Chapter 3: Accounting for Ethiopian Payroll system

3.1 Introduction to the basic accounting for payroll

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. In line with internationally recognized
best practice, employee’s income tax liabilities are calculated and paid directly by their
employer. As a result the government relies on employers to compute and withhold the tax to be
paid by employees. To discharge this responsibility properly, employers may need to know in
advance what counts as income or shall be able to distinguish what kind of income is to be taxed
or not. This article provides guidance to help employers in this respect.
However, for comprehensive understanding, students are strongly advised to refer to the
proclamation No 979/2016, Regulation No. 78/2002, Directive No. 21/2009 and circular on
severance tax.

1.1.1. 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.

1.1.2. Definition of payroll related terms

1. Salary and Wages: Salary and wages are usually used interchangeably. However, the
term wages is 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.
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 Therefore, wages are usually paid when a particular piece of work is completed or
weekly. On the other hand, salaries refers 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.
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. Gross Earnings: are taxes collected from the earnings of employees by t he employer
organization as per the regulations of the government. These have to be submitted (paid)
to the government because3d employer organization is only acting as an agent of the
government in collecting these taxes from employees.
7. 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.
8. 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.
a. An employee with a basic salary of Br. 5,200 has been working for ABC Company from
September 1 till October 12. Determine the pension contribution of this employee.

4.2 Overview of Ethiopian Employment income and taxing system

4.2.1 Employment Income

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
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trading activities or business. Among these incomes the employment income includes but not
limited to:
Salary, wage, an allowance, bonus commission, gratuity, or other remuneration received by an
employee in respect of a past, current, or future employment;
- The value of fringe benefit received by an employee in respect of a past, current, or future
employment,
- An amount received by an employee on termination of employment, whether paid
voluntarily, under an agreement, or as a result of legal proceedings, including any
compensation for redundancy or loss of employment, or a golden handshake payment.

The government relies on employers to compute and withhold the tax to be paid by employees.
To discharge this responsibility properly, employers may need to know in advance what counts
as income or shall be able to distinguish what kind of income is to be taxed or not.

4.2.2 Specific element of Gross Earning of employee

A. 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.

B. 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 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

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 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.

C. Allowances

Allowances are money paid monthly to an employee for special reasons, like:
- Position 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 new 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. Employment income tax shall not include exempted income for tax and retirement
benefit purpose.

4.2.3 Employment Income Deduction

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

a. Employment Income Tax:

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Every citizen is required to pay employee tax to the government in almost all countries. In
Ethiopia also, income tax is charged on the gross earnings of the employee at the rates indicated
under schedule A of the Proclamation N. 979/2015- Income tax proclamation.
The tax rates under Employment Income tax are presented in the following page:

Schedule “A”
Employment Income Income
(per month) Tax rate Deduction
Over Birr To Birr

0 600 Exempt (Free from Tax) No deduction

601 1,650 10% 60

1, 651 3,200 15% 142.50

3,201 5,250 20% 302.50

5,251 7,800 25% 565

7,801 10,900 30% 955

Over 10,900 35% 1,500

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 b. Overview of Ethiopian Pension law
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.

c. 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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 1.2.4. 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;
(h) The Tax Authority is empowered to determine the amount of payments specified under (b),
(d) and (e) of the above element and based on that

Net Pay
Net pay represents the excess of gross earnings over total deductions of an employee.

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:
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 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?
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

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Total payroll deduction = Tax + Pension
= Br. 1,787 + Br. 448
= Br. 2,235
Net Pay = Gross earning – Total payroll deduction
= Br. 9,740 – Br. 2,235
= Br. 7,505

Note:
Payroll expense…………………………………..Br. 9,740
Pension contribution…………………………… Br. 704
Total Salary expense …………………………. Br. 10,444

4.3 Accounting systems for payroll and payroll tax presentation

4.3.1 Possible components of a payroll register

1. Employee Tax Identification Number (TIN)

Number assigned to employees for identification purpose when a relatively large number of
employees are involved in a payroll register.

2. Name of Employees
3. Earnings
- Basic Salary
- Allowances
- Overtime Earning
4. Deduction
- Employment Income Tax
- Pension Contribution
- Other Deductions
5. Net Pay
6. SIGNITURE OF EMPLOYEE

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Using the solved illustration from the previous session 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

No.
Employee Basic Allo- Over Gross Income Pension Other Total Net Sign
salary wance .
Time Earning Tax Contr. Deduc. Deduc. Pay

001 Mr. Abebe 6,400 2,100 1,240 9,740 1,787 448 - 2,235 7,505 __

Total 9,740

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

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

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

 to record payment of withheld tax to the tax authority

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

4.3.3 Compensation and other funding taxation

When companies cut jobs or reduce their workforce, they may offer-
1) Compensation
2) Severance
3) Annual leave
4) Bonus and other funding to laid-off workers.
The employers shall take notice that these funding for laid-off workers is taxable. The base of
calculation for the tax to be withheld is the amount of compensation divided by the final salary
paid at the time of layoff.
This enables the employer to figure the specific period of time covered by the compensation.
Then the employer calculates the tax to be paid on a monthly basis and multiplies it by the
specific period of time covered by the compensation to figure the total tax to be levied on the
total compensation.
Example 1, suppose the compensation offered to the employee is 30,000 birr and the final
regular salary paid when compensation is granted is 2500 birr then the specific period of time
covered by compensation is going to be 12 months i.e. 30000/ 2500= 12. Hence, the tax to be
levied on or withheld from the monthly salary is 448 birr whereas the tax for the period covered
by the compensation is 5376 birr i.e. 448 multiplied by 12.
Example 2, suppose the compensation offered to the employee is 30, 900 birr and the final
regular salary paid when compensation is granted is 2500 birr then the specific period of time

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 covered by compensation is going to be 12 month with a remainder of 900 birr. The employer is
therefore required to withhold 93 birr on the remainder in addition to the tax amounting to
5376 birr.

assignment
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 OT
name Salary Allowance worked (hr) Work
0029345682 Amen Abebe Br. 3,400 1,000 10 Weekly Rest Day
0029345683 Yonas Meles 6,720 - 8 Before 10:00 pm
0029345684 Joel Zola 9,600 2,000 12 Public holiday
0029345685 Hassen Jemal 6,400 - 14 After 10:00 pm

Additional Information:

 The normal work hours per week are 40

 There were no absentees during the month.
 All employee are permanent except Yonas Meles
 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
v. Journalize the necessary payroll transactions

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