Payroll Accounting – Ultimate Guide

Payroll is another term to refer to employee compensation its related fringe benefits have a large shape of the current liabilities. Payroll is the most significant liability any company incurs. Cost of labor is very important to companies to an extent that they develop a payroll accounting system.

The term payroll is used to refer to both the wages and salaries. Companies have a responsibility (according to the law) to maintain payroll records for every employee, to pay and file payroll taxes, and also ensure that they comply with the federal and state tax laws related to the employees compensation.

Administrative, managerial and sales personnel generally receive salaries as payments. Different terms to describe employees pay

  • Wages-are the payments stated in hourly rates
  • Salary-is payments stated on weekly, monthly or annual rates. For example, $54300 per year or $980 per week
  • Commissions-is the pay termed in percentage of a given amount of sales amount. E.g. 2% commission on sh. 10000 sales would give;

2/100 *sh. 10000=sh200 commission

  • Bonus: is the amount of payment over and above the base salary. It is usually paid for an exceptional performance by an employee
  • Benefits: these are items not paid directly to employees. Such includes disability, insurance, health cover, life among others

The employer provides for all the benefits to ensure that employees are motivated and feel comfortable while working in their respective companies.

Business owners pay their employees at a given base for set number of hours, known as straight time. For any additional hours worked, employees may be entitled to additional payments, what is known as overtime.

The term payroll though doesn’t apply to payments made to professionals such as attorneys, CPA’s (Certified Public Accountants), and architects. Such and other related professionals are independent contractors and are not salaried as employees. Their payments are referred to as fees.

Their payment is different in the government regulations on payments for payroll taxes applies to employees only

Determination of payroll

Gross pay

This is the total amount of wages or salaries before taxes and deductions. It also includes bonuses and commissions earned by the employees during a pay period. Companies determine the gross pay by multiplying the number of hours worked by hourly pay rate.

Further, the law also requires companies to pay 1½ times regular hourly rates for overtime of the workers

Payroll deductions

Most states and federal governments require employers to deduct taxes from their employee’s paycheck. Investments and insurance companies may also reach some of their employee’s payroll. The amount which is withheld from the paychecks is known as withholding deductions. Types of deductions

Payrolls can either be:

  • Mandatory Required Deductions
  • Voluntary Deductions

Mandatory Required Deductions

The mandatory payrolls are those required by the law, consisting of income taxes and FICA taxes. Voluntary payroll deductions are from the employee decisions. These include charitable contributions, union dues and insurance premiums. Mandatory deductions are classified into two;

  • Required/mandatory withholding for income tax
  • Employee social security (FICA) tax

Employers serve as mere agent. They subsequently deduct the payments and give it to the government.

Required/mandatory withholding for income tax

The law of US requires companies’ employers to withhold employee’s income tax from their paychecks. The amount of income withheld depends on the employer’s gross pay and the number of allowable with holdings he/she claims.

The employer files a Form W-4 with the employee to show the number of claimed allowances for the income tax holding. Any of following allowance lowers the tax amount which is being withheld;

  • Childless couple claims 2 allowances
  • An unmarried employee claims 1 allowance
  • Married couple with a child clams 3 allowances, and so on.

Factors that determine the amount of payroll deductions

  1. The employees gross income
  2. Number of allowances claimed by employee
  3. Length of pay time

There is no limit on the level of gross earnings subject to the income holdings.

Required/mandatory deductions: employee social security (FICA) tax

FICA-Federal insurance contributions act, also known as Social Security Act was responsible for eh creation of Social Security Tax. The act was enacted in 1937 by the congress with a view to provide the workers with employment disability, supplemental retirement ad medical benefits.

In 1965, the congress extended the benefits to accommodate Medicare for individuals over 65 years. These benefits are financed by tax levied on the employees pay check. The amount of FICA tax withheld varies from one year to the other.

Components of FICA taxes

  • 1) Old age, survivals and disability income (OASDI)
  • 2) Medicare (health insurance)

In 2010, OASDI tax applied to the first $106, 800 per employee each year. The tax rate then was at 6.2%, and hence the maximum tax an employee would be deducted in this case would be:

6.2% X $106, 800=$6,622

The taxable earnings keep on adjusting annually.

At the time of introduction, FICA taxes rate was at 1% for the first $3,000 of the gross income (earnings) or a maximum of $30 yearly. However, these rates have been changing drastically since then.

In 2008, the rate was at 7.65%, inclusive of 6.2% social security and 1.45% Medicare, for the first $102,000 of the gross earnings per employee.

Optional/voluntary deductions

Any voluntary deductions from employee’s gross earnings should be authorized in writing by the employee involved. The authorization may be done individually or as a part of the group. The voluntary types of deductions have no effect on the payroll tax expense to the employers

Most employers provide cafeteria plus, which allows their employees to also select from a list of insurance coverage.

Health, union dues and life insurance coverage are mostly made on group basis.

Net pay

Also known as take-home pay, the remainder after deductions has been made from an employee’s gross earnings;

Net pay=Gross pay-Deductions

The net pay is what employees receive in the paycheck. Some companies deposit the net pay in employee’s bank accounts while others pay in checks.

EMPLOYERS PAYROLL

Employers too, are required to pay at least 3 payroll taxes;

  • 1) Employer FICA tax
  • 2) Federal unemployment tax
  • 3) State unemployment tax

These taxes added to other items such as pensions and vacations are collectively known as fringe benefits.

Employer FICA taxes

Each employer has an obligation to pay FICA taxes. Further, employers are required to match each of the employee’s contribution of FICA. This matching contribution leads to payroll tax expenses to employers.

Employer’s FICA tax is subject to same rate and same employees maximum earnings. The employer records the payroll tax in FICA tax payable account; same account is used to record employee’s taxes and deductions.

Federal unemployment taxes

The tax was established by the Federal Unemployment Tax Act (FUTA), with the purpose of providing benefits for a specific time period for employees who lose their job with no fault of their own.

The entire federal unemployment tax is borne by the employer. There is no withholding or deductions made from employees. Companies usually use Federal Unemployment Tax Payable Account to recognize such a liability.

State unemployment taxes

These are all unemployment compensation programs in all states under SUTA (States Unemployment Tax Act. The tax works similarly to the federal taxes in providing benefits to the employees who lose their jobs. The basic rate of state unemployment taxes is usually 5.4% for the first $7,000 of wages paid to the employees.

The basic tax rate is adjusted to employer’s rating on experience.

Payroll entries

There are 3 types of payroll entries;

  • (A) Primary payroll entry
  • (B) Accrued payroll entry
  • (C) Manual check entry

Primary payroll entries

This type of entry is for initial payroll re coordination. It records wages earned by the employees, plus with holdings and any other additional tax owed by a given company. It’s the summary level entry compiled from the payroll register and is either recorded in general ledger or payroll journal.

The entries include debit for salaries, labor expenses and companies portion of payroll taxes which have not been paid, and the cash which has already been paid as the net pay.

There may arise other additional deduction in the payroll entries. Examples of such deductions may include life insurance, pension plus, vision insurance and health insurance.

Accrued payroll entries

It’s common to have some unpaid wages at each accounting period, and hence the expense should be accrued. Accrual entry is simpler than comprehensive payroll entry because all the payroll taxes are clumped into a single expense account, while liability account is offset.

After the entry has been made, the same should be reversed in the next accounting period, recording actual payroll expenses when they occur.

Manual paycheck entries

It’s quite common to create a manual check, either the company is laying off or firing its employees, or because the employee had short payments in prior payroll and hence is obligated for the person to get paid before the next payroll schedule.

The check may be paid through corporate account payable bank account, rather than from the payroll account and hence the entry should be made through account payable system. If it is recorded directly to the payroll journal or general ledger, the same line items should be used for t he entry of payroll journal.

Payroll recording

This involves maintaining payroll departmental records, recognizing expenses and liabilities in payroll, and recording payment of payroll. A payroll record is similar to cash payments journals. It serves as a check register for payroll check recordings.

Maintaining payroll departmental records

An employer, in a means to comply with federal and state law, must keep cumulative record of every employee’s gross earnings, deductions and net pay, for each year. The record which contains such information is known as employees earning records.

Companies maintain separate records for each employee’s earnings and update them after each pay period. Employers use the cumulative payroll data earning records to;

  • File state and federal payroll tax return
  • Determine when employee has reached maximum earnings in accordance to FICA taxes requirements
  • Provide employees with statements of their gross earnings as well as tax with holdings for the year

Most companies, in addition to employee’s earnings records, necessitate for preparation of payroll register. It accumulates the employees earning, deductions and net pay for each pay period.

In other companies, payroll register still functions as book of original entry or journals. Postings made from it are put directly to the ledger accounts.

Others use payroll register to serve as memorandum record which provides data for posting in the general journal and subsequent posting to ledger accounts.

Internal control over payroll

There are 2 primary controls for payroll;

  • 1) Controls for efficiency
  • 2) Control to safeguard assets of company against unauthorized payrolls

Controls for efficiency

Bank account reconciliation can be time consuming since there is a possibility of lots of outstanding paychecks. Most companies use two payroll bank accounts to limit the number of checks outstanding. The payroll for the current month is paid using one account, while the next payroll is paid with the other payroll account, for the coming month.

This way, reconciliation can easily be done for each account every other month, which decrease the accounting expenses. Employer’s data on payroll are stored in a file. The computer does the calculations, printing of pay checks and payroll recording and afterwards electronically makes the adjustments in the employee earning records.

Controls to safeguard payroll disbursements (unauthorized payrolls)

Irregularities often arise due to tax internal control system. Some of the common frauds involved in payroll include unauthorized Pirates, continued termination of employees on payroll, addition of fictitious employees on payroll, overstated hours and distribution of duplicated payrolls.

To guard against such practices, strict internal controls for payrolls should be maintained.  Hiring and firing of employees should be treated separately from passing out paychecks and from accounting. Use of photo ID’s ensures that no ghost workers get payments.

How to improve the control system for payroll

  • Employee advances: It’s common for employees to ask for advances on the next paycheck or have the cost of next trip covered on company’s behalf. Either way, possibility of losing track of advance is high.  Hence, the following controls are important to ensure that such advances are eventually paid back;
  • Continual review of outstanding advances: When employees get paid, it’s important that continuous review and follow up of such advances be done. A simple way to control is where a company has a policy that requires automatic deduction of all advances from the next payback.
  • Prior approval of employees advances by management: When employees request for such payments, it’s best that the same should be communicated to their supervisors, for a formal signing and approval. The reason is that some advances are short-term loans and would require management deliberation and approval.
  • Payroll checks: Problems in storage, printing and distribution associated to any type of check also apply to payroll checks. If employees are to be paid through direct deposits, then the following controls may not apply;
  • Control check stock: The check stock shouldn’t be stored along with papers ad pens as a person my remove a stack and use it with forged signature from stealing funds from the company. Add relevant features to check stock: checks can be easily copied or modified. To prevent this from happening, the company should purchase security such as “void” copyright that appears when such check is copied.
  • Control signature plates: When unauthorized person gets access to signature plates of a company, it’s not only to forge pay checks but can also pave way for other legal documents from the company to be stamped.