Fundamentals of Accounting II Chapter Three August, 2022

CHAPTER 4: PAYROLL SYSTEM IN ETHIOPIAN CONTEXT

3.1 INTRODUCTION
Accounting systems for payroll and payroll taxes are concerned with the records and reports associated
with the employer-employee relationship. Well-designed accounting system has a mechanism that ensures
payroll payments should be in accord with the employment contract duly signed by both parties based on
the prevailing labor laws in that jurisdiction. All employees of an organization expect and are entitled to
receive their remuneration at regular intervals following the closing of each payroll period. Regardless of
the number of employees and the difficulties in computing the amounts to be paid, the payroll system must
be designed to process the necessary data quickly and assure payment of the correct amount to each
employee timely. The system must also provide adequate safeguards against unauthorized payments to
employees and other misappropriations of funds.

In this chapter, therefore you are expected to acquaint yourself with major payroll records/documents by
working through all the procedures common to most payroll systems such as the employee’s earnings
record, payroll sheet (or register), and journal entries related to payroll. Each of these concepts is
illustrated and discussed by taking into account the current tax law of the country. As much as possible the
text attempts to give you adequate knowledge about payroll systems in Ethiopia. However, if you come
across any confusion or difficulties you can consult the authorities in the Ministry of Finance and
Economic Cooperation(MoFEC) or Ethiopian Revenue and Customs Authority(ERCA) in your locality, or
refer the relevant proclamations especially; Proclamation No. 979/2016.

3.2 IMPORTANCE OF PAYROLL ACCOUNTING

Accounting for payroll is particularly important because:
i Payroll often represents the largest expense that a company incurs.
ii Both federal and state governments require that detailed payroll records be kept, and
iii Employees are sensitive to payroll errors of irregularities.
To maintain good employee morale, payroll must be paid on a timely and accurate basis.

3.3 DEFINITION OF PAYROLL RELATED CONCEPTS/TERMINOLOGY

a) Salary and Wages: Salary and wages are usually used interchangeably. However, the term wages is
more correctly used to refer to payments to unskilled labor. It is usually paid based on the number of hours
worked or the number of units produced. Therefore, wages are usually paid on a weekly basis or when a

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page1

Fundamentals of Accounting II Chapter Three August, 2022
particular piece of work is completed. 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. In this context wages and salaries means a payment to an ‘employee’ who works
primarily to an organization and whose activities are under the direct supervision of the employer.A self-
employed person on the other hand, provides his/her services on a fee basis to various firms
b) The pay Period: A pay period refers to the length of time covered by each payroll payment.
c) The Pay Day: The payday is the day on which wages or salaries are paid to employees. This is
usually on the last day of the pay period.
d) 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.
e) Pay Check; A business can pay payroll by writing a check for 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 be paid by cash at the organization.
f) Gross Earnings: is the total earnings of the employees for a given pay period before deductions.
g) Withholding Taxes: are taxes collected from the earnings of employees by the employer organization
as per the regulations of the government. These have to be reimbursed (paid) to the government because
employer organization is only acting as an agent of the government in collecting these taxes from
employees.
h) Payroll Deductions: are deductions from the gross earnings of an employee such as employment
income taxes, employee pension contribution (withholding taxes), labor union dues , fines, credit
association pays etc.
i) Net Pay: Net pay is the earning of an employee after all deductions have been made. This is the take
home pay amount collected by an employee on the payday.
3.4 POSSIBLE COMPONENTS OF A PAYROLL REGISTER
i) Employee Identification Number: - Number assigned to employees for identification purpose when
a relatively large number of employees are involved in a payroll register. It could be an identification
card of the employees or a simple serial number.
ii) Name of Employee: This column lists names of employees of the organization.
iii) Earnings: Money earned by an employee from various sources. This may include.
a) Basic Salary: - a flat monthly salary of an employee for carrying out the normal work of
employment and subject to change when the employee is promoted.

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page2

Fundamentals of Accounting II Chapter Three August, 2022
b) Allowance: - Money paid monthly to an employee for special reasons, like:
Position allowance: - a monthly allowance paid to an employee for bearing a particular
office responsibility.
Housingallowance: - 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.
Hardshipallowance / or disturbance allowance: - a sum of money given to an employee
to compensate for an inconvenient circumstance caused by the employer. For example,
unexpected transfer to a different and distant work area or location.
Desertallowance – 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 his/ her workplace if the employer has committed itself to provide
transportation service.
iv)OvertimeEarning: - Overtime work is the work performed by an employee beyond the regular
working hours. Overtime earnings are the amount paid to an employee for overtime work performed. In
Ethiopia, the hourly rate of overtime work varies depending on the time period in which the work is
performed. Accordingly, a worker shall be entitled to be paid at a rate of
a) One and one –quarter (1¼) times his ordinary (regular) hourly rate for overtime work performed
before 10:00 P.M in the evening. (6:00AM-10:00 PM)
b) One and one half (1½) times his ordinary (regular) hourly rate for overtime work performed
between 10:00 P.M and six (6:00A.M.) in the morning.
c) Two times the ordinary (regular) hourly rate for overtime work performed on weekly rest days.
d) Two and one half (2½) times the ordinary (regular) 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, overtime and other
earnings like bonus.
v) Deductions: are subtractions made form the earnings of employees required either by the government
or permitted by the employee herself. The following are some of the deductions:
a) Employment Income Tax: - Almost in all countries across the globe, citizens pay tax on their
employment income at different level. In Ethiopia also, income tax is charged on the gross earnings of the

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page3

 Fundamentals of Accounting II Chapter Three August, 2022
employee at the rates indicated under schedule A of the proclamation No 979/2016- “Income Tax
proclamation”.
Taxable income includes any payment or gains in cash or in kind received from employment by an
individual, including income from former employment, or otherwise, from prospective employment. The
tax schedule is provided hereunder:
Taxable We may use the deduction approach as an
alternative
Income
Employment Income Income Tax Payable
From To On the next Tax Rate (per month)
From Birr To Birr
Zero Br. 600 Br.600 0% (Exempted) Zero Br. 600 No tax (tax free)
601 1,650 1,050 10% 601 1,650 (10% X EI)-60
1,651 3,200 (15% X EI)-142.5
1,651 3,200 1,550 15%
3,201 5,250 (20% X EI)-302.5
3,201 5,250 2,050 20% 5,251 7,800 (25% X EI)-565

5,251 7,800 2,550 25% 7,801 10,900 (30% X EI)-955

above Br. 10, 901 (35% X EI)-1500
7,801 10,900 3,100 30%
Br. 10,901 and above 35%

b) Pension Contribution: Permanent employees of governmental and private organizations in Ethiopia

are expected to pay or contribute 7% of their basic salary to the pension trust fund administered by the
government. This amount is withheld by the employer from each employee on every payroll and later be
reimbursed to the respective government body administering the fund. The employer should also
contribute towards the same fund 11% of the basic salary of every permanent employee. This is additional
expense the employer contributes to the employees’ pension and usually called as payroll tax by employer.

Therefore, the total contribution to the pension fund is equal to 18% of the basic salary of all of its
permanent employees. This enables employee to be entitled for the pension pay when retired provided the
employee satisfies the minimum requirements to enjoy the benefits. Non-governmental not-for profit
organization (NGO’s) also have this kind of scheme to benefit their employees with some modifications.
A fund known as provident fund as established and both the employer and the employee contribute
towards this fund monthly. When an employee retires or leaves employment, a lump sum amount is paid
to her/him.

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page4

 Fundamentals of Accounting II Chapter Three August, 2022
c) Other Deductions: Apart from the above two kinds of deductions, employees may individually
authorize additional deduction such as deductions to pay life insurance premiums, to repay loan from the
employer, to pay for donations to charitable organization, contributions to “Idir”etc.
vi) Net Pay: - represents the excess of gross earnings over total deductions of an employee.
vii) Signature: -The payroll sheet should have a column for signature of the employee to be taken when
the employee collects the net pay. This works only when the payroll system is working manually. In an
electronic payment system, signature may not be required as the transfer is made electronically directly to
the individual accounts.

3.5 MAJOR ACTIVITIES INVOLVED IN ACCOUNTING FOR PAYROLL

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.
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.
Totaling and proving the payroll register –the grand total for earnings must be checked if its equal to
the sum of the grand totals of deductions and net pays.
The accuracy and authenticity of the information summarized in the payroll should be verified by a
different person from the one who prepared it.
The payroll should be approved by authorized personnel (individual)
Paying the payroll either in cash or by writing a check.
The payment of the payroll and income taxes withheld from employees (withholding tax liability)
should be recorded in journal entry form.
The withholding tax must be paid to the relevant government authority in time (promptly) and this is
recorded in journal entry form.

3.6 ILLUSTRATION OF A PAYROLL REGISTER

Rift Valley Enterprise is a government agency recently organized to rehabilitate street children. It has five
employees whose salaries are paid according to the Ethiopian calendar month. The following data relates
to the month of Megabit, 2010.
\

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page5

 Fundamentals of Accounting II Chapter Three August, 2022
Ser.No. Name of Employee Basic Transportation Duration of Overtime OT Work
Salary Allowance Worked(hr)
01. Abraham Getu Br. 10,400 1,200 4 6:00-10:00p.m
02. BekumaJirra 9,600 - 8 Sunday(8:30-5:30)
03. MeymunaHunduma 8,000 - -
04. Tewodros Alemayhu 7,200 - -
05. Ahmed Mohammed 4,800 - 6 Public Holiday
Additional Information
According to the employment contract every employee works 40 hours in a week as regular working
hours. During Megabit there are four weeks. There were no absentees during the month
All employees are permanent except Tewodros and Ahmed
Bekuma agreed to contribute monthly Br. 480 from his salary as a monthly saving in the credit
association of the enterprise.
Transportation allowance which is above br. 800 is taxable
Required
1) Prepare a payroll register (sheet) for the enterprise for the month of Megabit,2010.
2) Record the payment of salary as of Megabit 30, 2010 using check stub No. 0123.
3) Compute and record the payroll tax expense for the employer
4) Record the reimbursement of the claim of the credit association of the enterprise on Miazia 1, 2010.
Use check stub No. 0124.
5) Record the payment of the withholding taxes and pension contribution to the concerned government
body on Miazia 7, 2010.
Computation of Earnings, Deductions, and Net Pay
Gross Earnings = Basic salary + Allowance + Overtime Earning
Since basic salary and allowances are direct, first let’s calculate overtime earning of the three employees
who has worked overtime during the month

01. Overtime Earning

Overtime earning = OT hrs worked X (ordinary hourly rate X relevant OT rate)
1. ABRAHAN:
OT Earning = 4 hours Xbr.10,400 X 1.25
160 hours
= br. 325.00

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page6

Fundamentals of Accounting II Chapter Three August, 2022
NB Every employee is expected to work 160 hours permonth (i.e. 40 hours x 4 weeks)
You should compute the regular hourly rate first:
Regular Hourly Rate = Monthly salary (Basic Salary)
Total Hours worked in the Month
= br. 10,400
160 Hours
Therefore, the regular hourly payment = br. 65
The regular hourly payment must be multiplied by the appropriate OT rate as follows:
Br. (65 x 1.25) x 4 hours …………..br. 325
2. BEKUMA:
OT Earning = 8 hours X br.9,600 x 2 ………br. 960.00
160hrs
3. AHMED:
OT Earnings = 6 hours X br. 4,800 x 2.5 .……br. 450.00
160 hours
Now we can determine the gross earning of each employee as follows:
02. GROSS EARNINGS
Gross Earnings = Basic salary + Allowance + OT Earnings
1. ABRAHAM:
Gross Earning = BR. 10,400 + BR. 1,000 + BR. 325
= BR. 11,925.00
Remember taxable income in this case is br. 11,125.00 because of the transportation allowance br.
1,200, br. 800 is not subject to taxation.
2. BEKUMA:
Gross Earning = BR. 9,600 + BR. 960
= BR. 10,560
The Gross Total Earnings of Bekuma consists of the br 9,600 basic salary plus the overtime
earnings of br. 960, which is br. 10,560.
3. MEYMUNA:
Gross Total Earnings = BR. 8,000,which is only the basic salary
4. TEWODROS:
Gross Total Earnings = BR 7,200,which is the basic salary alone.

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page7

 Fundamentals of Accounting II Chapter Three August, 2022
5. AHMED:
Gross Total Earnings = BR. 4,800 +450.00
= BR. 5,250.00
03. DEDUCTIONS AND NET PAY
1. ABRAHAM:
Gross Total Earnings ----------------------------------------- br. 11,925.00
•Gross Taxable Income (br. 11,925-br.800) --------------- 11,125.00
Employee Income Tax =Earnings X Income Tax Rate
0-600 br. 600 0 br. 00.00
601-1,650 on 1,050 10% 105.00
1,651-3,200. on 1,550 15% 232.50
3,201 – 5,250 on 2,050 20% 410.00
5,251 – 7,800 on 2,550 25% 637.50
7,801 – 10,900 on 3,100 30% 930.00
> 10,900 on 225 35% 78.75
TOTAL --------------- br. 11,125 Br. 2,393.75
Total Deductions:
Income tax on br. 11,125 taxable income………………………...BR. 2,393.75
Pension Contribution ( br. 10,400 x 0.07) 728.00
Total Deduction (br. 2,393.75 + br. 728.00) BR. 3,121.75
NB the income tax would be computed using the short-cut method as follows:
= (Taxable Income x 35%) – br.1,500
= (BR. 11,125 X 0.35) – BR. 1,500 = BR. 2,393.75
2. BEKUMA:
Gross Total Earning …….. br. 10,560.
Employee Income tax
br. 00.00
601-1,650 on 1,050 10% 105.00
1,651-3,200. on 1,550 15% 232.50
3,201 – 5,250 on 2,050 20% 410.00
5,251 – 7,800 on 2,550 25% 637.50
7,801 – 10,560 on 2,760 30% 828.00
TOTAL ---------------br. 10,560 Br. 2,213.00

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page8

Fundamentals of Accounting II Chapter Three August, 2022
Total Deductions
Tax on br. 10,560 .................………………. br. 2,213.00
Pension Contribution (br. 9,600x0.07) ………… 672.00
Credit Association ............................. 480.00
Total Deductions ...............................br. 3,365.00
3. MEYMUNA:
Gross Total Earnings ................... 8,000.00
Employer Income Tax
Earnings X Income Tax Rate = Income Tax
0-600 br. 600 0 br. 00.00

601-1,650 on 1,050 10% 105.00

1,651-3,200. on 1,550 15% 232.50
3,201 – 5,250 on 2,050 20% 410.00
5,251 – 7,800 on 2,550 25% 637.50
7,801 – 8,000 on 200 30% 60.00
TOTAL br. 8,000--------------- Br. 1,445.00
Total Deductions:
Income Tax on br. 8,000.00 …………….. br. 1,445.00
Pension contribution (br. 8,000x0.07)....... 560.00
Total Deductions ------------------------------br. 2,005.00
4. TEWODROS:
Gross Total Earnings br. 7,200.00
Gross Taxable Income 7,200.00
Employee Income Tax:
Earnings X Income Tax Rate = Income Tax
0-600 br. 600 0 br. 00.00
601-1,650 on 1,050 10% 105.00
1,651-3,200. on 1,550 15% 232.50
3,201 – 5,250 on 2,050 20% 5,251 – 410.00
7,200 on 1,950 25% 487.50
TOTAL br. 7,200--------------- Br. 1,235.00
Total Deduction is only the tax which is -----------------br. 1,235.00

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page9

Fundamentals of Accounting II Chapter Three August, 2022
NB. No Pension contribution because he is not permanent employee of the organization. Therefore,
total deduction is the same as Employee Income Tax, br. 1,235.00
5. AHMED:
Gross Total Earnings br. 5,250.00 Employee Income Tax:
Earnings X Income Tax Rate = Income Tax
0-600 br. 600 0 br. 00.00
601-1,650 on 1,050 10% 105.00
1,651-3,200. on 1,550 15% 232.50
3,201 – 5,250 on 2,050 20% 410.00
TOTAL br. ----------------------------------5,250 Br. 747.50
Pension contribution should not be computed for Ahmed because he is not permanent employee of
the enterprise. Thus, the only deduction from his earnings is the employee income tax. NB. It is
also possible to compute income tax using the short-cut method:
04. NET PAY:

Net pay = Gross Total Earnings – Total Deductions

1.ABRAHAM:
Net pay = br.11, 925.00 – br. 3,121.75
Net pay = BR. 8,803.25
2.BEKUMA:
Net pay = br. 10,560.00 – br. 3,365.00
Net pay = BR. 7,195.00
NB. Bekuma is saving br. 480.00 that is why his deduction is above Abraham
3.MEYMUNA:
Net pay = br. 8,000 – br. 2,005.00
Net pay = BR. 5,995.00
4.TEWODROS:
Net pay = br. 7,200 – br. 1,235.00
Net pay = BR. 5,965.00
5.AHMED:
Net pay = br. 5,250.00 –br. 747.50
Net pay = BR. 4,502.50

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page10

 Fundamentals of Accounting II Chapter Three August, 2022
05. PROVING THE PAYROLL:
Total Earnings:
Basic salary BR.40, 000.00
Allowances 1,200.00
Overtime 1,735.00
Grand Total BR. 42,935.00
Deductions:
Employee Income Taxes BR. 8,034.25
Pension contributions 1,960.00
Other Deductions 480.00
Total Deductions BR. 10,474.25

Net pay Total BR. 32,460.75

Total Deductions plus Net pay BR. 42,935.00
The payroll register (or sheet) for Rift Valley Enterprise prepared for the Month of Megabit, 2010 is
shown below.
Rift Valley Enterprise
Payroll Register (Sheet)
For the Month of Megabit,2010
Ser. Name Earning Deductions Total Net Pay Sign.
No Gross Deduction
Basic Allowances Over Income Pension Other
Earning
Salary Time Tax Contr. Deduc.
01 Abraham G. 10,400 1,200 325 11925 2393.75 728 - 3121.75 8803.25

02 Bekuma J. 9,600 - 960 10560 2213 672 480 3365 7195

03 Meymuna H. 8,000 - - 8000 1445 560 - 2005 5995

04 Tewodros A. 7,200 - - 7200 1235 - - 1235 5965

05 Ahmed M. 4,800 - 450 5250 747.50 - - 747.50 4502.50

Totals 40,000 1,200 1735 42,935 8,034.25 1960 480 10474.25 32460.75

Prepared by Accountant Checked by Finance Head Approved by Manager

Signature: ______________ Signature: ______________ Signature: ______________

06. Journal Entries Related to Accounting For Payroll Recording the payment of salary :
Megabit 30. Salary Expense ……………………42,935.00
RVU Departmentof Accounting and Finance (By: Firomsa T.) Page11
Fundamentals of Accounting II Chapter Three August, 2022
Cash ……………………………………………. 32,460.75
Pension contribution payable ………………….. 1,960.00
Employees Income Tax payable ………………… 8,034.25
Payment for Credit Association ………………… 480.00
Also, on this same date, the company (as an employer) has to contribute 11% of the basic salary of
permanent employee to the government’s pension trust fund.
Therefore, totals basic salary of permanent employees x 11%=
(10,400 +9,600 +8,000) x 11 % = br. 3,080.00
The following journal entry, therefore, is recorded on Megabit 30, 1996.
Pension cont. Expense/payroll tax …………….. 3,080.00
Pension contribution payable ………….. 3,080.00
Recording the payment deduction form Bekuma’s salary to the credit Association:
Miyazia 7. Payable to credit Association ………….480.00
Cash ……………………………………….. 480.00
Recording the payment of employees’ income tax withheld and the 18% pension contribution of the
government body:
Miazia 7 pension contribution payable ………………….. 5,040.00
Employee Income tax payable ………………..…………. 8,034.25
Cash ……………………………………………………………..13,074.25

RVU Departmentof Accounting and Finance (By: Firomsa T.) Page12