Payroll Accounting

The calculation, management, recording, and analysis of employees’ compensation

What is Payroll Accounting?

Payroll accounting is essentially the calculation, management, recording, and analysis of employees’ compensation. In addition, payroll accounting also includes reconciling for benefits, withholding taxes and deductions related to the compensation. The calculation of payroll is highly influenced by each country’s legal requirements (it even depends on the state or city requirements).

 

Payroll Accounting

 

Main Costs of Payroll Accounting

The costs are related to obligations (expenses) assumed entirely by the employer. They are 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 under 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), or the asset is used (through amortization).

 

Performance Obligations under Payroll Accounting

Performance obligations are related to withholdings or deductions to employees’ wages. The retentions are not paid directly to employees, but they are usually 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.
  • Union dues

 

 

Performance Obligations under Payroll Accounting

 

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)

It is used to track federal tax payments. A company can 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, biweekly or monthly; however, all payments 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 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 can calculate the withholding applicable to employees) 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:

  1. 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).
  2. Then, sum indirect concepts as commissions and bonuses (Check your federal and state requirements if they should be included in the calculation for withholdings or deductions).
  3. 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 applicable requirements.
  4. 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.
  5. Record entries in the books.
  6. 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. The process may often be contracted out to third parties, such as Ceridian.
  7. 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.

 

Key Takeaways

The key for payroll accounting is to recognize when a concept is assumed by the employer or the employee. By mastering the calculation basis for the federal, state, and city taxes and deductions, you will be able to correctly calculate the payroll payments. As provisions are based on estimations, you will need to recalculate them before the payment in order to detect any possible adjustment. It is also important to set up all legal and procedural requirements before hiring an employee because it will help you to reduce the reprocessing activity.

 

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

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