br. 2,235
= Br. 7,505

Note:
o Payroll tax expenses (PC of the employer) = 0.11*6,400= 704
o Total Pension contribution (448+704 = 0.18*6,400)
o Total Salary expense of the period…………………………..Br. 9,740
o Total Salary expense ……………………………………….9,740

Journal Entries related to the payroll of the month

1. To record the payment of the salary:

Salary Expense-----------------------9.740

Cash -------------------------------------7,505

Income tax payable--------------------1,787

Pension contribution payable ---------448

2. TO record payroll tax expense of the period

Payroll tax expense------------------704
PC payable--------------------------704
3. To record payment of Income tax and PC to the concerned gov’t offices
Income tax payable------------------1,787
PC payable ---------------------------1,152
Cash------------------------------------------2.939

Payroll Sheet

Using the solved illustration above the computed information’s are presented in
the following page payroll register:

ABC Company

Payroll Register

For the month of May

TIN Name of Earnings Deductions

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No. Employe Basi Allo- Over Gross Incom Pensio Other Total Net Sig
e c wanc e n n.
Tim Earnin Dedu Dedu Pay
salar e
e g Tax Contr. c. c.
y

001 Mr. 6,40 2,100 1,24 9,740 1,787 448 - 2,235 7,50 __
Abebe 0 0 5

Tota 9,740
l

Prepared by ___________ Checked by ____________ Approved by

___________

Payroll expense ………Br. 9,740

Pension contribution… Br. 704

Total salary expense… Br.10,444

4.3.2 Payroll Related Journal Entries

The payroll process will be completed after the journal entries presented in the
following table are made and posted in the appropriate ledger (account).

 to record payment of salary and withholding of tax, pension and

contribution
Payroll expense…………………………………………9,740

Pension contribution (11%)…………………………… 704

Cash (Net pay) ……………………..……………. 7,505

Payroll tax payable…………………….………... 1,787

Pension Payable (7% + 11%)…………………… 1,125

 to record payment of withheld tax to the tax authority

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 Payroll tax payable………………………………1,787
Cash ………………………………………...1,787

 to record payment of withheld pension to the pension trust fund

Pension payable (7% + 11%)……………………1,125
Cash ………………………………………...1,125

Exercise questions
ABC Company engaged in Selling Imported goods to local customers. The
following information related to the operation for the month ended Ginbot 30 of
the current Ethiopian calendar is presented below:
TIN No Employee Basic Transportation Overtime Duration of
name Salary Allowance worked OT Work
(hr)
0029345682 Amen Br. 2,000 10 Weekly Rest
Abebe 13,400 Day
0029345683 Yonas 10, - 8 Before 10:00
Meles 720 pm
0029345684 Joel Zola 9,600 2,000 12 Public
holiday
0029345685 Hassen 6,400 - 14 After 10:00
Jemal pm

Additional Information:

 The normal work hours per week are 40

 There were no absentees during the month.
 Hassen agreed to contribute Br. 1,000 per month as a saving in the
credit association of the agency.
 Joel Zola is a Kenyan citizen
Required

iii. Compute the earning, deduction and net pay of each employee
iv. Prepare a payroll register
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v. Journalize the necessary payroll transactions

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