Payroll Accounting Explained
/What is Payroll Accounting?
Payroll accounting is the process of recording and managing all financial transactions related to employee compensation. It includes calculating gross pay, withholding taxes and other deductions, determining employer payroll tax obligations, and issuing net pay to employees. Payroll accounting also covers the recognition of payroll expenses, accrued wages, benefits, and related liabilities in the accounting records. Accurate payroll accounting ensures compliance with tax laws and labor regulations, supports timely financial reporting, and helps a business track the full cost of its workforce.
Payroll Process Flow
Payroll processing requires you to complete a number of steps, which are presented below. Though some systems that incorporate more or less automation may not include all of these steps, the following process flow will apply to most payroll systems.
Step 1. Set Up New Employees
Have new employees fill out payroll-specific information as part of the hiring process, such as the W-4 form and medical insurance forms that may require payroll deductions. Set aside copies of this information in order to include it in the next payroll. This step is completed by the human resources department.
Step 2. Collect Timecard Information
Salaried employees require no change in wages paid for each payroll, but you must collect and summarize information about the hours worked by non-exempt employees. This may involve having employees scan a badge through a computerized time clock, or enter it through an online form. Other options are to use a phone-based timekeeping app, or to manually fill out a timesheet. In cases where employees engage in nearly identical tasks every day, the system can be set up to autofill tasks completed, with employees adjusting these items as needed.
Step 3. Verify Timecard Information
Summarize the payroll information just collected and have supervisors verify that employees have correctly recorded their time. Much of this activity can be automated when a computerized timeclock is used, though supervisors will likely want to review overtime hours worked, at a minimum. It is also useful to review payroll information to ensure that employees are not continuing to be paid after they have left the business. If a supervisor is busy, it is helpful to have an assigned backup reviewer for this task.
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Step 4. Summarize Wages Due
Multiply the number of hours worked by the pay rate for each employee, also factoring in any overtime or shift differentials. This step may be addressed automatically by your payroll software. Whether the summarization is manual or automatic, it can make sense to review the results for errors. This review may be by a senior payroll clerk with experience in spotting errors.
Step 5. Enter Employee Changes
Employees may ask to have changes made to their paychecks, usually to the taxes or pension amounts withheld. Some companies allow employees to enter these changes through an employee-specific software module. You may need to record much of this prior to calculating taxes, since it impacts the amount of wages to which taxes are applied.
Step 6. Calculate Taxes
Use IRS tax tables to determine the amount of taxes to be withheld from employee gross pay. This step is handled automatically, if you are using payroll software. If you calculate taxes manually, then be sure to have the results reviewed by an experienced payroll clerk.
Step 7. Calculate Wage Deductions
There may be a number of additional deductions to take away from employee net income, including deductions for medical insurance, life insurance, garnishments, and union dues. You must also track the goal amounts for these deductions, so that you stop deducting once the goal totals are reached. Some payroll systems track the progress toward goal amounts automatically, and will stop deductions once each goal is reached.
Step 8. Deduct Manual Payments
If manual payments have already been made to employees, such as advances, then deduct these amounts from the remaining net pay. This may require input from the payables clerk, who is tracking the amount of these advances. Have someone else review these deductions for accuracy, since invalid deductions will undoubtedly draw of ire of the impacted employees.
Step 9. Create a Payroll Register
Summarize the wage and deduction information for each employee in a payroll register, which you can then summarize to also create a journal entry to record the payroll. It may require several iterations before you have confirmed that everything listed on the payroll register is correct. This document is automatically created by all payroll software packages. Have the payroll manager initial and date the final approved payroll register, and archive it.
Step 10. Print Paychecks
Print employee paychecks using the information in the payroll register. You normally itemize gross pay, deductions, and net pay in a remittance advice that accompanies the paycheck. Paychecks are then put into envelopes and sealed before being delivered to employees. Paychecks should be handed directly to employees whenever possible, since this proves that the employees received the payment. Some employers have their employees sign for received paychecks as an additional form of evidence.
Step 11. Pay by Direct Deposit
Notify your direct deposit processor of the amount of any direct deposit payments, and issue remittance advices to employees for these payments. The remittance advices may be sent by email or printed and handed out manually.
Step 12. Deposit Withheld Taxes
Deposit all withheld payroll taxes and employer-matched taxes at a bank that is authorized to handle these transactions. This step is handled by your payroll processor, if you have outsourced this service. Be sure to retain copies of all receipts, in case tax authorities later question the timing and/or amount of these payments.
Example of Payroll Journal Entries
The primary journal entry for payroll is the summary-level entry that is compiled from the payroll register, and which is recorded in either the payroll journal or the general ledger. This entry usually includes debits for the direct labor expense, salaries, and the company's portion of payroll taxes. There will also be credits to a number of accounts, each one detailing the liability for payroll taxes that have not been paid, as well as for the amount of cash already paid to employees for their net pay. The basic entry (assuming no further breakdown of debits by individual department) is:
When you later pay the withheld taxes and company portion of payroll taxes to the IRS, you then use the following entry to reduce the balance in the cash account, and eliminate the balances in the liability accounts:
It is quite common to have some amount of unpaid wages at the end of an accounting period, so you should accrue this expense (if it is material). The accrual entry, as shown next, is simpler than the comprehensive payroll entry already shown, because you typically clump all payroll taxes into a single expense account and offsetting liability account. After recording this entry, you reverse it at the beginning of the following accounting period, and then record the actual payroll expense whenever it occurs.
Payroll Accounting FAQs
How should bonuses be accounted for in payroll records?
Bonuses should be recorded as compensation expense when earned and reasonably estimable. If employees earn the bonus before period-end but payment occurs later, accrue a liability in the current period. When paid, reduce the liability and record any remaining payroll taxes, withholdings, or related employer payroll tax expense.
How are paid time off and vacation obligations handled in payroll accounting?
Paid time off and vacation obligations are accrued as employees earn them when payment is probable and reasonably estimable. The employer records compensation expense and a related liability before the leave is taken. When employees use the leave or receive payout, the liability is reduced and cash or wages are recorded.
How are payroll errors corrected in the accounting records?
Payroll errors are corrected with adjusting entries that reverse incorrect amounts and record the proper payroll expense, liabilities, or cash disbursement. Corrections may affect wages, withholdings, employer taxes, or benefit deductions. Each correction should be documented, approved, and reconciled to payroll reports and the general ledger for accuracy.
How does payroll accounting address multi-state payroll obligations?
Payroll accounting addresses multi-state obligations by tracking wages, tax withholdings, and employer payroll taxes separately for each jurisdiction. Since states and localities have different tax rates, filing rules, and nexus standards, employers need detailed records, jurisdiction-specific liability accounts, and regular reconciliations to ensure accurate reporting and timely tax remittances.
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