What is Payroll?

Payroll is a comprehensive record of employees that are paid by the company. Payroll classifies employees into various categories according to their function and pays scale (basic wage, allowance, income tax, other taxes, employee loans, etc.). Payroll processes form the bedrock of every organization as it contains sensitive information on the ‘wage and paycheck’ portion of the company’s strength—its employees. The organization needs to keep a track of the employees currently on the payroll, the net payout for the company, the record of transactions related to the employees including deductions and payroll taxes to identify the liability and its effect on the balance sheet (and other financial statements). Payroll records also include qualitative factors such as the conduct of the employee.

However, before we discuss accounting for payroll, and payroll tax entries, let us first understand how books of accounts are created and maintained.

What is Double-Entry Bookkeeping?

Double-entry bookkeeping is the system of bookkeeping or accounting that conceptualizes that every accounting transaction has two entries (double-entry)—debit and credit. The system follows the golden rules of accounting which state:

a) Debit the receiver, credit the giver.

b) Debit what comes in, credit what goes out.

c) Debit all expenses and losses, credit all incomes and gains.

All entries are recorded in a general ledger, where the corresponding debit and credit entries match. From the general ledger, items are appropriately moved to the income statement (or profit and loss account) and the balance sheet which contains assets and liabilities (along with owner’s or share capital).

Assets = Liabilities + Equity

A complete understanding of this system of bookkeeping is necessary to fully appreciate the overall system of payroll records, and how payroll accounting is carried out.

What are the Steps in Bookkeeping?

Accounting and bookkeeping are process-driven activities that record, measure, and display the financial health (and information) of the entity. It is a meticulous process that involves the following steps. It is important to understand these steps before we may be able to apply the same principles towards payroll transactions and accounting.

1. Understanding and analyzing the nature of all financial transactions and assigning them to their specific accounts.

2. Passing original journal entries that have a debit and credit effect on the appropriate accounts (with appropriate source documents).

3. Posting the journal entries into the ledger accounts (general ledger).

4. Preparing the unadjusted trial balance, which is a set of balanced accounts, which is the basis for preparing the set of financial statements.

5. Adjusting and passing entries at the end of every accounting period to accommodate changes and fluctuations, following the applicable financial reporting standards followed in the country.

6. Closing the books for the determined financial period (which may vary from one month to one year) and ensuring that the appropriate balances are carried forward to the following financial period.

What is a Payroll Record and What Information is Included on a Payroll Record?

A payroll record is a set of personnel files and documents relating to the employees of the company, starting from their interview records, up to their financial records, and include information up to their termination or resignation. They also contain detailed breakdowns of employees’ salaries, other compensation, leave policy, employee benefits, and payroll-related tax deductions (and other computations) that are required to be calculated and kept on record as per compliance requirements.

While payroll records are mandated to be maintained by law, they are also extremely useful in assessing the nature and amount of expenses due to employees, who are the backbone of any organization. ‘Salaries’ is a line item that is debited to the profit and loss account, and therefore has an immediate impact on the financial statements. The employer must, therefore, exercise caution and vigilance while creating and maintaining payroll records.

A payroll record contains information relevant to every employee and often includes the following information:

• The gross number of hours worked
• Payroll Compensation policy and workings
• Gross pay or gross wages
• Bonuses
• Commissions
• Fixed and variable pay
• Allowances and employee benefits
• Income tax payable on salaries
• Medicare tax
• Overtime workings
• Remittances made on behalf of the employee
• Take-home salary
• Voluntary deductions
• Net pay
• Employee handbook
• Any deviances or misbehavior
• Vacations taken
• Leave policy
• Leaves taken/ encased
• Employer’s portion of fringe benefits applicable
• Federal unemployment taxes (if applicable)
• Social security tax
• Deductions for employee pension/insurance/gratuity/retirement benefit
• Pension details
• Post-tax workings and compensation
• Pay period
• Bank account details of employee
• Payment made to the employee

How to record a payroll journal entry?

Recording a payroll journal entry involves debiting and crediting several accounts, but as with the tenets of bookkeeping, the debits and credits must match each other. All gross salaries and wages, along with their related taxes must be debited to their respective expense accounts, which is ultimately a debit to the profit and loss account. The credit respectively goes to the liability accounts, since for all purposes of accounting, employees are considered creditors, to whom the organization owes money.

According to the ‘Matching principle’ in accounting, every organization must match their expenses with the revenue and recognize them in the same period that they are earned, and not when they are received. Every organization (employer) thus, maintains a payable account and an accrual account to record for transactions that pertain to the particular period but will be realized only in a different accounting period. A ‘Payable’ account is for creditors and liabilities and an ‘Accrual’ account is for debtors and expenses. An organization’s payroll is its strength, and the employees represent creditors to the employer/organization.

Before we look at the payroll journal entries, let us understand some important payroll-related accounting terms.

• Federal Insurance Contributions Act (FICA) taxes: Payroll accounting is complex due to the components and taxes that go into making one definite account, i.e., Salaries. FICA taxes are those that are paid for Medicare and Social Security, where the limit is fixed by the government.

●  Federal Income Taxes: These are taxes levied on the income and withheld from the compensation due to the employee, when they file certain regulatory forms, such as 1040 and 401(k), depending on the deduction from the latter.

Organizations group their payroll journal entries differently based on department, nature, and size of the organization and category of expense.

The following are the payroll journal entries that are recorded in the books.

Step-by-step Payroll Journal Entry Example

Part 1: Creating the Payroll liability

Part 2: Paying the Payroll liability

In the first journal entry, all payroll-related expenses are debited to the profit and loss account, and all payables are credited, representing a liability. The second journal entry represents the payroll liability paid to the employees. ‘Bank’ is a debit account. Here it has been credited, which means that there is a payout. Likewise, ‘Payables’ is a credit account, and here it has been debited. This represents the completion of the said transaction, thus effectively substantiating double-entry bookkeeping. 

Payroll information is essential for any employer to identify the amount invested in the organization’s employees, including their healthcare and other benefits which are essential to the productivity of their employees. It also enables the employer in measuring the revenue against which amount is payable to the employees.

Tax payable for payroll is usually recorded as a separate entry, where payroll tax expense is debited, and respective payroll tax payable is credited. This represents FICA payable, health insurance payable, and any other payroll-related tax. The first payroll journal entry mentioned above has been combined with debiting the payroll expense account along with crediting the payroll tax payable. In certain organizations, this may be two different entries.

Payroll accounting is therefore a series of well-structured entries that are extremely important in understanding the overall financial health of the organization.

Common Mistakes and Pitfalls

Payroll entries can be accounted for through accounting software or manually. The manual payroll process, however, can be labor-intensive, with scope for several errors. Mistakes in payroll transactions could also arise due to the following scenarios:

1. Miscalculating the payroll compensation for the employees by the employer (as stated in the record).
2. Wrong or incorrect computation of taxes payable (this may include federal unemployment taxes, state unemployment taxes, FICA, social security taxes, etc.). This error could also occur if the wrong tax rates and slabs are considered.
3. Not updating payroll records, including recruits or termination of employees.
4. Incorrectly debiting and crediting payroll or other accounts in journal entries or wrongful posting to the trial balance.

Context and Applications

This topic on payroll entries and accounting for payroll is significant in the professional exams for both undergraduate and graduate courses that have accounting, payroll, and commerce at their core.

This may be especially applicable for:

• B. Com
• M.Com
• MBA (Finance), MBA (Human Resources)

This topic may also be significant for the professional certifications that include:

• Chartered Accountancy;
• Certified Public Accountant (CPA);
• Association of Chartered Certified Accountants (ACCA)