Introduction to Payroll Accounting
It's a fact of business—if a company has employees, it has to account for payroll and fringe benefits.
In this explanation of payroll accounting we'll introduce payroll, fringe benefits, and the payroll-related accounts that a typical company will report on its income statement and balance sheet. Payroll and benefits include items such as:
- bonuses & commissions to employees
- overtime pay
- payroll taxes and costs
- Social Security
- federal income tax
- state income tax
- state unemployment tax
- federal unemployment tax
- worker compensation insurance
- employer paid benefits
- sick days
- insurance (health, dental, vision, life, disability)
- retirement plans
- profit-sharing plans
As we proceed with our explanation of payroll accounting, it will be helpful to recall the matching principle of accounting. This principle will guide us to better understand how payroll and fringe benefits are reported on financial statements. (We're assuming that a company follows the accrual method of accounting.)
The matching principle requires a company to match expenses to the accounting period in which the related revenues are reported. If a direct connection between revenues and an expense does not exist, then the expense should appear on the income statement for the accounting period in which it was incurred. Keep in mind that expenses are often incurred (or occur) in a different accounting period than when they are paid.
Let's use three payroll examples to illustrate this point:
A company employs a student to work a total of five days—from December 26 through December 30, 2014. On December 30 the student submits her time card. The company issues her payroll check on the next scheduled payday, January 5, 2015.
Even though the check is dated January 5, 2015, the matching principle requires that the company report the expense and the liability in December 2014 when the work was performed (and the company incurred the liability). Because the student was only employed for the last five days of December, the company would not have any wage or fringe benefits expense for her during January. The paycheck issued on January 5 merely reduces the company's liabilities and cash.
Let's assume that a company gives its sales manager an annual bonus of 1% of sales, to be paid on January 15, 2015. The bonus amount is calculated by multiplying the sales from January 1 through December 31, 2014 times 1%.
The matching principle requires that the company report 1% of sales as a Bonus Expense on its income statement (and a liability for the total amount owed must be reported on its balance sheet) in every accounting period in which sales occurred in 2014. If the company violates the matching principle by ignoring the bonus expense throughout the year 2014 (when sales actually occurred) and reports the entire bonus amount as an expense for just one day (January 15, 2015), every income statement pertinent to 2014 will report too much net income and the income statement that includes January 15, 2015 will report too little net income. The matching principle requires that the bonus expense pertinent to the 2014 sales be matched with the 2014 sales on the 2014 income statement.
If the entries are recorded properly, the balance sheet dated December 31, 2014 will report a current liability for the total bonus amount owed to the sales manager. On January 15, 2015 (when the company pays the bonus) the company will not have an expense; rather, the payment will reduce the company's cash and reduce the current liability that was established when the bonus was recorded as an expense in 2014.
A company has a vacation plan that will provide two weeks of vacation in the year 2015 if the employee worked the entire year of 2014. In the year 2014 (when the employee is working) the company reports the vacation expense on its 2014 income statement. The company's December 31, 2014 balance sheet will report a current liability for the two weeks of vacation pay that was earned by each employee but not yet taken. In 2015 (when employees take the vacations that were earned and expensed in 2014), the company will reduce its cash and its vacation liability.
As you learn about accounting for payroll and fringe benefits, keep the matching principle in mind. As the above examples show, the date on which a company pays wages or fringe benefits is not necessarily the date on which the company reports the expense on its financial statements.