Complete guide to payroll accounting

Payroll accounting can be difficult and complicated, but crucial to be on top of in order to run a stable business and keep your employees satisfied at work.

In Summary: Payroll accounting involves costs related to employees. For example, their wages or salaries, any bonuses or benefits they receive, and any taxes they pay.

There are many things to take into account with payroll accounting - from legislation and compliance to filing your taxes efficiently. So we’ve broken down all the key need-to-knows to help you better understand payroll.

Payroll accounting can be a lot simpler with HMRC compliant payroll software. Read the benefits of a payroll system to find out more. 

What is payroll accounting?

Payroll accounting is the process of paying employees correctly and on time. It takes into account everything from tax to additional benefits, and helps employers keep track of what they owe their team and how this impacts cash flow.

Let’s break this down in more detail…

‘Payroll’ means any tax withheld from a worker’s salary by an employer, who then pays the tax to the government on the worker’s behalf. 

Payroll accounting, then, is the process by which an employer works out and records the payroll tax payments they make, as well as payments for employer compensation and employer taxes.

This requires working out the gross and net pay for all employees for the period of payment - whether that’s monthly or more frequently.

In order to process payroll, you need to:

• look after personnel data

• run payroll and work out payroll taxes

• maintain employee forms

You’re also obligated to prepare and file end of year payroll accounting reports. These reports allow HMRC to clearly see and confirm any benefits, expenses and taxes that your business has paid. Our payroll year end checklist could come in handy for this!

These reports also involve your employees as they’ll receive a P60, which gives a breakdown of their yearly gross and net pay, as well as a breakdown of taxes and National Insurance contributions.

Payroll accounting vs. management accounting

Payroll accounting, financial accounting, and management accounting are distinct branches of accounting, each serving different purposes within an organization.

Payroll Accounting:

• Focuses on employee compensation, benefits, and deductions.

• Ensures accurate and timely payment to employees, compliance with tax regulations, and expense tracking.

• Specific to payroll-related transactions and adheres to relevant tax laws.

Management Accounting:

• Serves the internal management team by providing information for decision-making, planning, and control.

• Aids in making informed business decisions, formulating strategies, and optimizing resource allocation.

• Involves budgeting, cost accounting, variance analysis, and performance measurement tailored to internal management needs.

In summary, payroll accounting focuses on employee compensation, financial accounting is geared toward external reporting, and management accounting is internally focused, providing information for managerial decision-making.

Why is accurate payroll important for small businesses?

We understand that every penny counts for a small business. Here’s why having accurate payroll is essential, from compliance with the law, to protecting your bottom line.

• Helps you analyse your company expenses, including the costs associated with each employee. This can help you make more informed business decisions.

• Gives a record of business-related expenses and how they relate to labour costs. This helps you work out the cost of hiring more permanent staff or contractors.

• Ensures you and your employees know the legal and tax obligations. Employees can track deductions like NI or their pension, and you’ll be legally compliant.

As a small business, there’s a lot to consider (which is why payroll software can help).

Payroll accounting record-keeping

Recording payroll accounting isn’t as simple as noting down what you take from your business account and what you credit to your employees. We’ve broken down the record-keeping aspects of payroll accounting to make it easier to understand.

Is payroll a business liability or an expense?

In simplest terms, expenses are the costs your business incurs by operating, while liabilities are amounts that your business owes (see: accounts payable).

In practice, you should treat gross wages as expenses. This is the amount that your business must remove from its accounts to pay your workers. 

Within this gross expense, however, businesses have liabilities. Some, such as National Insurance, are payments removed from a worker’s wages and sent to the government. Others, like the wages themselves, are owed to the workers. 

Even if you’ve transferred the money out of your business’s account, the amount remains a liability until it is paid. That is, until it reaches its proper recipient’s account. 

For example, if you run payroll every month, your employees’ wages for the work they did over the course of that month are liabilities - costs you owe that you must pay. Once you’ve done so, they become expenses - costs you have paid.

Payroll, then, is an expense at the end of each accounting period. Until it is paid, it is a liability.

Types of payroll accounting entries

When recording payroll, it’s important to keep clear and consistent records, which come in three forms. Crucially, you need to make sure that you’re entering data as you go - don’t just leave it to the end of the accounting period!

There are three types of payroll accounting entries: initial recordings, accrued wages and manual payments. 

• Initial recordings - Also known as originating entries, initial recordings are the type of entry you’ll deal with most often. This is because they’re exactly what they sound like: the first record of every transaction. They should include the gross wages earned by your employees, all withholdings from those wages and any employer taxes you owe on those wages. 

• Accrued wages - Accrued wages are recorded at the end of each period of accounting, and show the amount of wages you owe to employees that haven’t yet been paid. These are liabilities, not expenses - a distinction we’ll get into below. 

• Manual payments - Finally, manual payments are used to keep track of any adjustments you have to make outside your usual accounting periods. If an employee stops working for you, for instance, or you have to make any unplanned payments, these would be recorded as manual payments.

Forms you’ll need to do payroll accounting

You’ll also come across some essential paperwork during your payroll including:

• P45s (given to employees when they stop working for a company) and 

• P60s (given to employees working for you on the last day of the tax year)

The P46 form is no longer in use, replaced by the ‘starter checklist’ for new employees.

How to do payroll accounting

Now that we’ve outlined the different types of records to keep, we can explore how you actually go about doing it. Let’s break it down into simple steps. 

• Record expenses - Calculate the gross amounts you need to pay, and debit your business accounts for those amounts.

• Record liabilities - Calculate the specific liabilities you need to pay on each gross transaction, and credit those amounts to your liabilities control accounts.

• Pay - Transfer the money from your liabilities account to the proper recipient - HMRC for taxes and national insurance, and your workers’ current accounts for their wages.

• Transition - Finally, at the end of each accounting period, close out your books, zero your accounts and begin producing records for the new accounting period.

One of the most important aspects of payroll accounting is making sure you’ve calculated wages, salaries, deductibles and taxes correctly - especially for the year end reports.

For this example, let's assume the employee worked 40 hours in a week, has an hourly rate of £10, and there are National Insurance (NI) deductions.

Here's a table illustrating the payroll calculation:

This is a simplified example, and in a real-world scenario, there might be additional factors to consider, such as income tax, pension contributions, or other deductions specific to the employee or the employer. It's crucial to stay updated with the latest tax regulations and consult with a qualified professional for accurate payroll calculations.

Using an automated payroll system, or an integrated system with your current accounting software, makes it much easier to work these figures out. Not only will most payroll software auto update tax rates and bands, so there’s less for you to keep track of, it importantly reduces the risk of human error.

Without payroll software, you run the risk of relying on Excel spreadsheet formulas, calculations and manual data entry to get you by. We all know how easy it is to hit the spacebar and delete a formula in Excel, and not notice until it’s too late. There’s also no data verification over the sheet, which can lead to human error and mistakes.

It’s crucial that you begin proper payroll accounting techniques as soon as you employ your first staff member. You should also stay compliant with payroll guidelines, legislation and regulatory requirements. This means keeping up to date with tax rates each new tax year and tracking employee data like holiday allowances, statutory sick pay, overtime, benefits and even stock options. You’ll also need the below for employees:

• Their National Insurance number

• Their payment type – how much they’re paid, depending on experience or role

• Their payment period – how often they’re paid, so monthly or bi-weekly

• Any employee benefits or insurance, for example a retirement plan

• Their P45, showing their pay/tax information from a previous employer 

For a more detailed look at what you need to do to fully comply with payroll, see the UK government’s page exploring this issue.

What does a payroll accounting system provide?

Don’t worry if this all sounds complicated - in truth, it is. And that’s why most small business owners use a payroll accounting system or work with an accountant to ensure they’ve done everything properly. 

Using a payroll accounting system can provide a huge range of benefits, allowing you to:

• Keep things simple by linking your accounts and presenting all relevant information together. 

• Stay up to date with the latest changes to tax codes and payroll compliance requirements. 

• Keep IT costs down by running your accounts smoothly from a single source. 

• Set up automatic payments so you (and your employees) don’t have to worry about being late with their pay.

• Keep thorough records as the system can sort and store all required records

• Reduce the risk of human error with automated payments, deductions, contribution calculations and more.

In short, it’s a great way to keep your stress levels low and stay on the right side of HMRC.

If you already use a payroll software system but it doesn’t satisfy your business needs, you might need to consider switching payroll companies.

Should I consider hiring an accountant?

One surefire way to keep your payroll functioning smoothly is to hand the responsibility to a qualified accountant. They can handle the entire process for you, ensuring that payroll data is kept up to date and that pay is made on time. You can use our Find an accountant feature to locate a professional that suits your business needs. 

Integrating payroll with your accounting software

Simplify everything by integrating your payroll system with your accounting software to save time and improve accuracy.

Integrating the two systems carries significant benefits, such as:

• Eliminating the possibility of transposition errors There’s no need to copy and paste the figures from your online payroll calculator or third party payroll service into your accounting service

• Improve efficiency in data reporting and budgeting Payroll figures can be combined into budgets, making it easier to spot figures that are over budget. This gives you the information you need efficiently, allowing you to make informed decisions, quickly.

• Confidently track Changing Tax Rates The points your employees hit particular tax thresholds can change at any time, depending on progression and pay rises.

• Maintaining one central source for all employee data Integrating your accounting and payroll softwares makes it much easier to complete forms, such as a P60. QuickBooks streamlines the process to make the actual data entry for these forms as seamless as possible.

• Improving billing and matching hours to job As a business owner, understanding which jobs are most profitable, and why, is essential to growing your business. Having all your data in one system makes for complementary reporting, allowing you to drill down and see what’s affecting your bottom line.

• Keeping tax tables up to date An automated system with regularly scheduled updates keeps you safe when you start making deductions. The correct numbers are inputted automatically, ensuring complete data integrity and consistency.

The majority of accountants recommend their clients use a fully integrated accounting and payroll system to manage all aspects of the business. From bookkeeping, to inventory management, to payroll, having integrated systems ensures maximum time management, reliability and accuracy.

FAQs

What is meant by ‘payroll accounting?’

Payroll accounting involves the systematic recording, calculation, and management of financial transactions related to employee compensation, including wages, benefits, and deductions, to ensure accurate and compliant payroll processing.

Do I need an accountant for payroll?

While it's possible to manage payroll independently, hiring an accountant is advisable for ensuring accuracy, compliance with tax regulations, and navigating complex payroll-related issues, particularly as a business grows.

We hope this article has helped explain some of the complicated world of payroll accounting. To learn more about business accounting and how QuickBooks can help, why not browse some more posts on our small business blog?