Payroll accounting is a system that tracks and manages records of employee compensation in an organization, mainly including wages, salaries, bonuses, and others.
Companies usually prefer an accrual accounting method over cash accounting to maintain precise payroll accounting. Accrual accounting recognizes revenues and expenses when they are incurred, irrespective of when the actual cash transactions happen. This is why accrual accounting correctly reflects the financial position more than cash accounting.
In this article, we will define payroll accounting and explore its nuances to understand how it shapes an organization’s financial outlook.
What is Payroll Accounting?
Payroll accounting involves managing all the calculations and records of the compensation a company owes to its employees. This includes salaries, wages, bonuses, tax deductions, and other benefits. The goal is to ensure that all employee compensation is accurately accounted for and that financial records comply with the legal requirements.
To manage payroll accounting well, it’s necessary to be familiar with accounting terms, which makes it easier to keep track of everything correctly. For instance, you can apply deductions correctly if you know what gross pay, net pay withholding, and accruals mean. This knowledge makes payroll accounting easier to handle.
Benefits of Payroll Accounting
Now that we know what payroll accounting is, let’s understand how it can benefit you as a business owner. Here are some of the most significant advantages of payroll accounting:
- Accurate and Timely Compensation: Payroll accounting can ensure that everyone gets paid correctly and on time, which helps keep your team happy and motivated. By getting the numbers right and avoiding delays, you maintain a smooth payment process within your organization.
- Legal Compliance: It keeps you on the right side of the law by ensuring you meet all tax laws and labor regulations. This way, you can avoid fines and legal troubles since all legal requirements are properly addressed.
- Financial Insights: Payroll accounting gives you a clear picture of how much you spend on your employees, which is necessary for budgeting and planning. This helps you understand how payroll costs influence your overall financial situation.
- Employee Morale: Getting payroll right boosts employee morale because people appreciate being paid accurately and on time. This reliability shows that you value and respect your team, which creates a more positive and motivated work environment for everyone.
Components of Payroll Accounting
The payroll accounting system consists of several essential components determining employees’ gross pay for a given accounting period. Here are 4 essential elements to consider:
Gross Pay Calculation
Gross pay is an essential component of payroll accounting, which represents the total amount an employee is paid before taxes and other deductions. It includes regular wages, salaries, overtime, commissions, bonuses, tips, vacations, holidays, and sick pay.
Let’s take an example to understand how this works. Suppose a person worked 40 hours a week at an hourly rate of $15. They also worked 5 hours of overtime at $22 per hour. In this case, the calculation will be:
- Regular pay: 40 hours x $15 = $600
- Overtime: 5 hours x $22 = $110
- Gross pay: $600 (regular pay) + $110 (overtime pay) = $710
Deductions and Net Pay
Gross pay is the starting point, not what an employee takes home. That’s where deductions come in – the amount subtracted from gross pay to arrive at the final net amount, which an employee gets in hand. Again, these are typically divided into 2 main categories:
- Mandatory Deductions: These are non-negotiable. The government takes its share first, including federal income tax, state income tax, social security tax, medicare tax, and court-order deductions, which may include child support or wage garnishments[1], depending on the court’s order.
- Voluntary Deductions: These are not mandatory, meaning that it’s up to the employee to opt if they want to. This includes health insurance premiums, life insurance premiums, union dues, charitable contributions, and retirement plan contributions (e.g., 401(k), 403(b)).
Payroll Taxes
Payroll taxes represent the taxes that employers are legally obligated to withhold from employee wages and salaries. These are not considered business expenses but liabilities until they are remitted to the government because they are held in trust and actually owed to the government until finally paid. Some common deductions and their rates include:
- Federal Income Tax: The amount withheld depends on the employee’s W-4 form (Employee’s Withholding Certificate)[2] and earnings.
- State Income Tax: Varies from state to state.
- Social Security Tax: 6.2% of the first $168,600 of an employee’s annual wages
- Medicare Tax: 1.45% of all wages, with no annual limit
Benefits and Other Compensation
These are the perks that employees receive from their employers apart from the regular pay. Some of these benefits include:
- Health and wellness benefits: These plans differ in terms of services covered, deductibles, copayments, and premiums. Some common types include health maintenance organization (HMO), Preferred Provider Organization (PPO), Point of Service (POS), and Exclusive Provider Organisation (EPO) plans.
- Mental health and wellness: Wellness benefits include counseling for mental illness and substance abuse treatment. These programs may also cover gym memberships, coaching, and therapy.
- Financial and retirement benefits: Such benefits help employees plan for their future and ensure financial security in old age. Retirement plans are an essential part of this, which includes defined benefit and contribution plans, most commonly including 401(k) plans[3]. Life and disability insurance is another critical component that provides financial assistance to the beneficiaries of deceased employees and employees who cannot work due to a severe injury or illness.
- Time off and leave benefits: These benefits allow employees to take breaks from work due to vacations, illness, or family responsibilities without losing pay. Some of these benefits include paid time off, which covers vacation days, sick leave, personal days, and other types of leave, such as bereavement and jury duty.
- Work-life balance benefits: These benefits help employees manage their personal and professional lives. These include flexible work hours, remote work options, and support for commuting.
- Fringe benefits and at-work benefits: Employers may also offer additional offerings, such as discounts, free meals, on-site fitness facilities, wellness programs, and other benefits accessible at the workplace.
How To Do Payroll Accounting?
When it comes to manual handling of payroll processes, it comes down to 4 main steps. Here’s how to do payroll accounting:
Step 1: Gather Payroll Reports
The first step is to gather payroll reports. These are documents employers need to create for every pay period to record financial information related to pay rates, tax withholdings, and other financial aspects of employee compensation. This helps ease reporting on taxes you will hold and potential tax liability.
Step 2: Record Payroll Journal Entries
Once you have gathered the payroll reports, record payroll journal entries to document all payroll-related transactions in your accounting system. This step ensures that your wage expenses, taxes, and other deductions are correctly tracked and reported. There are 3 types of journal entries under it, which are outlined below.
- Initial Recording: It is the primary entry for each payroll cycle and includes the gross wages earned by employees, deductions for taxes and benefits, and the final net pay. Basically, it sets up the payroll liabilities and expenses for a given period.
- Accrued Wages: This entry comes at the end of the accounting period when it (the period) doesn’t align with the payday. These entries identify the wages earned but not yet paid so that the expenses and liabilities are recorded for the period they rightfully belong to.
- Manual Payments: This entry is used for any payments made outside the regular payroll cycle, typically including bonuses, commissions, or adjustments for previous periods. It can also be used to issue manual checks for terminations or other special circumstances that require a separate off-cycle payment to be processed.
Step 3: Post Payroll Journal Entries to the General Ledger
Once the payroll journal entries are recorded, they are posted to the general ledger – the company’s main accounting record. It includes all the financial transactions and balances for various accounts.
To post payroll accounting entries correctly, it is necessary to use the appropriate accounts from the chart of accounts. This chart lists all the accounts used in the general ledger and is categorized based on assets, liabilities, equity, revenue, and expenses.
Step 4: Reconcile Payroll to the General Ledger
The final step is reconciling (comparing) payroll to the general ledger. This ensures that the payroll in the general ledger matches the actual payroll expenses and liabilities. Here are the steps to reconcile:
- Verify that the total payroll expenses match with the postings in the general ledger.
- Check for any differences between the payroll register and the general ledger. Some of the discrepancies may include unrecorded adjustments or errors in data entry.
- Make necessary adjustments to rectify these errors and ensure the general ledger accurately reflects the payroll transactions.
Legal and Regulatory Considerations
A significant part of understanding the distinction of payroll accounting is understanding the legal and regulatory considerations involved. Adhering to these regulations is necessary to avoid hefty fines, potential legal issues, and, of course, any threat to reputation.
Labor Laws
Labor laws set the standard for wages, working hours, and other employment conditions. The Fair Labour Standards Act (1938)[4] is one of the most important federal laws that governs minimum wages, overtime pay, and record-keeping requirements.
The federal minimum wage is $7.25 per hour[5], meaning employers cannot pay their workers less than this amount. However, some states have set higher minimum wages, so businesses must comply with the higher rate if it applies to them. For example, California’s minimum wage is $16 per hour[6], which is higher than the federal level.
Overtime pay, on the other hand, applies when non-exempt employees (those eligible for overtime) work for more than 40 hours in a workweek. The Fair Labour Standards Act mandates that these employees receive 1.5 times more[7] than their regular pay rate for overtime hours. For instance, if an employee earns $10 an hour, then they should be paid $15 for each overtime hour.
Note: An employer must keep detailed records of their employees’ total hours worked, regular and overtime wages, and deductions from pay for at least 3 years[8]. Failing to keep these records can result in fines and penalties, back pay and damages, or even the inability to defend against wage and hour violation claims.
Federal Income Tax
One of the primary responsibilities in payroll accounting is withholding federal income taxes from employees’ paychecks. This tax is purely based on the employees’ earnings and the information they provide on their withholding certificates, such as marital status and the number of allowances claimed. Employers should deduct the correct amount of federal income tax from each paycheck and send it to the Internal Revenue Service, the statutory authority to administer and enforce internal revenue laws.
Social Security and Medicare Taxes (FICA)
The Federal Insurance Contributions Act states that employers and employees must contribute to Social Security and Medicare, which provides benefits to retired, disabled, and other individuals who need support.
The current FICA tax rate is 15.3%[9] of an employee’s wages, which splits between the employer and the employee. The breakdown is 6.2% for Social Security[10] and 1.45% for Medicare. For higher earners, there is an extra 0.9% Medicare tax on wages, but that only applies to limits above a certain threshold.
Federal Unemployment Tax Act (FUTA)
Employers pay federal unemployment taxes to help fund unemployment benefits for workers who lose their jobs. The FUTA tax rate is 6% on the first $7000[11] of each employee’s wages. However, employees can claim a credit of up to 5.4% if they pay state unemployment taxes, which reduces the FUTA tax rate to 0.6%. However, employers must file and pay FUTA taxes annually using Form 940.
State Unemployment Taxes (SUTA)
Just like FUTA, employers are also required to pay state unemployment taxes, which go into the state fund for temporary financial assistance to unemployed individuals. The amount to be paid can depend on the state where a business operates, its industry, and its lay-off history.
Each state sets its own tax rates and wage base, which is the maximum amount of wages on which taxes are calculated. For example, employers pay a percentage of each employee’s wages up to this wage base. Alaska, New Jersey, and Pennsylvania[12] are an exception where both employers and employees must pay this tax.
Data Protection and Privacy Laws
Both federal and state regulations enforce data protection standards in payroll accounting. It varies on the state level, but on a federal level, there are several prominent laws to consider:
- The Americans with Disabilities Act (ADA): It is a civil rights law that protects people with disabilities against discrimination during hiring, promotions, and other processes. An employer can enquire about disability-related details or require medical assessment only if they have made a job offer or are ready to meet the unique needs of the concerned individual. Also, if an employer has 15 or more employees[13], they must provide reasonable accommodation to qualified individuals with disabilities.
- Health Insurance Portability and Accountability Act: This law specifically focuses on protecting the security and privacy of an individual’s medical data. It ensures that all the information obtained through workplace plans or programs stays confidential and not disclosed without their consent.
- Fair Credit Reporting Act: It is common to conduct background checks for candidates during the hiring process, which can include evaluating their credit reports. This law ensures that an employer cannot do so without the applicant’s consent. They need to get written consent from the job applicant before conducting the background check.
Note: Employer must also provide a copy of the report and a summary of the candidate’s rights as per the FCRA rules. This empowers an applicant to challenge any discrepancy that might hinder them from getting the job based on discriminatory grounds.
- Fair and Accurate Credit Transactions Act: This act was introduced as an amendment to the FCRA Act in 2023[14]. It allows a person to get one free credit report annually or an option to buy a credit score to protect themselves against identity theft. This ensures fair treatment of credit reporting, which has become a significant issue influencing employees’ decisions based on credit details.
- The Privacy Act: It governs the collection, usage, and circulation of personal details by federal authorities. Although it doesn’t directly impact the dynamics between an employer and their employee, it certainly protects individuals from information breaches.
Challenges in Payroll Accounting
Payroll accounting may seem straightforward, but it can be tricky at times. Mistakes in this area can cause heavy headaches for employers and employees. Let’s look at some common payroll accounting errors to understand how these can affect your organization’s financial health.
Common Payroll Accounting Errors
It is common to come across accounting errors such as miscalculated wages, wrong records of tax withholdings, or inaccurate accounting for overtime. When this happens, employees might get paid too little or too much, often leading to frustration and loss of trust.
Similarly, incorrect tax withholdings can result in fines from the IRS, which can be a substantial financial burden. These errors can significantly affect payroll operations and harm the company’s finances and reputation. Hence, one needs to pay close attention to these minute details and regular checks for mistakes to keep everything running smoothly.
Ensuring Accuracy and Compliance
Efficient payroll means getting every detail right—employee hours or tax withholdings. However, compliance in payroll accounting often gets overwhelming when there are so many rules to follow, which also vary widely depending on state regulations.
Given these complexities, one really needs to follow the letter of the law in every respect of payroll. Missing even a tiny detail, whether it is failing to update tax rates or overlooking new labor laws, can lead to severe consequences.
Managing Payroll for a Diverse Workforce
Managing payroll for a diverse workforce can be extremely tough. Employees may have different pay structures – salaried, hourly, or contractual and each one needs a different way of calculating pay and taxes. Then, various benefits and deductions depend on employees’ locations or roles.
Language and cultural differences can also make it hard to explain pay and benefits clearly, leading to potential misunderstandings or communication gaps. Keeping up with different labor laws in various states or countries can add another layer of complexity. All these factors make payroll accounting a challenging task requiring careful attention to detail and robust systems to get it right.
Staying Updated with Changing Regulations
Payroll accounting can be tricky if you don’t stay updated, as rules and regulations change frequently. Balancing these tasks while managing different aspects of the business can be overwhelming.
A recent example is the changes in Federal Insurance Contributions Act tax limits. In 2023, the Social Security wage base increased by almost 9%, from $147,000 to $160,200[15]. This means employers must now withhold social security tax on employee earnings up to $160,200 instead of $147,000. If a business fails to adjust as per these changes, it can lead to under-withholding or over-withholding, resulting in compliance issues and even heavy fines.
Best Practices for Payroll Accounting
Payroll management is a multifaceted task that requires attention to detail. Following best practices can help ensure equal attention to all these aspects.
Regularly Reviewing Payroll Processes
Regularly reviewing payroll processes is critical to keeping everything accurate and timely. For example, if you update your overtime policies but don’t review its payroll system, the system might continue miscalculating overtime, which can lead to legal issues and, of course, unhappy employees. Timely reviews can easily catch this mistake and allow you to adjust the payroll system accordingly.
Conducting Internal Audits
Internal audits can help you detect discrepancies, frauds, and other errors that might otherwise go unnoticed. They can reveal any weakness in the system, whether in the segregation of duties or outdated software that could be prone to errors. With internal audits, you can quickly address this issue by implementing better controls and adopting updated technology to run your payroll operations smoothly.
Ensuring Data Security
Data security in payroll accounting is necessary to protect both employee and company information. Multi-factor authentication is generally recommended, as it adds an extra layer of protection and makes it harder for unauthorized users to access sensitive data.
Similarly, you can use regular software updates to fix security loopholes that hackers could exploit. This way, minimizing human errors becomes easier, which is a common cause of data breaches.
Providing Employee Training
Regular training sessions for your team to stay updated on the latest practices and legal changes can work wonders to improve the efficiency of your payroll processes. Conducting workshops and refresher courses are great ways to make this happen. It equips your team with skills and keeps them updated on the latest changes.
How To Become a Payroll Accountant
Similar to other professions, becoming a payroll accountant is straightforward. Here is what it typically looks like:
Earn a Degree
To become a payroll accountant, you will need to get a degree. A bachelor’s degree in accounting, business administration, or similar can be a good starting point, but make sure the college or university you join is accredited. This is really important because it ensures the quality of your education meets industry standards.
You can go ahead with institutions holding accreditations from the Higher Learning Commission (HLC), the Association to Advance Collegiate Schools of Business (AACSB), and other prominent institutions.
Secure an Internship
Once you are qualified, start exploring opportunities through job boards, networking events, or university career centers to learn about open roles for interns. This can be a great way to get hands-on experience in processing payroll, handling employee benefits, and learning activities related to compliance with text revolutions.
During this period, you will come across paid and unpaid opportunities. Depending upon your preference, you can go with either of them but focus on maximum learning during your internship.
Gain Experience
After completing your education and internship, try to gain more relevant work experience as a professional payroll accountant. You can start with general accounting roles such as financial reporting, tax preparation, or accounts payable/receivable.
This experience will teach you how to actually calculate wages, manage deductions, and comply with payroll laws to maintain accurate records. Everything you learned during the internship will apply during this period and help you get extensive experience to prepare for specialization.
Obtain Certifications
Certifications always add more value to your knowledge and skills by making you stand out as a qualified and trustworthy professional. Along with your work experience, you can pursue certifications like Certified Payroll Professional (CPP) and Fundamental Payroll Certification (FPC) from the American Payroll Association (APA).
Once you obtain them, you might need to go through specific education to pass the exam, depending on the certification you have applied for.
Develop Professionally
Once you gain relevant experience and certifications, it becomes necessary to keep a learning mindset if you want to climb the ladder higher. This needs a sharp focus on advanced proficiency in payroll software, analytical abilities, and an in-depth understanding of laws and regulations.
Participating in workshop seminars and professional courses can be a great way to improve in these areas, as it helps you stay updated with the latest industry practices and trends.
When To Use Payroll Software
As a business grows, manual processes can become time-consuming and prone to errors. This is particularly true for payroll management, where mistakes can lead to compliance issues and financial discrepancies.
Automation via payroll software can reduce this manual workload, prevent heavy, costly mistakes, and simplify compliance with tax regulations. Many businesses have been increasingly adopting popular payroll software like ADP Payroll, Deel, and Paycor to make their payroll processing faster and more accurate.
What is the Difference Between Payroll Accounting and General Accounting
While these two may sound similar, there are several differences between payroll accounting and general accounting. The main difference is that payroll accounting focuses specifically on processes and expenses related to employees, while general accounting is a broader concept that’s concerned with managing an organization’s overall finances.
Payroll accounting is about tracking and processing employee wages, taxes, and benefits, while general accounting includes managing the financial accounts of a company, mainly its expenditures and revenue. Here are some of the best accounting software for general purposes.
Conclusion
Employees are a business’s greatest asset, and it’s necessary to clearly understand the cost of keeping them on board. The payroll accounting process ensures accurate and timely compensation and that this process doesn’t violate legal and regulatory requirements. This information is equally critical to decision-making because when you know exactly how much you are spending on your employees, you can manage your business’s costs and taxes efficiently.
Data References
2. Employee’s Withholding Certificate
3. 401(k) Plans
4. Fair Labour Standards Act (1938)
7. Federal overtime provisions
10. Social Security basics for new workers
11. FUTA tax rate
13. Employment rights as an individual with a disability
14. Fair and Accurate Credit Transactions Act of 2003