Complete guide to payroll accounting

Payroll accounting can be complicated at first, but it’s crucial to stay on top of it. Using the right payroll software can help you run a stable business and keep your employees satisfied.

There are many things to consider with payroll accounting—from legislation and compliance to filing your taxes efficiently. We’ve broken down all the key need-to-knows to help you better understand payroll and its benefits.

Payroll accounting: In summary

• Payroll accounting involves costs related to employees, such as their wages or salaries, bonuses or benefits, and any income taxes they pay.

• The three main types of payroll accounting entries are: initial recordings, accrued wages and manual payments—all of which ensure accurate financial records.

• Integrating payroll with your accounting software could help to improve efficiency in data reporting, eliminate transposition errors, and keep tax tables up to date. 

What is payroll accounting?

Payroll accounting is the process of calculating, managing, and distributing salaries or wages to ensure employees are paid correctly and on time. It takes into account everything from taxes to additional benefits, helping employers keep track of wages and their impact on cash flow.

‘Payroll’ refers to 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 any employee compensation and employer taxes.

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

You’re also obligated to prepare and file end-of-year payroll accounting reports. These reports allow HMRC to clearly see and confirm the benefits, expenses, and taxes that your business has paid. This is where our payroll year-end checklist could come in handy.

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 their tax and National Insurance (NI) contributions.

Payroll accounting vs. management accounting

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

Payroll accounting:

• Focuses on employee compensation, benefits, and deductions.

• Can help ensure accurate, timely employee payments, tax regulation compliance, 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 optimising resource allocation.

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

Why is accurate payroll important for small businesses?

We understand that every penny counts for a small business. Having accurate payroll is essential; it can help to ensure compliance with the law and protects 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.

Key components of payroll accounting

Payroll accounting goes beyond just paying staff—it’s a thorough, systematic process that tracks all financial transactions related to employee compensation. Here are the key elements it involves.

Gross pay

Gross pay is the total amount of money an employee earns before any deductions are made. Payroll accounting calculates these earnings, including hourly wages, salaries, overtime, bonuses, and commissions.

Deductions

Deductions represent any money subtracted from gross pay before net pay is calculated. This includes:

• Statutory deductions: Income Tax, National contributions, and student loan repayments.

• Voluntary deductions: Pension contributions, union dues, and other employee-elected deductions.

Net pay

Also known as take-home pay, this is the actual amount of money employees receive in their bank accounts. It represents the final earnings after all deductions are taken from an employee’s gross pay, including mandatory taxes, any contributions, and voluntary benefits.

Employer costs

Employer costs encompass any additional business expenses that go beyond salary. This includes mandatory expenses such as pension contributions (minimum 3%) and employer National Insurance (15%), as well as hidden and variable costs, such as recruitment costs and HR and administration.

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?

Simply put, expenses are the necessary costs incurred by operating your business, 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, are 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.

In essence, payroll is an expense at the end of each accounting period. Until payroll is paid, it’s 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.

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 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. 

• Manual payments:  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, or you have to make any unplanned payments, these would be recorded as manual payments.

Information you’ll need to do payroll accounting

To do payroll accounting – and payroll in general – you’ll need the following details from employees:

• Personal details – full name, address, and National Insurance number

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

• Payment period – how often they’re paid, whether it’s monthly, bi-weekly, or weekly

• Benefits or insurance – for example, a retirement plan or private medical insurance

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

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

• 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. 

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.

The payroll process: How does payroll work?

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

1. Gather employee data

One of the most important aspects of payroll accounting is ensuring you have all the necessary data to hand. Start by collecting relevant employee data, including personal information, salary details, social security contributions, tax code, and any allowances or deductions.  

2. Enter hours worked and earnings

Once you’ve gathered the employee details, you’ll then need to track the hours worked for the pay period. That includes wages or salary, overtime, holiday allowance, sick days, and any bonuses. The data you enter may vary depending on whether they’re a salaried or hourly employee.

3. Calculate pay and deductions

Use the data to calculate the employee’s total earnings (or gross pay). You’ll then need to subtract mandatory taxes, such as NI, voluntary contributions like pension and healthcare, to determine their net pay. 

4. Pay employees

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

5. Report to HMRC

Finally, submit your Full Payment Submission (FPS) to HMRC. This is a mandatory Real Time Information (RTI) report that must be sent from your software on or before payday. At the end of each accounting period, close out your books, zero your accounts, and maintain records for the new accounting period.

What is an example of calculating payroll? 

Payroll can be complex, requiring careful coordination and consideration to ensure compliance. As an example, let's assume an 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 out these figures. Not only will most payroll software automatically update tax rates and bands, but it also reduces the risk of human error – especially if you rely on Excel spreadsheet formulas, calculations and manual data entry to get you by. 

It’s crucial that you begin proper payroll accounting techniques as soon as you employ your first staff member. Payroll guidelines, legislation and regulatory requirements should help you stay compliant. 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. 

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. 

• 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 who suits your business needs.

Payroll terms explained

Managing payroll is almost like a juggling act, balancing several intricate tasks at once. So it stands to reason that there are specific phrases, terms, and concepts surrounding the process, too. 

What is a payroll number?

A payroll number is a unique identifier assigned to employees. It accurately tracks pay, tax information, and employment history within an employer’s payment system. Payroll numbers in the UK typically consist of letters and numbers, and are often generated using payroll software. 

What is a payroll schedule?

A payroll schedule is a plan that defines how often employees are paid and on what specific dates they receive their wages or salary. Common payroll frequencies include weekly, biweekly, monthly, and quarterly. 

Payroll benefits

Payroll benefits are taxable employee perks that employers calculate and deduct Income Tax directly through payroll in real time. Common benefits include pensions, health insurance, phone subsidies, company cars, and more.

What is a payroll specialist?

A payroll specialist is exactly that – a finance or HR professional responsible for managing a business’s payroll. Their key roles include calculating pay, processing payments, ensuring compliance, employee support, record maintenance, and more.

What is shadow payroll?

Shadow payroll is a ‘mock’ payroll that runs in parallel to the home country’s actual payroll. It’s a system designed for employees working abroad, helping to ensure tax compliance without duplicating actual salary payment and preventing legal penalties. 

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 overbudget figures. This gives you the information you need efficiently, allowing you to make informed decisions more 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 software 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 input automatically, ensuring complete data integrity and consistency.

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

Payroll accounting guide 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 help 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 to help you ensure accuracy, compliance with tax regulations, and navigate complex payroll-related issues, particularly as a business grows.

Do I need special software for payroll accounting?

You’re not strictly required to use specialised software to run payroll. However, implementing payroll software is highly recommended – and often necessary. Using an HMRC-recognised payroll software that supports Real Time Information (RTI) is essential to paying your employees correctly while staying HMRC-compliant.

Can I outsource my payroll?

Yes, outsourcing payroll is a common practice for businesses of any size. This helps you save time and money that you’d otherwise use for in-house payroll, as well as minimise the risk of costly errors. You’ll also benefit from the additional skills of payroll specialists while you focus on core business strategies.

What happens if I make a mistake in payroll?

If you make a mistake in payroll, you can update the year-to-date figures in your next Full Payment Submission (FPS) to HMRC. You may also send an additional FPS before the next regular FPS is due. It’s important to fix any errors as soon as possible to ensure all information is correct.

The information on this website is provided free of charge and is intended to be helpful to a wide range of businesses. Because of its general nature the information cannot be taken as comprehensive and they do not constitute and should never be used as a substitute for legal, accounting, tax or professional advice. We cannot guarantee that the information applies to the individual circumstances of your business. Despite our best efforts it is possible that some information may be out of date. Any reliance you place on information found on this site or linked to on other websites will be at your own risk.

This information is intended to outline our general product direction, but represents no obligation and should not be relied on in making a purchasing decision. Additional terms, conditions and fees may apply with certain features and functionality. Eligibility criteria may apply. Product offers, features, functionality are subject to change without notice.