Payroll accounting

Chapter three
3. Current Liabilities and Accounting Systems for Ethiopian Payroll
Objective of the chapter
At the end of this chapter the students are be able to:
 Define current liabilities
 describe characteristics of liabilities

 distinguish between current liabilities and long-term liabilities

 illustrate Ethiopian payroll accounting

3.1 Introduction
In the previous chapter we were discuses about assets based on their liquidation. In this chapter
we will discuss about current liabilities and payroll accounting in Ethiopian context. Liabilities
are “probable future sacrifices of economic benefits arising from present obligations of a
particular entity to transfer assets or provide services to other entities in the future as a result of
past transactions or events.” Generally liabilities are classified in to two major categories’, these
include: Long – term liabilities current liabilities, but In this chapter we will discuss only current
liabilities.
3.1.1 Definition of liability
The FASB, as part of its conceptual framework study, defined liability as ‘’ a probable future
sacrifices of economic benefits arising from present obligations of a particular entity to transfer
asset or provide services to other entities in the future as a result of past transaction or event’’
In other words, a liability has three essential characteristics:

1. It is a present obligation that entails settlement by probable future transfer or use of cash,
goods, or services.
2. It is an unavoidable obligation.
3. The transaction or other event creating the obligation has already occurred.
Classification of liability: there are two major categories of liability, these includes
1. Long term liability
2. Short term (current) liability
Current liabilities are obligations whose liquidation is expected to require the use of existing
current asset or the creation of other liability within one year or an operating cycle.

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3.2 . Meaning of Payroll

The term payroll often refers to the document prepared to pay remuneration for the service
rendered in a given period of time.
3.2.1 The Importance of Payroll Accounting
The payroll accounting of a firm has to be given emphasis of significance 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.
For the aforesaid reasons the need for accurate system of handling the payroll of a business is
unquestionable.
3.2.2 Definitions of Payroll Related Terms
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.
The Pay Period: It is the length of time covered by each payroll payment. Pay periods for
wage workers are usually made on weekly or bi-weekly. On the other hand, salaried
employees pay periods are monthly or semi-monthly.
The Pay 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.
A Payroll Register (Sheet): It is 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

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payroll period. The basis for the preparation of the payroll register can be the attendance
sheets, punched (clock) cards or time cards.
Pay Check: It is 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 pay.
Gross Earnings: It is the total pay to an employee before deduction for the pay period.
Payroll Taxes: They are taxes levied against the employer on the payroll of a firm. It is an
additional payroll related expense to an employer.
Withholding Taxes: These are taxes levied against the earnings of the employees of an
organization and withheld by the employer per the regulations of the concerned government.
Payroll Deductions: These are all the reductions from the gross earnings of an employee
such as withholding taxes, union dues, fines, credit association pays, etc.
Net Pay: The gross earnings after subtracting all the deductions, it is sometimes known as
take home pay - the amount collected by an employee on the pay day.
3.2.3 Possible Components of a 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. Earnings: money earned by an employee(s) of a firm from various sources. 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:
i. Position Allowance: monthly sum paid to an employee for bearing a particular
office responsibility, e.g. Head of a particular department or division.
ii. 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.
iii. Hardship Allowance: a sum of money given to an employee to compensate for an
inconvenient circumstance caused by the employer. For instance, unexpected

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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 region.
v. 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 Earning
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.
1. A worker shall be entitle to be paid at rate of one and one quarter( 1 1/4)times his
ordinary hourly rate for overtime work performed before 10 o’clock in the
evening(10p.m).
2. A worker shall be paid at the rate of one and one half (1 1/2) times his ordinary hourly
rate for overtime work performed between 10 o’clock in the evening (10p.m) and six
o’clock in the morning (6a.m).
3. Overtime work performed on the weekly rest days shall be paid at a rate of two (2) times
the ordinary hourly rate of payment.
4. 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 subtractions made from the earnings of employees that are 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:

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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 600 Birr. The money on which a person does not have to pay income
tax is an Exemption.
The income tax proclamation effected states the following about employment income tax and its
computations:
1. The first six hundred Birr (Birr 600) income from employment shall be exempt from
payment of income tax in all cases.
2. The tax on income from employment over six hundred birr (Birr 600) shall be
charged, levied and collected monthly according to the following schedule.
Taxable Monthly Income Rates of Tax(%) on Every Deductions
(In Birr) Additional Income
1 0-600 0% -
2 601- 1,650 10% 60
3 1,651- 3,200 15% 142.5
4 3,201- 5,250 20% 302.5
5 5,251- 7,800 25% 565
6 7,801- 10,900 30% 955
7 Above 10,900 35% 1,500
Generally, taxable income from employment includes salaries, wages, allowances, director’s fee
and other personal emoluments, all payments in cash and benefits in kind. However, there are
some income items, which are exempted/free from taxation.
The following income items are exempted from employment income tax.
 Income from employment received by casual employees. Casual employees are workers
who do not work for more than one month for the same employer in any twelve-month
period.
 Pension contribution, provident fund and all forms of retirement benefit contributed by
employers that does not exceed 15% of the monthly salary of employees.
 Subject to reciprocity, income from employment of diplomatic and consular representatives
 Amounts paid by employer to cover the actual cost of Medical treatment of employees.

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 Allowance in lieu of means of transportation granted to employees under contract of

employment. However, the treatment of transportation allowance differs at Federal and
City administration level. For example at federal level only transportation allowances up to
25% of the Basic Salary of the employee or an amount that does not exceed 1200 birr is
exempted from tax. Any amount in excess of this is subject to tax. In Addis Ababa & Dire
Dawa City administrations, the exempted amount of transportation allowance is 15 % the
Basic Salary of the employee or an amount that does not exceed 600 birr is exempted from
tax.
 Hardship Allowance
 Amounts paid to employees in reimbursement of travelling expenses incurred on duty.
 Allowances paid to members and secretaries of boards of public enterprises and public
bodies as well as members and secretaries of study groups set up by federal and regional
government.
 Income from persons employed for domestic duties(home servants)
b) Pension Contributions
Permanent employees of an organization, employees who 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 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 11% of the
basic salary of every permanent employee of it. It is this total amount that we called earlier as
payroll tax expense to the employer organization (i.e.11% 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 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 of scheme to benefit their employees
with some modifications. This is made in some NGO’s by keeping a fund known as Provident

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Fund. Both the employees and the employer contribute toward this fund monthly. Ultimately,
when an employee is retired or drawn out of work a lump-sum is given at once.
c) Other Deductions
Apart from the above two kinds of deductions from employees earnings, employees may
individually authorize additional 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.
Ultimately, the sum of the employees’ income tax, pension contributions, and other deductions
gives the total deductions from the gross earnings of an employee.
5. 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 payee.
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 names of employees.

3.2.4 Major Activities Involved in Accounting for Payroll

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o Gathering the necessary data. All the relevant information about every employee should
be gathered. This requires reviewing various documents such as attendance sheets and
doing some arithmetic work.
o Entering the names of employees along with the gathered data such as earnings,
deductions and net pays in the appropriate columns of the payroll register.
o 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 payroll register.
o The accuracy and authenticity of the information summarized in the payroll should be
verified by a different person from the one who prepared it.
o The payroll should be approved by an authorized personnel (individual)
o 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.
o Recording the payment of the payroll and recognition of the withholding tax liabilities.
o Recording the payroll tax expense of the employer.
o Paying and recording withholding and payroll tax liabilities to the concerned authority,
in our case to Inland Revenue Administration, on time.
Illustration:
Ethiopia Pharmaceutical Company, a wholly government owned company, pays salary to its
employees according to the Ethiopian calendar month and submit income tax withheld from
employees to the Federal Inland Revenue Authority (FIRA) on a monthly basis. The forth -
coming data relates to the Month of Ginbot 2009.
OT Basic
Basic Transportation Hours Duration of OT Salary Per
[Link]. Name Salary Allowance Worked Work Hour
01 Meron 10,400 900 10 Up to 10 P.M 65
02 Haile 1,920 - 8 10 P.M to 5 A.M 12
03 Dawit 7,400 - 6 Weekly rest days 46.25
04 Emnet 4,160 600 - - 26
05 Getu 1,200 100 10 Public Holidays 7.5

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N.B The management of the company usually expects a worker to work 40 hours in a week and
during Ginbot 2009 all workers have done as they are expected. Besides, all workers of the
Company are permanent except Haile. Dawit agreed to have a monthly Birr 300 be deducted and
paid to the Credit Association of the Company as a monthly saving.
Required: Based on the above information

1. Prepare a Payroll Register (or Sheet) for the Company for the month of Ginbot 2009
2. Record the payment of salary as of Ginbot 30, 2009 using Check No. 41 as a source
document.
3. Record the payroll tax expense for the month of Ginbot 2009. The source document for
this transaction is Memorandum No. 10
4. Record the payment of the claim of the Credit Association of the Company that arises
from the Ginbot Payroll assuming that the payment was made on Sene 1, 2009.
5. Assuming that the withholding taxes and pension contribution of the month of Ginbot
2009 have been paid on Sene 5, 2009 via Check No. 50, record the required journal
entry

Solutions:

1. Preparation of Payroll Register (Sheet)

Step 1: Calculate OT Earnings of Employees
OT Earnings = OT hrs. Worked * Ordinary hourly rate * OT rate
 Meron
OT Earnings = 10 Hrs * 65 * 1.25 = Birr 812.5
 Haile
OT Earnings = 8 Hrs * 12 * 1.50 = Birr 144
 Dawit
OT Earnings = 6 Hrs * 46.25* 2.00 = Birr 555
 Getu
OT Earnings = 10 Hrs * 7.5* 2.50 = Birr 187.5

Step 2:Calculate the Gross Earnings and Taxable Earnings of employees

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Gross Earnings = Basic Salary + Allowances + OT Earning

 Meron
Gross Earnings = Birr 10,400 + 1300 + 812.5= Birr 12,512.5
Taxable Earnings = Birr 12,512.5– Birr 1200 = Birr 11,312.5. The tax law says that the
transportation allowance exempted from the payment of tax for Federal Government
Organizations[Ethiopia Pharmaceutical Company is a Federal Public Enterprise] is the lower of
what the employee get or 25% of the employee basic salary, if what the employee gets is less
than Birr 1200. On the other hand, if what the employee get is greater than Birr 1200 the
exempted transportation allowance is the lower of Birr 1200 or 25% of the employee basic
salary. Meron’s case falls on the second range. What she gets is Birr 1300 which is greater
than .Birr 1200. So, the exempted allowance is the lower of Birr 800 or 25% of Birr 10400 which
is Birr 2600. By applying the tax rule the exempted transportation allowance will be Birr 1200
only.
 Haile
Gross Earnings = Birr 1920 + 0 + 144 = Birr 2,064. The taxable earning of Haile is equal to his
gross earnings because he doesn’t get transportation allowance, which could have been tax
exempt.
 Dawit
Gross Earnings = Birr 7400 + 0 + 555 = Birr 7955 The taxable earning of Dawit is equal to his
gross earnings because he don’t get transportation allowance, which could have been tax exempt.
 Emnet
Gross Earnings = Birr 4160+ 1200 + 0 = Birr 5360
Taxable Earnings = Birr 5360– Birr 1040 = Birr [Link] transportation allowance for
Emnet should be the lower of Birr 1200 or 25% of her Basic salary because what she gets is less
than Birr 1200. 25% of Birr 4160 is Birr 1040. So, the exempted transportation allowance will be
Birr 1040.
 Getu
Gross Earnings = Birr 1200 + 100 + 187.5 = Birr 1487.5
Taxable Earnings = Birr 1487.5 – Birr 100 = Birr 1387.5. Nontaxable transportation allowance
for Getu should be the lower of Birr 1200 or 25% of his Basic salary because what he gets is less

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than Birr 1200. 25% of Birr 1200 is Birr 300. So, the exempted transportation allowance will be
Birr 100.
Step 3: Go to the Calculation of Income Taxes and Pension
 Meron
Income Tax = (Birr 11,312.5* 0.35) – 1500 = Birr 2459.375
Pension = 7% * Birr 10,400 = Birr 728
Haile
Income Tax =(Birr 2,064 * 0.15) – 142.5 = Birr 167.1
Pension for Haile is Zero as he is not a permanent worker.
 Dawit
Income Tax =(Birr7955 * 0.3) – 955 = Birr 1431.5
Pension = 7% * Birr 7400 = Birr 518
 Emnet
Income Tax =(Birr 4320* 0.2) – 302.5 = Birr 561.5
Pension = 7% * Birr 2160 = Birr 291.2
 Getu
Income Tax =(Birr1387.5* 0.1) – 60 = Birr 78.75
Pension = 7% * Birr 1200= Birr 84

Step 4: Completing the payroll Register (Sheet)

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Ethiopia Pharmaceutical Company

Payroll Register (or Sheet)For the Month of Ginbot 2009
Earnings Deductions

S. No. Name Gross Total Net Pay

Deductions
Allowance
Transport
Earnings Deductions

Pension
Income
Salary

Other
Basic

Time
Over

Tax
01 Meron 10400 1300 812.5 12,512.5 2459.375 728 - 3187.375 9,325.125

02 Haile 1,920 - 144 2,064 167.1 - - 167.1 1,896.9

03 Dawit 7,400 - 555 7955 1431.5 518 300 2,249.5 5,705.5
04 Emnet 4,160 1200 - 5360 561.5 291.2 - 852.7 4507.3

05 Getu 1,200 100 187.5 1,487.5 78.75 84 - 162.75 1324.75

25,080 2600 1,699 29,379 4698.225 1621.2 300 6,619.425 22,759.575

Total

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2. Recording the Payment of Salary

Salaries expenses ---------------------------------Br.29, 379
Income tax payable ---------------------------4698.225
Pension contribution payable -----------------1621.2
Payable to credit associations -----------------300
Cash----------------------------------------------22,759.575
3. Record the payroll tax expense
Payroll tax expenses -----------------------------------2,547.6
Pension contribution payable------------------2,547.6
4. Record the payment of the claim of the Credit Association of the Company
Payable to credit associations ----------------------300
Cash -----------------------------------------------300
5. Recording the payment of withholding tax and pension contribution to Inland Revenue
Authority and Pension Trust Fund
Income tax payable-----------------------------------4698.225
Pension contribution payable--------------------------4,168.8

Cash -----------------------------------------------8867.025

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