Payroll accounting is essentially the calculation, management, recording, and analysis of employees’ compensation. In addition, payroll accounting also includes reconciling for benefits, and withholding taxes and deductions related to compensation. The calculation of payroll is highly influenced by each country’s legal requirements (it may also depend on state or local city requirements).
Payroll accounting is essentially the calculation, management, recording, and analysis of employees’ compensation.
The key for payroll accounting is to recognize when a concept is assumed by the employer or the employee.
Main Costs of Payroll Accounting
Payroll costs are related to obligations (expenses) assumed by an employer. They fund compensation paid to employees for their direct labor or as a consequence of mandatory benefits defined by legal requirements.
The sum of all the concepts listed above forms the accrued expense for keeping an employee on the payroll.
Under accounting principles, all accrued expenses must meet the matching principle. The matching principle states that all expenses need to match in the period when all the related revenues are reported (it does not depend on the payment date). For example, if an employee is hired on the first day of December but paid on the first week of January, the expense related to the labor of the employee must be recognized in December.
Note:Compensation for the labor of employees is not always recognized as an expense. For example, if the labor of employees served for manufacturing a product or asset, the compensation (including provisions) should be registered as cost of manufacturing the product (inventory) or asset and recognized as expense when the inventory is sold (through cost of sales).
Performance Obligations under Payroll Accounting
Performance obligations are related to withholdings or deductions from employees’ wages. These retained amounts are not paid directly to employees, but they are paid later to government institutions or private companies. The most common withholdings according to US laws are:
Federal withholdings: Retentions for federal income taxes
State withholdings: Retentions for state income taxes
FICA payable: Retentions for Social Security and Medicare
State disability: State disability taxes
Employee health insurance: Retentions for health insurance coverage
401K: Retentions for retirement savings.
Other withholdings include:
Court-ordered withholdings: Deductions from salary ordered by the court for specific purposes.
Setting up Payroll Accounting
Before starting the hiring process, there are some important requirements or considerations that employers must fulfill. They are in accordance with US federal legislation and may vary from state to state.
1. Federal Employer Identification Number (EIN)
This is used to track federal tax payments. A company must get an EIN from the IRS.
2. Payment type and periodicity
After deciding the salary level (according to position, experience, industry, etc.) and type (hourly or annual wage), select the period in which the employees are going to be paid. Payments are usually selected between weekly, bi-weekly, or monthly. Payment periods should not be longer than the monthly basis.
3. Employees’ benefits and insurance
If employers offer extra benefits such as insurance or a 401K retirement plan, they will have to decide how much to contribute as the employer, and how much of the cost the employee must assume to get the benefit.
4. Employees’ forms
When hiring employees, it is important to gather all the information related to the right to work in the US and personal information. The most important forms are I-9 Form (to verify if the employee has the citizenship or the right to work in the US under a work permit), W-4 form (Employees’ Personal information – by completing this form, you obtain the information needed to calculate the withholding applicable to an employee) and Direct Deposit Form.
Calculations in Payroll Accounting
After setting up the company to hire employees and gathering all the information related to the employees, the company will need to follow these steps:
Calculate the direct and indirect compensation for labor: When finishing a month, sum all the costs for direct compensation, such as salaries and overtime (most of the withholdings and provisions are calculated based on these concepts).
Then, sum indirect concepts such as commissions and bonuses (Check your federal and state requirements to see if they should be included in the calculation for withholdings or deductions).
Calculate withholdings and deductions: After determining the basis for each withholding or deduction according to the previous step, calculate your employees’ taxes and wage deductions according to the applicable requirements.
Calculate provisions: Provisions are accrued expenses that generate liabilities which are going to be paid in the future. The expenses that are the result of legal requirements like holidays and vacations are recognized as provisions in the period they are incurred, although they are paid in subsequent months. They are the result of the contractual relationship with the employee.
Record entries in the books.
Generate payments: After calculating and registering the accounting entries, companies need to generate the payments to employees, government entities (related to withholdings), and other entities. This process may often be contracted out to third parties, such as Ceridian.
Calculate posterior adjustments to provisions: Due to the nature of provisions, which are based on estimates, is important to recalculate and adjust provisions if necessary.
Thank you for reading CFI’s guide to Payroll Accounting. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below: