Gross to net calculations - Deductions for tax, national ins...

Learning Outcomes

After reading this article, you will be able to explain how gross pay is reduced to net pay through statutory and voluntary deductions, identify different types of payroll deductions including income tax, national insurance, and pensions, and process these through ledger entries as required for ACCA FA1. You will also understand employee and employer responsibilities related to payroll deductions.

ACCA Recording Financial Transactions (FA1) Syllabus

For ACCA Recording Financial Transactions (FA1), you are required to understand payroll calculations and relevant deductions applied to employees’ pay. Focus your revision on:

• The concept of gross pay versus net pay for employees
• Types of statutory deductions: income tax and national insurance contributions
• Types of non-statutory (voluntary) deductions, such as pension contributions
• Employer responsibilities for deducting and paying statutory and voluntary amounts to relevant authorities
• Recording payroll transactions accurately within the accounting system

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is a statutory deduction from an employee’s gross pay?
   1. Health club subscription
   2. Income tax
   3. Charity donation
   4. Company canteen payment
2. An employee’s gross pay is $2,000. Income tax is $350 and national insurance is $150. What is the net pay before any other deductions?
   1. $1,500
   2. $1,650
   3. $1,850
   4. $2,500

3. True or false? Pension contributions can be both a statutory and a voluntary payroll deduction depending on the pension scheme and jurisdiction.

4. Briefly explain the employer’s responsibility in handling deducted taxes from employee wages.

Introduction

An employee’s gross pay is the starting point for payroll—this is the total earnings before any deductions are made. However, employees do not receive this full amount. Various deductions are taken from gross pay before the employee receives their net pay. Understanding these deductions, why they are made, and how to process them is essential for accurate accounting.

Payroll systems must distinguish between statutory (required by law) and non-statutory (voluntary) deductions, apply them correctly, and ensure both employees and external bodies (such as tax authorities) receive the appropriate payments. Both employers and employees have clear roles in this process, which is tested in the ACCA FA1 exam.

Key Term: gross pay
The total earnings of an employee before any deductions.

Key Term: net pay
The amount the employee actually receives after all deductions have been made.

Gross Pay and Net Pay

Gross pay is the starting point for calculating employees’ salary or wage payments. This includes basic salary or wage, overtime, bonuses, and commission. Net pay, sometimes called "take-home pay," is the amount an employee receives after deductions.

Payroll Deductions – An Overview

Deductions from gross pay fall into two main categories:

• Statutory deductions – Required by law.
• Non-statutory (voluntary) deductions – Optional deductions agreed between the employee and employer.

Key Term: statutory deduction
A deduction from pay that an employer is required by law to make, such as income tax or national insurance.

Key Term: non-statutory deduction
A payroll deduction made at the employee’s request or with their consent, such as pension contributions, union subscriptions, or charity giving.

Types of Deductions

Statutory Deductions

The two most common statutory payroll deductions are:

• Income Tax: Deducted from pay and paid directly to the tax authority. The amount depends on tax codes and rates in force.
• National Insurance Contributions (NIC): Contributions to state benefits (such as state pension or healthcare), deducted before net pay is calculated.

Employers are legally responsible for calculating, deducting, and remitting these amounts on behalf of employees to the tax authorities.

Non-Statutory (Voluntary) Deductions

These deductions are made only if the employee agrees. Common examples:

• Pension contributions to an occupational or personal pension scheme
• Union subscriptions
• Payroll savings or charity schemes
• Payments for company-provided benefits (e.g., health insurance, canteen meals)

Worked Example 1.1

An employee’s monthly gross wage is $2,100. Statutory deductions: income tax $350 and national insurance $180. Non-statutory deduction: pension contribution $70. What is the employee’s net pay for the month?

Answer:
Net pay = Gross pay – all deductions
Total deductions: $350 (tax) + $180 (NIC) + $70 (pension) = $600
Net pay: $2,100 – $600 = $1,500

Processing Payroll Deductions in the Accounting System

Employers must process payroll deductions using the accounting system. The main entries are:

1. Calculate gross pay for all employees.
2. Deduct statutory and non-statutory amounts to determine net pay.
3. Record the gross pay as an expense.
4. Record liabilities for deducted amounts yet to be paid to third parties (e.g., tax authorities, pension providers).
5. Record payment of net pay to employees.
6. Settle liabilities for deductions by paying the authorities and agencies.

Key Term: payroll
The recorded list of all employees and the wages or salaries due to each, including deductions.

Key Term: employer’s contribution
The amount the employer adds to state benefits or pension funds, in addition to the employee’s own deduction.

Worked Example 1.2

A company’s payroll for one month includes:

• Total gross wages: $9,000
• Income tax deducted: $1,600
• National insurance deducted from employees: $950
• Employee pension contributions: $450
• Employer national insurance contribution: $1,100
• Employer pension contribution: $500
• Net wages paid to employees: ?

Calculate the total net wages and describe the ledger entries for this payroll.

Answer:
Total deductions: $1,600 (tax) + $950 (NIC) + $450 (pension) = $3,000
Net wages: $9,000 – $3,000 = $6,000
Ledger entries:

• Debit wages and salaries expense for $9,000
• Credit bank for net wages paid ($6,000)
• Credit tax, NIC, and pensions payable accounts for $3,000
• Debit expense for employer’s NIC ($1,100) and pension contribution ($500)
• Credit liability accounts for these additional employer contributions

Exam Warning

Be careful not to confuse statutory deductions (required by law) with non-statutory deductions (optional). Statutory deductions must be paid to authorities; failure to do so is a severe legal compliance breach.

Employers' and Employees' Responsibilities

• Employers must:
  • Calculate correct deductions according to applicable laws and payroll contracts.
  • Make payments to employees and remit deductions to tax authorities and other agencies on time.
  • Provide payslips showing how net pay was calculated.
• Employees should check their payslips for accuracy and notify payroll if they believe there are errors.

Key Term: payslip
A statement given to an employee showing gross pay, deductions, and net pay for a pay period.

Practical Considerations

• Ensure that payroll records are complete and confidential.
• Timely remittance of statutory deductions is both a legal and accounting requirement.
• Employers must also keep payroll records for inspection by tax authorities.

Revision Tip

Carefully distinguish between statutory and non-statutory deductions when practicing and answering ACCA questions. Make sure you can clearly classify each type.

Summary

Gross pay is the total amount earned by employees before deductions. Deductions—both statutory (like tax, national insurance) and non-statutory (like pensions)—are subtracted to determine net pay, the amount employees actually receive. Employers are responsible for calculating and paying over these deductions, and for correct accounting entries reflecting payroll costs and liabilities.

Key Point Checklist

This article has covered the following key knowledge points:

• The definition and distinction between gross pay and net pay
• Statutory and non-statutory payroll deductions
• Roles and responsibilities of employers in deducting and remitting these amounts
• Basic ledger entries for processing gross to net payroll calculations
• Importance of accurate and timely payroll records and remittances

Key Terms and Concepts

• gross pay
• net pay
• statutory deduction
• non-statutory deduction
• payroll
• employer’s contribution
• payslip