Gross-to-net payroll - Basic pay, overtime, and allowances

Learning Outcomes

After studying this article, you will be able to outline the components of payroll, distinguish between gross and net pay, describe and calculate basic pay, overtime, and common allowances, and record payroll transactions in the general ledger. You will also identify common exam pitfalls and apply double-entry rules to payroll scenarios.

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand how payroll expenses are identified, calculated, and recorded. Focus your revision on:

• The distinction between gross pay and net pay
• The elements of payroll: basic pay, overtime, and allowances
• Calculating payroll, including overtime and typical allowances
• Recording payroll transactions, including employer and employee contributions
• The presentation of payroll costs in the general ledger and financial statements

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 best describes "net pay"?
   1. Total pay before deductions
   2. Take-home pay after all deductions
   3. The hourly wage without overtime
   4. Total cost to the employer including taxes
2. An employee earns a weekly basic wage of $400 and works 10 overtime hours at a 50% premium. What is their total gross pay if the normal hourly rate is $10?
   1. $450
   2. $500
   3. $550
   4. $600

3. True or false? Allowances such as travel or housing are added to the basic wage to reach gross pay.

4. Outline the basic double-entry required to record the payment of wages to staff, including statutory deductions.

Introduction

Payroll represents a substantial business expense and a frequent transaction in most entities. Understanding the move from gross pay (the total earned by employees before deductions) to net pay (amount received after statutory and voluntary deductions) is essential for recording financial transactions accurately. This article examines the key components of payroll: basic pay, overtime, and allowances. It also explains how to calculate gross and net pay, and the correct accounting treatment for payroll costs.

Key Term: gross pay
The total amount earned by an employee before any deductions, including basic pay, overtime, and allowances.

Key Term: net pay
The amount received by an employee after all deductions have been made from gross pay.

Key Term: overtime
Additional hours worked beyond the standard contract, usually paid at a higher rate (premium).

Gross-to-Net Payroll: Key Components

Payroll is made up of several elements, each with different accounting implications.

Basic Pay

Basic pay is the agreed amount for the standard contract hours, paid to an employee before any additions or deductions. For hourly employees, it is calculated as:

Basic pay = Number of standard hours × Hourly rate

For salaried staff, it is typically a fixed monthly or weekly sum.

Overtime

Overtime is paid when employees work beyond their contracted hours. Overtime usually attracts a premium, such as “time and a half” (150%) or “double time” (200%). The calculation is:

Overtime pay = Overtime hours × Overtime rate

Where:

Overtime rate = Basic hourly rate × Overtime premium (%)

Allowances

Allowances are regular additional amounts paid for specific circumstances, such as housing, transport, or responsibility. These are added to basic pay and overtime to calculate total earnings.

Key Term: allowance
A regular addition to an employee’s pay for specific reasons (e.g. travel, housing), taxable unless otherwise stipulated.

Payroll Calculations

To calculate gross and net pay, follow these steps:

1. Calculate basic pay for contracted hours.
2. Calculate overtime payments at the appropriate premium.
3. Add allowances.
4. Deduct taxes (e.g. income tax, national insurance) and other statutory deductions.
5. Arrive at net pay—the amount actually paid to the employee.

Key Term: statutory deduction
A legal deduction from gross pay, such as income tax or social security/national insurance.

Recording Payroll in the General Ledger

The correct recording of payroll transactions is critical for reliable accounts. Payroll usually creates several entries:

• The gross pay is treated as an expense in the statement of profit or loss.
• Statutory and voluntary deductions held to pay government or third parties are recorded as liabilities.
• Net pay represents the cash paid to employees.

Worked Example 1.1

An employee works 40 standard hours at $12/hour and does 6 hours overtime at 150%. The employee also receives a travel allowance of $30. Statutory deductions come to $75.

Required: Calculate gross pay and net pay. Show the relevant double-entry bookkeeping.

Answer:

• Basic pay: 40 × $12 = $480
• Overtime pay: 6 × ($12 × 1.5) = 6 × $18 = $108
• Allowance: $30
• Gross pay: $480 + $108 + $30 = $618
• Statutory deductions: $75
• Net pay: $618 – $75 = $543

General ledger entries:

• Debit: Wages and salaries expense $618
• Credit: Bank (net pay paid to employee) $543
• Credit: Payables (statutory deductions owed) $75

Worked Example 1.2

A business has 10 employees. Each earns a basic monthly salary of $1,800, works 12 overtime hours at 125% and receives $100 housing allowance. Calculate the total gross wages for the payroll run.

Answer:

• Basic pay per employee: $1,800
• Overtime per employee: 12 × (hourly rate × 1.25)
• Hourly rate: $1,800 ÷ (4 weeks × 40 hours) = $11.25
• Overtime pay: 12 × ($11.25 × 1.25) = 12 × $14.06 = $168.72
• Allowance: $100
• Gross per employee: $1,800 + $168.72 + $100 = $2,068.72
• Total gross for 10 employees: 10 × $2,068.72 = $20,687.20

Common Statutory Deductions

Typical deductions include:

• Income tax (PAYE)
• National insurance/social security contributions
• Pension contributions
• Other mandated deductions per local law

Deduction amounts are calculated based on law, and are not part of the profit or loss expense until paid to the authorities.

Presentation in Financial Statements

Payroll expenses are reported in the statement of profit or loss as “wages and salaries.” Deduction liabilities appear under current liabilities until paid out. Net pay is reflected in the cash at bank balance after paying staff.

Key Term: payroll
The total amount payable to employees, after calculation of gross pay, allowances, overtime and deductions for a period.

Summary

Payroll is a major business cost and must be carefully calculated and recorded. Gross pay comprises basic pay, overtime, and allowances. Statutory deductions are made to reach net pay. All amounts must be recorded accurately in the general ledger, with liabilities shown for deductions yet to be paid to authorities.

Key Point Checklist

This article has covered the following key knowledge points:

• Identify and calculate basic pay, overtime, and common allowances
• Calculate gross pay and net pay through typical payroll steps
• Define statutory deductions and describe their accounting treatment
• Prepare correct general ledger entries for payroll transactions
• Recognise how payroll expenses and liabilities are presented in financial statements

Key Terms and Concepts

• gross pay
• net pay
• overtime
• allowance
• statutory deduction
• payroll