Chapter 7: Payroll

Question 1

Key terms ; PAYROLL

Answer 1

Payroll is the record a business keeps of employees’ work, remuneration (wages, salaries, bonuses, etc.), and other expenses.

Question 2

EMPLOYEE

Answer 2

An employee is a person who works for the business in return for wages or salary.

Question 3

WAGES

Answer 3

Wages are amounts paid to work employees. Wages can be based on hours worked or the output achieved.
For example, an employee can be paid $10 for each hour worked or $1 for each item produced.

Question 4

SALARY

Answer 4

Salaries are fixed payments to employees for the period of employment, regardless of hours worked or their output level.
For example, a salaried employee is paid $2,000 every month.

Question 5

PAYROLL SYSTEM

Answer 5

The payroll system is the set of procedures a business uses in dealing with all payroll-related matters. The procedures include determining the amount to pay its employees, making physical payments, and recording these payments in the general ledger.

Question 6

PAYROLL FUNCTION

Answer 6

The payroll function/department manages the payroll system.

Question 7

Responsibilities of the payroll function

Answer 7

• calculating gross pay
• calculating and making payments for government deductions
• preparing journal entries to be recorded in the General Ledger
• preparing and distributing payslips to employees
• physically paying the employees

Question 8

CALCULATING GROSS PAY

Answer 8

• Gross pay is the amount each employee earns before any statutory deductions are made.
• Gross pay can be made up of wages or salaries. It can also be combined with many elements, including overtime, bonus, commission, and others.
  *Gross wage or salary is an employee’s earnings BEFORE DEDUCTIONS are made

Question 9

CALCULATING AND MAKING PAYMENTS FOR GOVERNMENT DEDUCTIONS

Answer 9

Most governments expect employers to make deductions from employees on their behalf, such as:

Employee income taxes
State benefit contributions
Employee’s pension contributions.

The payroll department is responsible for applying the government’s rules to correctly calculate the amount deducted from each employee’s gross pay.

As a result of these deductions, an employee is paid less than the amount earned.

For example, an employee earns a salary of $2,000 a month. A total of $450 is deducted from the employee for tax. Therefore, the employer will pay $1,550 to the employee and $450 to the government.
The $2,000 monthly salary is the employee’s gross salary, and the $1,550 he receives is his net salary.

Question 10

PREPARING JOURNAL ENTRIES TO BE RECORDED IN THE GENERAL LEDGER

Answer 10

All payroll transactions, such as payroll expenses and employee payments, must be accounted for and recorded in the general ledger.

The payroll department is responsible for creating journal entries to record all payroll information at each point of transaction.

Question 11

PREPARING AND DISTRIBUTING PAYSLIPS TO EMPLOYEES

Answer 11

Each employee is provided with a detailed payslip every time they are paid. A payslip is a document given to the employee showing gross pay, deductions, employee information, etc.

Question 12

PHYSICALLY PAYING THE EMPLOYEES

Answer 12

Employees will be paid by cash, cheque, or direct credit. Security and control procedures ensure payments are made correctly.

Question 13

TYPES OF GROSS PAY

Answer 13

• salary
• wage
• overtime
• other additional earnings
• holiday pay
• statuatory sick pay and maternity pay
• back pay

Question 14

Salary =

Answer 14

Salaries are fixed amounts paid to employees each month regardless of output. They form part of BASIC PAY

Question 15

Wage =

Answer 15

Wages are based on variable factors such as the number of hours worked or the amount of output achieved (piecework). Wages form part of BASIC PAY.

To record the employee work hours, businesses may:
- use a “CLOCKING IN” machine where employees swipe their cards on arrival and exit
- provide employees with TIMESHEETS where working hours are recorded

Wages paid according to the amount of output achieved is called piecework. To calculate an employee’s wages based on piecework, businesses must determine the pay rate per unit and the number of units (output) produced by an employee.
- Employers may give employees a minimum wage to ensure they still get paid for production belows specific amounts.

Gross wage or salary is an employee’s earnings BEFORE DEDUCTIONS are made

Question 16

Overtime

Answer 16

Agreements between employer and employee are set in place, stipulating work conditions such as expected working hours.

Employees who work more than the contracted hours are paid overtime. Employers usually pay overtime at a higher rate than normal.

For example, an employer may pay time-and-a-half (150% of the normal rate) or double-time (200% of the normal rate).

Question 17

Other Additional Earnings

Answer 17

Employees may also earn additional pay in addition to their regular wage or salary. This could be bonus payments due to excellent work performance or commission payments on the number of goods the employee sells.

Commission payment is generally based on the percentage of sales generated, the number of units sold, or the monetary value of units sold. Commission gives employees a strong incentive to increase sales for the business.

Question 18

Holiday Pay

Answer 18

Businesses have legal requirements to pay employees holiday pay in most countries.

Question 19

Statutory Sick Pay and Maternity Pay

Answer 19

Employees who cannot work due to sickness or have recently delivered a baby can still receive payment. Factors determining the amount of sick pay and maternity pay vary by country and business.

Question 20

Back Pay

Answer 20

Employees may receive pay increments on a fixed date each year. Employees are entitled to the rise from a selected date, and additional amounts paid to reflect this backdated increase are known as back pay.

Question 21

• When referring to GROSS PAY, it can be formed from ANY COMBINATION of the elements above.
  Several ways to earn gross pay, each of which has a different calculation

Answer 21

Example 1
1.Wages based on Hours worked
Jasmine earns $6.70 an hour and is expected to work 36 hours each week.

Joey earns $7.50 an hour and is expected to work 30 hours weekly.

Answer:
If each employee works their expected hours, their gross basic wage each week is:
Jasmine: $6.70 × 36 hours = $241.20
Joey: $7.50 × 30 hours = $225.00
If Jasmine only works 24 hours a week, her gross basic wage would be $6.70 × 24 hours = $160.80.

2.Wages based on Piecework (Constant amount per unit)
Melissa receives $2 for each item she produces.
In Week 1, she produces 360 items. Therefore, Melissa’s weekly wage is 360 units × $2/unit = $720.
The following week (Week 2), there were not as many orders, and Melissa only produced 190 items. However, the employer guarantees a minimum weekly wage of $400.

Answer:
Melissa’s wage for week 2 is 190 units × $2 per unit = $380.
However, this is less than the $400 minimum wage the employer has promised to pay. Therefore, she earns the minimum wage of $400 in Week 2.

3. Wages based on Piecework (Piecework rate per hour)
   Gautham is paid on a piecework basis. Each unit he makes is allowed a fixed amount of time. If there is a set rate for each productive time hour, it is known as the piecework rate per hour. The piecework rate per hour is $4.

Each unit Gautham makes is allowed a fixed amount of time. The time allowed for each unit is as follows:
Unit of A = 1 hour
Unit of B = 0.5 hours.
In a 38-hour week, Gautham produced 20 units of A and 30 units of B.

Answer:
To work out the piecework (productive) hours

= number of units produced × time allowed for the unit
Units of A = 20 units × 1 hour = 20 hours
units of B = 30 units × 0.5 hours = 15 hours
Total piecework hours = (20 hours + 15 hours = 35 hours)
Gautham is paid $4 for each piecework hour, so his gross wage is:
$4 × 35 hours = $140.

*Note that he is only paid for 35 standard hours, not the 38 hours he worked.

4. Overtime Payment
   Brian is expected to work 36 hours weekly, with overtime paid time-and-a-half.
   Cassie is expected to work 30 hours each week; overtime is paid double-time.
   In this example, the standard rate of pay is $7.50.
   In a week, Brian worked 40 hours, and Cassie worked 35 hours. The overtime payment is the excess of standard working hours.

Answer:
Overtime payment = (hours worked − expected hours) × overtime rate/hour
Brian is paid overtime of: (40 hours − 36 hours) × ($7.50 × 1.5) = $45
Cassie is paid overtime of: (35 hours − 30 hours) × ($7.50 × 2) = $75
Brian’s gross pay: (36 hours × $7.50) + $45 = $315
Cassie’s gross pay: (30 hours × $7.50) + $75 = $295

5. Commission Payment
   Javene has a gross annual salary of $15,000, and he receives $1,250 gross monthly. Apart from her salary, she gets a commission of 4% on the value of sales she has made in the previous month.
   Last month, Javene sold $25,000 worth of goods.

Answer:
Therefore, she will receive commission of $25,000 × 4% = $1,000.
Her gross pay will be $1,250 (salary) + $1,000 (commission) = $2,250

6. Bonus Payment (Fixed)
   Lavender works 37 hours at an hourly rate of $5.80 and is also offered a bonus of $100.

Answer:
Her gross pay for that week is: (37 hrs × $5.80 = $214.60) + $100 bonus = $314.60

7. Bonus Payment (per Unit)
   For every unit that Alicia produces over 1,200 units per week, she receives a bonus of $2 per unit.
   Alicia’s basic weekly wage is $250. This week, she produced 1,320 units.

Answer:
Bonus Pay = number of units qualified for bonus × bonus rate
(1,320 units - 1,200 units) × $2 per unit = $240
Alicia’s gross pay is $250 Basic + $240 Bonus = $490

8. Bonus Payment (Percentage)
   In Silk Savers Ltd, employees are paid a bonus of 13% of their basic wage of $340 per week if production is 5% more than planned. This week, the planned unit production was 3,000 units. The actual units produced were 3,201 units.

Answer:
Actual production must be at least 5% more than the planned production for bonus entitlement.
Production target for bonus entitlement: 5% of 3,000 units =150 extra units
3,000 units planned + 150 units extra = 3,150 units required to earn bonus.

Silk Savers employees produced 3,201 units, exceeding planned production by more than 5%, and are entitled to a bonus of 13% of their basic wage.

Bonus: 13% × $340 = $44.20

Gross Pay is: $340 Basic + $44.20 Bonus = $384.20

Question 22

Types of deduction
* The final payment an employee receives is the NET PAY (gross earnings LESS DEDUCTIONS)
It is the employer’s responsibility to forward employee deductions to the government accurately and on time

Question 23

Taxes

Answer 23

Governments of each county require individuals to pay income tax on their earnings. The government body in charge of income taxes is the tax authority.

To facilitate tax payments, employers deduct the income tax from the employee’s gross earnings and pay the deductions to the tax authority on the employee’s behalf.

Most countries’ tax authorities require payments to be made in the month following the deductions.

Question 24

State Benefit Deductions

Answer 24

State benefit contribution is another tax imposed on employees by tax authorities.

This contribution to the government supports the welfare of citizens by paying state pensioners, disabled and older people who cannot work.

State benefit contribution is also deducted from the employee’s gross payment by the employer. This is then paid over to the tax authority together with the income tax by the employer on behalf of the employee.

In addition to the employee’s contributions, employers may also pay a percentage of state benefit contributions on behalf of the employee.

Question 25

Private Pension Fund

Answer 25

An employee may also contribute to a private work-based pension fund. A private pension fund is an investment savings pot where individuals invest part of their gross earnings to be withdrawn after retirement.

The amount of contributions to the pension plan is usually a fixed percentage of their gross Pay. Contributions paid into private pension funds are voluntary in most countries.

In addition to the employee’s contributions, employers may also pay a percentage of private pension contributions into the employee’s fund.

Question 26

Other deductions

Answer 26

‘Other deductions’ covers anything else that needs to be deducted from an employee’s gross pay by the business.

Some businesses have voluntary saving schemes in which employees hold back part of their gross pay to be saved until an agreed date.

Employees may also choose to make donations to charity from their wages. This will be deducted from gross pay.

Question 27

Exam advice - FA1 questions may require deductions to be calculated as a direct amount or a percentage of gross pay.

The specific calculation of income tax and other deductions on an employee’s gross pay is beyond the scope of FA1.

Answer 27

Example
Stephanie earns a salary of $25,000 a year. She pays 6% of her salary into her pension, and her employer pays 10%.

How much do she and her company pay into the pension scheme in a month?

Answer:

Stephanie’s salary contribution (per annum) = $25,000 × 6% = $1,500 per year.
Stephanie’s salary contribution (per month) = $1,500 / 12 months = $125 per month

Company’s contribution (per annum) = $25,000 × 10% = $2,500 per year
Company’s contribution (per month) = $2,500 /12 = $208.33 per month

Question 28

Cost of an Employee in a Business

Answer 28

The cost of an employee to an employer includes all aspects of an employee’s gross pay, such as their basic wage, overtime, sick pay, and other earnings.

Also, businesses that contribute to employees’ state benefits and private pension funds must include these payments in the cost of an employee.

Question 29

Key point - the TOTAL COST OF AN EMPLOYEE IS:

Answer 29

GROSS PAY of employee + EMPLOYER CONTRIBUTION to employee state benefits/pension funds (or any other employer contributions)

example3
Wendy’s salary is $20,000 a year. The state benefit contribution the employer pays on top of the employee’s contribution is 12% of gross pay.

In addition, Wendy’s employer pays its contribution of 5% of gross pay into a pension fund. What is the total annual cost to the employer of employing Wendy?

Answer:

Employer state benefit contributions: $20,000 × 12% = $2,400
Employer pension contributions: $20,000 × 5% = $1,000

The total cost of an employee is = Gross pay + Employer contributions
$20,000 Gross + $2,400 State benefit + $1,000 Pension = $23,400

Question 30

The Payroll Report

Answer 30

All payroll details such as basic Wage, bonuses and deductions are entered into the computerised system using journal entries. A PAYROLL REPORT is generated from the information entered into the system.

The payroll report shows a summary of the information such as:

• Gross pay
• Income tax deduction from employees
• State benefit contribution deduction from employees
• Pension fund contribution deduction from employees
• State benefit contribution deduction from employer
• Pension fund contribution deduction from employer
• Net pay

example4
Rajiv from RFashion received the payroll report for RFashion, showing a summary of all payroll information for March 20X1.

Gross Pay 6,800
Income tax deducted 1,340
State benefit contributions deducted from employees 710
State benefit contributions from employer 865
Pension contributions deducted from employees 325
Pension contributions from employer 520
Net Pay to Employees
What is the total cost of employees to RFashion?
Answer:

The total cost to RFashion is the gross pay of $6,800 plus anything that is an additional cost for the employer:

State benefit contributions from employer = $865

Pension contributions from employer = $520

$6,800 Gross + $865 State benefit + $520 Pension = $8,185

What is the Net pay to employees of RFashion?
Answer:

Net pay to employees = Gross pay − All employee deductions

$6,800 Gross - $1,340 Income tax - $710 State benefit - $325 Pension = $4,425

Question 31

6 Relevant Payroll Ledger Accounts

Answer 31

A journal records transactions or adjustments in the general ledger and is, therefore, part of the double-entry process.

Payroll transactions are recorded using double entries to relevant payroll ledger accounts.

Question 32

1) payroll account (liability)

Answer 32

This account shows every transaction relating to payroll. The items in this account should have a zero balance every period end.

Question 33

2) employee account (expense)

Answer 33

This account shows all employee’s expenses to the business. It is debited because expense accounts are debit accounts.

This expense account can also be called wages cost or staff costs account.

Question 34

3. Income Tax Account (Liability)

Answer 34

This account records deductions from employees for income tax. It is credited to show that the business owes money to the tax authority.

Question 35

4. State Benefit Contribution Account (Liability)

Answer 35

This account records all amounts relating to state benefit contributions. It is credited to show that the business owes money to the tax authority.

Question 36

5. Pension Fund Account (Liability)

Answer 36

This account records all amounts relating to the pension fund. It is credited to show that the business owes money to the pension fund.

Question 37

6. Bank Account (Asset)

Answer 37

This account includes all the payments involved. This account will always be credited, as a payroll payment reduces the bank asset.

Question 38

Payroll Transactions and Double Entries

Answer 38

• Key Point - Salaries and other remuneration paid to the owner of the business as a sole trader are recognised as drawings, not business expenses (Wages)

The double entry for the owner’s (sole trader) remuneration is

Dr Drawings

Cr Cash / Bank

(Each payroll transaction is posted into the relevant ledger accounts. Below is a list of payroll transactions and their associated journal entries)

Question 39

Total Cost of Employees

Answer 39

The total cost of an employee is the gross pay plus any employer contributions. The cost of employing workers increases a business’s employee expenses (expenses).

The total cost of employees is recorded using double-entry in two ledger accounts.

• Employee Expense
• Payroll

Individual Account Category Explanation
Dr. Employee Expense Expense Employee Expenses increased
Cr. Payroll Liability Payroll (Liability) increased
The payroll liability account is purely used to control all the entries relating to payroll to ensure they have been appropriately recorded.

Question 40

Deductions

Answer 40

Income taxes, state benefit contributions and private pension contributions are deducted from an employee’s gross pay. An employer deducts these contributions on behalf of an employee. The employer owes that amount upon deduction to the tax authorities and pension fund institutions.

Since actual payments are made only in the following month, this gives rise to liability as the business owes money when the payroll is recorded.

Deductions from the gross payment affect two ledger accounts.

• Payroll
• Individual Deduction Institution (Income Tax/ State Benefit/Pension Fund)

Individual Account Category Explanation
Dr. Payroll Liability Payroll (Liability) decreased
Cr. Individual Deduction Institution Liability Deductions to Institutions (Liability) increased

To increase a liability account, we will credit the income tax, state benefits and private pension contribution liability accounts and debit the payroll liability account.

In the following month, payments are made to the tax authorities and pension fund.

The business will then debit the individual deduction institution account (liability decreased) and credit the bank account (asset decreased).

Question 41

Payments to Employees

Answer 41

The employees will be paid their net earnings (after all deductions) every month.

Payments to employees will impact two ledger accounts.

• Payroll
• Bank
  Individual Account Category Explanation
  Dr. Payroll Liability Payroll (Liability) decreased
  Cr. Bank Asset Bank (Asset) decreased

Employee wages and salaries are paid by bank transfer. This will decrease the balance left in the business’s bank account.

(see example)

Question 42

Key point* - Salaries and other remuneration paid to the owner of the business as a sole trader are recognised as drawings, not business expenses (Wages)

Answer 42

The double entry for the owner’s (sole trader) remuneration is

Dr Drawings
Cr Cash/Bank

Question 43

Journal Entries in Computerised Systems

Answer 43

Depending on the computerised system of each company, it may no longer be necessary to create manual journal entries. Most computerised systems have the option to automate posting these journals into the payroll ledger alongside generating payroll reports.

However, many small businesses with limited IT budgets still rely on manual journal entries to reflect transactions into the general ledgers. Moreover, it is essential to understand the basics of double entry and its’ effect on the accounting system.

Question 44

Payslips

Answer 44

Payslips are prepared by a company’s payroll function to be distributed to employees when payments are made. A payslip is a financial document with details of the employee, and it shows how an employee’s net amount paid is derived.

Question 45

Elements of a payslip

Answer 45

Header – Name of business

Name and dept – Name and department the employee works in

Employee information – The employee’s unique internal reference number, employee code and national identity number are shown. The tax code, payment date and payroll week are also shown.

Description – This column details every type of gross pay earned.

Hours – This column indicates the hours worked for each gross pay.

Amount (Gross) – This column shows the gross amount for each type of gross pay.

Deductions – This column shows all deductions from the employee’s gross pay.

Amount (Deduction) – This column indicates the deduction made from the employee’s pay.

Year-to-date totals – The summary payment in a tax year, broken down into gross pay, income tax, state benefit contributions and pension paid.
Note that a tax year runs from April to March in the UK.

This period – The total earned in the specific period.

Net Pay – The column shows the employee‘s actual amount received.

Question 46

Payment Methods - 2

Answer 46

There are 2 payment methods to pay their employees: cash/cheque or bank transfer. For a deeper understanding of various payment types, return to 5 Cash and Bank.

Question 47

Cash or Cheque

Answer 47

Cash or cheques are distributed to employees in envelopes with each employee’s name on the pay envelopes. The payslip is usually included together with the cash or cheque.

Question 48

Direct Credits

Answer 48

Bank transfers (direct credit) are typically used to make payments to employees. Organisations send the bank a list of employee bank accounts and the amount to be paid. The bank transfers money from the business’s bank account to the employees. Payslips are then sent to employees separately by email or in hard copy.

Question 49

Payment Security and Confidentiality
Payroll Payments Security

Answer 49

There are several safeguards a business will undertake when paying an employee, such as:

1. Manager authorisation is obtained for payroll payments to ensure:
   - Gross wage or salary has been correctly calculated
   - Correct deductions have been made for each employee. Businesses may face severe fines and penalties if an incorrect amount is paid to the government.
   - Only genuine employees are paid. If not, it may be possible that someone puts in a fictitious employee and directs wages into their account.
2. For larger organisations, ensure that the segregation of duties is in place. This means that different people oversee different activities within the payroll department.
   For example, the person calculating the net payment differs from the one issuing cheques.
3. For cash payments, employees need to produce identification cards or passports for verification
4. Employees are to provide signatures in the payroll record after receiving pay envelopes in case of future discrepancies
5. Only authorised payroll personnel can distribute pay envelopes to employees
6. In case of absent employees, pay envelopes should be stored in a locked safe

Question 50

Payroll Confidentiality Measures

Answer 50

The payroll department deals with private and sensitive information of business employees. Employee personnel records such as their name, address, date of birth, details of any work absences, qualifications and bank details are considered sensitive information.

The employer is legally responsible for keeping such information about employees safe per the data protection legislation.

If leaked, sensitive data can be used in a fraudulent manner whereby employees’ bank details are obtained, and money is stolen from their accounts.

Question 51

To ensure confidential payroll information is protected, safeguards should be placed as follows:

Answer 51

Businesses that keep paper records (manual)
- all info about an employee should be stored in a locked cabinet in a locked office
- only the payroll supervisor should have keys to the office and cabinet.
- Information should be stored alphabetically so it is organised and easy to access.

Businesses that store information on a computer (digital)
- Only payroll employees should be able to access the data on the computer. The payroll software must be password protected.
- The computer screen is locked if payroll personnel is away from the computer to prevent others from viewing the data on the screen.
- There must also be a regularly scheduled backup of the data.