The purpose of payroll accounting is to keep track of employee compensation and related payroll costs. Recording these costs can give small business owners an accurate picture of their expenses. You may find that hiring an accountant or bookkeeper to record these transactions can help you spend more time working on your business.
What is payroll accounting?
Payroll accounting keeps track of five essential payroll-related costs and obligations.
- Employee compensation: Salaries, wages, paid time off (PTO), and other taxable income reported on a Form W-2 at the end of the year.
- Taxes withheld from employee paychecks: Federal income taxes and Social Security, Medicare, and applicable state or local income taxes.
- Required employer taxes: Employer matching for Social Security and Medicare taxes, as well as federal and state unemployment taxes.
- Paycheck deductions for benefits: Often made for all or part of the cost of employee benefits, including health, dental, vision, and supplemental insurance. Employees may defer a portion of their compensation into an employer-provided retirement plan.
- Other government-mandated deductions: Garnishments for child or spousal support and outstanding tax liabilities.
Businesses should stay up to date on their payroll accounting, both for their financial knowledge and to stay compliant with government regulations. If your business is ever audited, you need records of your taxes and employee compensation. One way to record payroll is to use a series of journal entries.
What is a payroll journal entry?
One method for recording payroll is to create journal entries to account for each piece of payroll, including employee paychecks and employer taxes.
You’ll need to collect a few forms from your employees before you can run payroll:
- Form W-4, federal withholding form
- Form I-9, Employment Eligibility Verification form
- State withholding form, if applicable
You’ll use these to calculate withholdings for each employee.
Imagine your business has one employee, paid weekly. You must withhold taxes on the employee’s behalf, taken out of the employee’s gross wages. Here’s a journal entry example:
Journal 1 shows the employee’s gross wages ($1,200 for the week). After subtracting some of the most common payroll taxes, the employee’s wages payable or “take-home” pay is $925.
The second journal entry shows your business paying all those federal taxes, plus the taxes the business owes, for that employee. The third journal entry shows your business paying the state tax.
You pay unemployment taxes, both federal and state (if applicable), separately from the taxes shown in Journal 2 and Journal 3.
How to record payroll
Your first payday is an exciting event. Follow the basic steps to set up and run your first payroll.
1. Set up payroll-related accounts. These are explained in detail below. Essentially, payroll-related accounts include a mixture of expenses and liabilities.
- Employee compensation (expense)
- Employer taxes and insurance (expense)
- Benefits (expense)
- Payroll taxes payable (liability)
- Employee deferrals payable (liability)
2. Obtain necessary paperwork from new employees and add their names to your accounting records. The necessary paperwork includes three main forms:
- Form W-4, federal withholding form
- Form I-9, Employment Eligibility Verification form
- State withholding form, if applicable
3. Calculate taxes and other deductions based on compensation. Taxes and other deductions are based on the forms your employees fill out. The forms will tell you how much of an employee’s wages you should deduct each pay period. Calculations will also depend on your state and sometimes your city or county. Familiarize yourself with any local tax laws that could require additional payroll deductions.
4. Record payroll checks. This goes back to the Journal 1 example. In that journal entry, you’re recording all of the deductions you have to take, as a business owner, from the employee’s check. For transparency and visibility, employees can find these deductions on their pay stubs.
5. Record tax payments. This goes back to journals 2 and 3 where you’re recording all taxes you’ve paid. These include taxes the employee is paying via their withholdings each pay period, as well as taxes the business owes. For example, employees don’t pay unemployment taxes. Those are among their employer’s responsibilities. But a record of tax payments will show unemployment taxes listed alongside any taxes the employee paid.
Types of payroll accounting entries
Small business payroll accounting uses three basic types of journal entries: initial recording, accrued wages, and manual payments. And there’s a different use for each type.
The most used entry is the initial recording, also known as the originating entry. It’s the first entry you record to show a transaction has occurred. These entries include your employees’ gross earnings and withholdings. In these initial entries, you also record any employment taxes you owe.
Accrued wages for a certain period are recorded at the end of your accounting period. As the name suggests, these are wages that you owe your employees—wages you haven’t yet paid. After you pay these wages, you’ll make reversed entries in your ledger to account for this payment.
Finally, manual payment entries only come up occasionally. Use this type of entry if you have to adjust an employee’s pay. For example, you’d use a manual entry if you recently promoted an employee or let someone go.
What accounts will you need for recording payroll?
Several withholdings and deductions are taken out of an employee’s gross pay. The benefits you offer, your industry, and other factors affect which accounts you need to record payroll.
For instance, a small business with one or two employees may not offer 401(k) matching or even health insurance. By contrast, some employers may have additional accounts to add, like a fitness credit or education reimbursement.
To help you get started, here are some common examples of payroll withholdings and deductions:
- Compensation includes the employee’s salary or wages, plus any paid time off, bonuses, or commissions.
Employer taxes and insurance (expenses)
- Federal Insurance Contributions Act (FICA) taxes: FICA taxes include medicare and Social Security taxes. Employers and employees each pay half. So your accounts should show the FICA withholdings from employee paychecks, as well as your own taxes set aside.
- Federal and state unemployment taxes: The Federal Unemployment Tax Act (FUTA) requires employers to pay a 6% tax on the first $7,000 an employee earns, not to exceed $420. State unemployment tax rates differ from state to state, and some states don’t require them.
- Workers’ compensation: Most states require employers to offer workers’ compensation. This form of insurance replaces an employee’s pay if they sustain an injury while working. The amount that employers pay may depend on their industry or number of employees.
- Health insurance: Businesses with 50 or more full-time employees must offer health insurance. Depending on the type of health insurance you offer, you may withhold an insurance premium from each employee’s paycheck. Or an employee might ask that you withhold more for a Health Savings Account (HSA).
- 401(k) matching and employee contributions: If you offer 401(k) matching, you will likely have employee contributions to deduct as well as your own contributions.
- Vacation time: Some employers offer paid time off for employees. Offering more time off may make your business more competitive and attractive to talented workers.
- Sick time: Sick time is another type of PTO. Often, employees accrue sick time. Some employers allow employees to use sick time for their physical and mental wellness and to take care of others who are ill.
Payroll taxes payable (liabilities)
- Federal and state income taxes: These are employee-paid taxes, withheld from the employee’s gross wages by the employer. You’ll be in charge of passing on these taxes to the government.
Employee deferrals payable (liabilities)
- Wage garnishments: For example, government-mandated garnishments for child or spousal support or tax liens.
Examples of payroll liabilities
Payroll liabilities, or payables, are amounts you currently owe, pertaining to your business’s payroll. If you’re using a payroll journal, you enter payables as credits because you are increasing the amount you owe. Examples of payroll liabilities include employee wages or compensation and payroll taxes.
Employee wages or compensation
This might be the most expected payroll liability. Typically, employees work for a period of time before you pay them for their work. Until the money comes out of your business’s account, that payroll is a liability.
For example, let’s say your business runs payroll bi-weekly. Everyone works from January 2 to January 15. Then employees receive their paychecks for that pay period on January 17. Until you pay employees, those wages are a liability because it’s money you owe.
Most small business owners will not create an entry for this type of liability because employees are paid shortly after the pay period. However, it’s important business owners monitor their accounts around payday to make sure there’s enough money for payroll and any tax payments.
It might feel like there are a hundred kinds of payroll taxes. From Social Security and Medicare to state and federal unemployment taxes, the list goes on and on. As a business owner, it’s your job to pay your share of the taxes and manage tax withholdings from employee paychecks. And until all those taxes are deposited to their final destinations, they’re payroll liabilities.
Examples of payroll expenses
Payroll expenses are different from liabilities. A liability is an amount you owe, while an expense is an amount you’ve already paid. That means anything recorded as a payroll liability can become a payroll expense after you run payroll and disperse the money.
Say you wanted to see how much you spent on employee payroll last year, as opposed to the year before. All the wages you’d be looking at are payroll expenses (i.e., wages that you have already paid). Recall our previous example of employees getting paid on January 17, from work they did January 2-15. On January 17, once employee wages are fully paid, those liabilities become expenses.
Employee paid time off
An employer may have both liabilities and expenses for the same employee, due to paid time off. For example, say an employee has 24 hours of PTO and has already taken eight hours off. Those eight hours have already been paid out and are an expense. The remaining 16 hours are still owed to the employee and are, therefore, a liability to the company.
Small businesses rarely record this liability in their books. But business owners should keep in mind how many hours they’ll need to pay out in the future.
Using an existing payroll service
Payroll accounting is complicated, so you might think to automate the process with the help of a payroll service or software. Many are business-owner-friendly, while others may be more for accountants. Here are four things to look for when selecting a payroll service:
1. Positive reviews and rankings. It’s a bit like asking for a referral from thousands of strangers. Be sure to look at the business’s page and their ranking on top-10 lists for payroll services. Some review sites compare services so that you can get the pros and cons of each. If you plan to manage payroll accounting yourself, keep an eye out for reviews that specifically say “easy to use.”
2. Multiple services in one. Some payroll providers offer supplemental services that go hand-in-hand with paying employees. QuickBooks, for instance, offers HR services, workers’ compensation insurance, and more by connecting business owners to partners. The result is one place where you can manage multiple services.
3. Industry-specific features. Depending on the type of work you do and your location, you may have to meet certain payroll requirements. Restaurant owners, for instance, need to ensure their tipped employees meet minimum-wage requirements. You may have employees who earn overtime at a rate of time-and-a-half or even double time. You may need a payroll service or payroll software—and likely even a time tracking software—to manage that.
4. Pricing that fits your budget. Shopping for payroll isn’t much different than shopping for a car. Once you know what features you want, you’re probably comparing price tags to make a decision. Here are some factors you’ll want to consider as you make your decision:
- Frequency—are you being charged by month or pay period?
- Additional costs—are things like W-2 forms or direct deposit included in your pricing?
- Surprise fees—what happens if you need to add or adjust something within employee payroll?
- Free trial period—how long do you have to try out the product?
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