Introduction to Payroll Accounting
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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 will discuss the following payroll-related items:
- Gross salaries, wages, bonuses, commissions, and overtime pay
- Payroll taxes withheld from employees' gross pay
- Payroll taxes that are not withheld from employees and are an expense of the employer
- Employer-paid time off for holidays, vacations, and sick days
- Other employer expenses including worker compensation insurance, medical insurance, and others
Sample journal entries will be shown for several pay periods for hourly-paid employees and for salaried employees.
Many of the items discussed are subject to federal and state government regulations as well as labor contracts and company policies.
NOTE: When a company's financial statements are prepared using the accrual basis of accounting, all wages (including salaries, commissions, bonuses, etc.) that have been earned by the company's employees must be reported. This usually requires an accrual adjusting entry so that the company's balance sheet reports a current liability for the wages that have been earned by the employees but have not been paid as of the final moment of the accounting period.
On the other hand, the company must report to the Internal Revenue Service (IRS) the amounts it has paid to its employees. (The reason is that employees' personal income tax returns are prepared using the cash basis of accounting.) For instance, the IRS Form W-2, Wage and Tax Statement, that is given to employees in January reports the amounts paid to employees in the year that ended on December 31.
In this explanation of payroll accounting we will highlight some of the federal and state payroll-related regulations and provide links to some of the government agencies and publications. We conclude with sample accounting entries that a company will record so that its financial statements reflect the accrual basis of accounting.
You should consider our materials (explanation, practice quiz, quick tests, certificate of achievement, etc.) to be an introduction to payroll accounting.
Accrual Basis of Accounting and Matching Principle
Since the company's financial statements must reflect the accrual basis of accounting, a company's expenses should be reported as follows:
Match expenses to the related revenues when a cause-and-effect relationship exists. For example, a retailer's income statement should match the cost of goods sold (which may have been purchased and paid for in an earlier accounting period) in the accounting period in which the sales revenues are earned.
If there is no cause-and-effect relationship but there is a future value that can be measured, the cost should be reported as an expense on the income statement in the period in which the cost is used up or expired.
If a cost has no future value, it should be reported as an expense in the period in which it was incurred.
This means that on a retailer's financial statements, the wages, salaries, commission, bonuses, etc. of its employees should be reported as follows:
The amounts that were earned by the employees (and therefore incurred by the retailer) during the current accounting period should be reported as expenses on the retailer's current period's income statement (even if some of the amounts will be paid in a later accounting period or had been paid in an earlier accounting period).
The amounts that were earned by the employees (and therefore incurred by the retailer) but have not been paid as of the final moment of the accounting period, must be reported as a current liability on the retailer's balance sheet.
Let's illustrate these concepts with four payroll examples:
A company employs a student to work a total of five days—from December 26 through December 30, 2020. The company issues the student's payroll check on the next scheduled payday, January 5, 2021.
Even though the check is dated January 5, 2021, the matching principle requires that the company report the expense and the liability on the December 2020 financial statements 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 will not have any wage or fringe benefits expense for the student 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, 2021. The bonus amount is calculated by multiplying the sales from January 1 through December 31, 2020 times 1%.
The accrual basis of accounting and the related 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 on its balance sheet) in every accounting period in which sales occurred in 2020. If the company violates the matching principle by ignoring the bonus expense throughout the year 2020 (when sales actually occurred) and reports the entire bonus amount as an expense for just one day (January 15, 2021), every income statement pertinent to 2020 will report too much net income and the income statement that includes January 15, 2021 will report too little net income. The matching principle requires that the bonus expense pertinent to the 2020 sales be matched with the 2020 sales on the 2020 income statement.
If the entries are recorded properly, the balance sheet dated December 31, 2020 will report a current liability for the total bonus amount owed to the sales manager. On January 15, 2021 (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 2020.
A company has a vacation plan that will provide two weeks of vacation in the year 2021 if the employee worked the entire year of 2020. In the year 2020 (when the employee is working) the company reports the vacation expense on its 2020 income statement. The company's December 31, 2020 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 2021 (when employees take the vacations that were earned and expensed in 2020), the company will reduce its cash and its vacation liability.
A manufacturer begins operations in December and produces 1,000 units of product in December. The direct labor cost of $2,000 is assigned to the products. If all the units produced are sold in January, the $2,000 of direct labor cost will be part of the manufacturer's inventory cost as of December 31. When the units are sold in January, the $2,000 of labor will be part of January's cost of goods sold which is an expense on the January's income statement.
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.
Employees vs. Non-Employees
Payroll accounting pertains to a company's employees. However, there are some non-employees that also carry out some of the company's tasks. Here are a few examples:
- Many routine accounting tasks are performed by accountants who are employees, but some tasks are performed by accountants who are non-employees.
- Some of the computerized systems work is done by employees, but some computer tasks are performed by people who are non-employees.
- Office cleaning, grounds maintenance, and other tasks might be done by employees and some may be done by non-employees.
It is critical that employers properly classify each person performing tasks. A general rule is that the person is an employee (as opposed to an independent contractor, sole proprietor or business partner) if the employer:
- Has the right to control which tasks will be done, and
- Can control how the tasks will be done
To guide you further, the Internal Revenue Service (IRS) provides detailed information and examples in its Publication 15-A, Employer's Supplemental Tax Guide https://www.irs.gov/pub/irs-pdf/p15a.pdf
When a company has employees, it will involve the following:
- Having an Employer Identification Number (EIN) obtained from the Internal Revenue Service (IRS)
- Completing the U.S. Citizenship and Immigration Services (USCIS) Form I-9, Employment Eligibility Verification for each individual hired in the U.S.
- Having employees complete the IRS Form W-4, Employee's Withholding Allowance Certificates on which employees indicate if their federal income tax withholdings will be taxed as Single or Married and their number of allowances
- Recording each employee's hours worked and amounts earned
- Withholding Social Security taxes, Medicare taxes, income taxes, and voluntary deductions
- Remitting the payroll withholdings and the employer-paid payroll taxes
- Remitting the voluntary deductions
- Issuing the employees' paychecks or processing the direct deposits
- Providing employees with IRS Form W-2, Wage and Tax Statement by January 31
- Filing W-2 forms and IRS Form W-3, Transmittal of Wage and Tax Statements with the Social Security Administration (SSA) by January 31
- Filing IRS Form 941, Employer's Quarterly Federal Tax Return
- Filing IRS Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return
For more complete requirements including the critical dates and procedures for depositing payroll taxes, filing payroll forms, and distributing forms to employees see the following:
- IRS Publication 15, (Circular E), Employer's Tax Guide
- IRS Publication 15-A, Employer's Supplemental Tax Guide (Supplement to Pub. 15)
- IRS Publication 15-B, Employer's Tax Guide to Fringe Benefits
- Your state's agencies/departments' rules and regulations
Independent contractors are often referred to as non-employees. Hence, an independent contractor is not an employee, sole proprietor of the business, or business partner. Independent contractors are paid through the company's accounts payable system. As a result, an independent contractor submits an invoice for the services provided and the company issues a non-payroll check.
If the amount paid to an independent contractor (nonemployee compensation) during a calendar year is $600 or greater, the company must issue IRS Form 1099-NEC. However, if the provider of services is a corporation, Form 1099-NEC is not required.
Proprietors and Partners
A sole proprietor is the owner of a business organized as a sole proprietorship and is not considered to be either an employee or an independent contractor. Similarly, partners of a business partnership are neither employees of the business or independent contractors.
Salaries and Wages
In this section of payroll accounting we focus on the gross amounts earned by the employees of a company.
Salaries are usually associated with "white-collar" workers such as office employees, managers, professionals, and executives. Salaried employees are often paid semimonthly (e.g., on the 15th and last day of the month) or biweekly (e.g., every other Friday) and their salaries are often stated as a gross annual amount, such as "$48,000 per year." The "gross" amount refers to the pay an employee has earned before withholdings are made for such things as taxes, donations to United Way, savings plans, etc.
Since salaried employees earn a specified annual amount, it is likely that their gross pay for each pay period is the same recurring amount. For example, if a manager's salary is $48,000 per year and salaries are paid semimonthly, the manager's gross pay will be $2,000 for each of the 24 pay periods. (If the manager is paid biweekly, the gross pay would be $1,846.15 for each of the 26 pay periods.) A salaried employee's work period usually ends on payday; for example, a paycheck on January 31 usually covers the work period of January 16–31. This is convenient for accounting purposes if the company prepares financial statements for each calendar month.
NOTE: Occasionally, a salaried employee who is paid biweekly feels they are being "cheated" because their paycheck amounts are less than the paycheck amounts received by a salaried employee who is paid semimonthly. To illustrate, let's assume that the person paid biweekly has a gross salary of $2,000 on each paycheck. The person's friend who is paid semimonthly receives a gross salary of $2,166.67 on each paycheck. The biweekly-paid person thinks that the employer is paying its employees biweekly in order to save $116.67 each payday for every employee. This person doesn't consider that being paid biweekly means there will be 26 paychecks during the year, while the person being paid semimonthly will have only 24 paychecks during the year. The following shows that both are receiving the same gross salary for the year:
Biweekly-paid employee = 26 paychecks X $2,000 = $52,000 for the year.
Semimonthly-paid employee = 24 paychecks X $2,166.67 = $52,000 for the year.
Here are two additional points that may explain the misconception:
- If you divide the 52 weeks in a year by the 12 months in a year, there are on average 4.333 weeks in a month (not 4 weeks in a month)
- The 52 weeks in a year times 40 hours in a workweek = 2,080 work hours in a year. The 2,080 work hours divided by 12 months in a year = approximately 173 work hours in a month (not 160 work hours in a month)
Understanding these points will be helpful in calculating a salaried employee's hourly rate of pay and overtime pay earned by salaried employees.
Wages are often associated with production employees (sometimes referred to as "blue-collar" workers), non-managers, and other employees whose pay is dependent on hours worked. The pay for these employees is generally stated as a gross, hourly rate, such as "$13.52 per hour." Again, the "gross" amount refers to the pay an employee earns before withholdings are made for such things as taxes, contributions, and savings plans.
Hourly-paid employees receiving wages are often paid weekly or biweekly. To determine the gross wages earned during a work period, the employer multiplies each employee's hourly rate times the number of work hours recorded for the employee during the work period. Due to the extra time needed to make calculations for each employee, hourly-paid employees typically receive their paychecks approximately five days after the work period has ended.
When the hourly-paid employees have work periods that are weekly or biweekly, but the company's financial statements cover calendar months, the company will need to prepare an accrual-type adjusting entry at the end of the month. If hourly wages are a significant portion of a company's expenses, it is critical that the company report the correct amount of wages expense that pertains to the 30 or 31 days in the month, not the 28 days in a four-week work period. The company's balance sheet must also report a liability for the amount owed to the employees as of the end of the month.
Other Uses of the Term "Wages"
While many use the term "wages" to indicate the compensation earned by hourly-paid employees, the Internal Revenue Service (IRS) often uses the term to mean the wages, salary, bonuses, etc. paid to an employee. For example the annual maximum amount subject to the Social Security tax is referred to as the "annual wage limit". Similarly, the IRS Form W-2 is entitled Wage and Tax Statement.
Throughout our explanation, bonuses paid to employees and sales commissions paid to employees will be considered to be part of salaries or wages.