Payroll is the most complex accounting process you must complete.
Your accounting transactions are posted to general ledger, but is the information accurate? How do you get the payroll process right?
To understand how payroll ends up in general ledger, you need to review the accounting cycle.
Understanding the accounting cycle
The cycle is a set of tasks that are performed in a specific order.
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1. Source document
A source document is generated when an event happens in your business.
Payroll accounting, for example, is driven by the passage of time. Each pay period, your company incurs payroll liabilities for salaried workers. You may also owe gross pay to hourly employees and independent contractors.
Your source documents for payroll transactions include:
- Employee data: Pay rates and tax withholding documents for salaried workers.
- Hourly staff: Pay rates and time cards for the pay period.
- Independent contractors: Contracts that document amounts to be paid, and the work the contractor must complete to receive payments.
Once you gather source documents and make payroll calculations, you can post journal entries.
2. Post a journal entry
A journal is a record of each transaction that occurs, listed in chronological order, and accountants post activity using a journal entry.
Payroll journal entries impact the cash account, accounts for withholding taxes and health insurance activity.
If you’re looking for a particular journal entry, you’ll find it in general ledger.
3. Review general ledger
Each payroll entry is posted to general ledger, which is a record of every transaction posted in the accounting system.
Accountants review general ledger to verify that journal entries are posted correctly. A summary of the general ledger activity ends up in the trial balance.
4. Generate the trial balance
Your trial balance is a listing of each account used to post transactions and the current account balance.
This document provides a quick snapshot of your current financial condition. You can scan the list of accounts and balances to decide if the accounting data looks reasonable.
The trial balance is used to create the financial statements each month and year.
5. Financial statements
The financial statements include the balance sheet, income statement and statement of cash flows.
When you run payroll and complete the accounting cycle, you’ll note that each financial statement is affected by payroll.
Processing payroll can be summarized in five steps.
Five steps for payroll processing
A small business must complete these steps to calculate payroll expenses and submit tax payments:
1. Data collection: When an employee is hired, you need to collect information to withhold the proper amount of payroll taxes. Employers must withhold federal income tax, and may withhold dollars to pay for company-provided benefits. If, for example, you offer a retirement plan, a worker may want payroll dollars withheld and invested in the plan.
2. Calculating net pay: The net amount of employee pay is the gross pay less tax withholdings, less any benefit payment withholdings. You’ll also calculate withholdings for Medicare and Social Security.
3. Payments: You must pay each worker by check, or via direct deposit to a bank account.
4. Reporting: A tax filing for federal tax and state tax withholdings must be submitted to the IRS and the state department of revenue. Retirement plan contributions, state unemployment payments, Medicare tax and Social Security taxes are reported to other entities.
5. Withholding payments: All of the tax and benefit payments must be forwarded to the taxing authorities, retirement plan firms and other benefits providers.
Employer taxes and expenses include:
- Wage expense: For the worker’s gross pay.
- Medicare and Social Security tax: Companies pay a portion of the tax liability for each employee.
- Benefit payments: If your firm pays a share of health insurance costs, you’ll post the amounts to a separate expense account.
Keep in mind that your business must address changes to payroll, which complicates the process and requires more time.
Every year, employees may be added, promoted or let go. Workers also may change the tax and benefit withholdings, based on salary changes or family changes.
Payroll processing for independent contractors is much easier.
Contractors and tax withholdings
You must determine if each worker you hire is an employee or an independent contractor.
To process payroll correctly, you need to know each worker’s classification. Fortunately, the IRS provides a guide that explains how to assign workers to a particular category.
Simply put, your business has a great deal of control over the work performed by an employee. If the worker completes a task with little supervision, the independent contractor category will likely apply.
At the end of each year, you issue contractors a 1099 form.
The 1099 form reports the gross earnings paid, and 1099 forms do not include withholdings for income tax, Medicare or Social Security taxes.
Self-employed contractors post 1099 income to Schedule C, along with expenses. The net profit from self-employment is added to other sources of income on the personal tax return (Form 1040).
Contractors use Schedule SE to calculate Medicare and Social Security taxes, and contractors are responsible for paying the entire tax liability.
Your firm is responsible for calculating Medicare and Social Security taxes for employees.
Working with FICA taxes
Federal Insurance Contribution Act (FICA) taxes are collected to fund Social Security taxes and the Medicare tax.
For 2019, employers and workers each pay a 7.65% FICA tax rate on a worker’s gross wages. The worker’s taxes are withheld from gross pay, and the employer sends the payments to the federal government.
Medicare assesses the tax on every dollar of earnings. Social Security taxes, however, have a wage base limit. For 2019, workers pay Social Security tax on the first $132,900 in earnings.
When you set up your payroll system, you should use FICA accounts to post Social Security and Medicare tax activity.
Employers also fund state unemployment programs.
Accounting for unemployment insurance taxes
Federal Unemployment Tax Act (FUTA) and State Unemployment Tax Act (SUTA) were passed to provide temporary income for workers who lose employment, generally when the employee is not at fault.
Small businesses pay unemployment taxes through a joint program between the federal government and the states. Employers are the primary source of tax revenue.
The individual states administer the funds provided by employers. If an employee is eligible for unemployment, the state will pay unemployment under the prescribed guidelines. Your unemployment tax burden will change, based on the number of your former employees who file and receive unemployment benefits.
Let’s pull all of this information together and post payroll journal entries into general ledger.
Posting to general ledger
You need a current chart of accounts to record payroll entries.
A chart of accounts lists each account number and the account’s description. Balance sheet account numbers are listed first, followed by income statement accounts.
You can add, subtract and change accounts, as needed. To work with payroll, you’ll need a number of payroll-specific accounts.
Meet Julie, who needs to process payroll
Julie owns Sterling Landscaping, and she needs to process payroll on September 1st. The September 1st payment is for the payroll period from August 15th to August 31st.
To keep it simple, this payroll example is for one employee. Bob Smith is a foreman, and his gross pay for the 2-week accounting period is $2,000.
Net pay calculation
Here is the journal entry to record Bob’s gross wages, withholdings and the net pay:
Journal entry #1
Gross wages owed to employee
|4000||Federal income tax payable||400||
20% withholding for federal income taxes
|4100||State income tax payable||100||
5% withholding for federal income taxes
|4300||FICA tax payable- employee||153||
7.65% withheld for employee portion
|4600||Health insurance premiums- worker||70||
Worker’s share of health insurance premiums
|1000||Cash||1,277||Net pay to worker|
(To record wage expense, withholdings, and net pay)
As you scan through the entry, note the following:
- Sterling records gross wages of $2,000 as wage expense.
- For example purposes, the company withholds dollars for federal (20%) and state (5%) income taxes. The actual percentages are based on the current tax tables and other factors.
- FICA tax is withheld at the current rate of 7.65% for workers.
- Bob pays $70 for his share of health insurance premiums. The premium payments are based on the insurance contract.
- The net payment to Bob is $1,277.
The total debits equal credits, and the journal entry provides a description. It’s important to include a description, so that anyone who reviews general ledger can see the purpose of each entry.
When you record payroll, your business may incur several other types of expenses.
Other payroll-related expenses
Journal entry #2
|7100||FICA tax expense||153||
Employer share of FICA expense
|4400||FICA tax payable- employer||153||
7.65% withheld for employer portion
|7200||Unemployment insurance expense||50||
Unemployment insurance expense
|4500||Unemployment insurance payable||50||
Withholding based on current state formula
|7300||Health insurance premium expense||150||
Health insurance premium expense
|4650||Health insurance premiums- employer||150||
Employer’s share of health insurance premiums
(To record additional employer payroll expenses)
Journal entry #2 records three additional expenses that are related to payroll.
- FICA tax expense: Sterling must pay the employer’s share of FICA taxes.
- Unemployment insurance premiums: This expense is determined by each state’s unemployment insurance fund.
- Health insurance premiums: The health insurance contract explains the amount paid by each worker and the expense paid by the employer.
Each expense in the journal entry is paired with a liability account balance. The last for payroll is to pay all of the withheld amounts to the proper entity. Here’s that final entry:
Journal entry #3
|4000||Federal income tax payable||400|
|4100||State income tax payable||100|
|4300||FICA tax payable- employee||153||–|
|4600||Health insurance premiums- worker||70|
|4400||FICA tax payable- employer||153|
|4500||Unemployment insurance payable||50|
|4650||Health insurance premiums- employer||150|
Paid to various entities
(To record withheld amounts paid to various entities)
Each amount withheld in journal entries 1 and 2 is paid in the third journal entry. The liability accounts are debited (reduced), and cash is decreased with a credit entry.
Sterling has calculated net pay, posted additional payroll expenses and paid all the liability balances in cash. The company will generate separate checks to pay each entity.
What if you use spreadsheets instead?
Why spreadsheets are a problem
Processing your payroll using spreadsheets is a terrible idea.
- Input errors: You run a high risk of making input errors.
- Broken, incorrect links: Links between cells,and links between spreadsheet tabs, may have errors.
- Current version: You may not use the current version of a particular spreadsheet. It’s also more difficult to save and use the current version of a document.
- Integration: You can’t integrate a spreadsheet with many other applications. If you can’t integrate data, you’ll have to do more input manually.
It’s also important to document all of your payroll tasks.
Document in a procedures manual
Every routine task you perform should be documented in a procedures manual.
Your manual should list each routine task, how the task is performed and who is responsible for completing the work. A procedures manual clarifies how you do business and reduces confusion about your operation. The manual is also a great training tool for your staff.
If you create a more efficient payroll process, growing your business is much easier.
Get ready to scale
So, where do you go from here?
- Review the process: Review your last payroll period and make sure that you’re posting all of the proper journal entries. Check to see that you’ve set up the necessary accounts for payroll.
- Automate: If you’re using spreadsheets, make the switch to payroll automation.
- Ask an expert: Lean on CPAs to keep your payroll processing on track.
Growing your business requires more people. Use automation to process payroll efficiently and grow your business with confidence.
This article was produced by the Quickbooks Resource Center and syndicated by MediaFeed.org.
Featured Image Credit: DepositPhotos.com.