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In this explanation of payroll accounting we'll introduce payroll, fringe benefits, and the payroll-related accounts that a typical company will report on its income statement and balance sheet. Payroll and benefits include items such as: salaries wages bonuses & commissions to employees overtime pay payroll taxes and costs o Social Security o Medicare o federal income tax o state income tax o state unemployment tax o federal unemployment tax o worker compensation insurance employer paid benefits o holidays o vacations o sick days o insurance (health, dental, vision, life, disability) o retirement plans o profit-sharing plans
Many of these items are subject to state and federal laws; some involve labor contracts or company policies. NOTE: AccountingCoach.com focuses on financial statement reporting and not on income tax return reporting. You should consult with a tax professional or review the Internal Revenue Service publications to learn how employers and employees are required to report salaries, wages, and fringe benefits for income tax purposes. For the years 2011 and 2012, the U.S. government reduced the employee's tax rate for Social Security from 6.2% to 4.2%. (The employer's rate remains at 6.2% and the employee and employer Medicare tax rates remain at 1.45%.) The tax rate for Social Security and the amount subject to the tax can be found at http://www.irs.gov/pub/irs-pdf/p15.pdf
Matching Principle
As we proceed with our explanation of payroll accounting, it will be helpful to recall the matching principle of accounting. This principle will guide us to better understand how payroll and fringe benefits are reported on financial statements. (We're assuming that a company follows the accrual method of accounting.) The matching principle requires a company to match expenses to the accounting period in which the related revenues are reported. If a direct connection between revenues and an expense does not exist, then the expense should appear on the income statement for the accounting period in which it was
incurred. Keep in mind that expenses are often incurred (or occur) in a different accounting period than when they are paid. Let's use three payroll examples to illustrate this point: 1. A company employs a student to work a total of five daysfrom December 26 through December 30, 2011. On December 30 the student submits her time card. The company issues her payroll check on the next scheduled payday, January 5, 2012.
Even though the check is dated January 5, 2012, the matching principle requires that the company report the expense and the liability in December 2011 when the work was performed (and the company incurred the liability). Because the student was only employed for the last five days of December, the company would not have any wage or fringe benefits expense for her during January. The paycheck issued on January 5 merely reduces the company's liabilities and cash. 2. Let's assume that a company gives its sales manager an annual bonus of 1% of sales, to be paid on January 15, 2012. The bonus amount is calculated by multiplying the sales from January 1 through December 31, 2011 times 1%.
The matching principle requires that the company report 1% of sales as a Bonus Expense on its income statement (and a liability for the total amount owed must be reported on its balance sheet) in every accounting period in which sales occurred in 2011. If the company violates the matching principle by ignoring the bonus expense throughout the year 2011 (when sales actually occurred) and reports the entire bonus amount as an expense for just one day (January 15, 2012), every income statement pertinent to 2011 will report too much net income and the income statement that includes January 15, 2012 will report too little net income. The matching principle requires that the bonus expense pertinent to the 2011 sales be matched with the 2011 sales on the 2011 income statement.
If the entries are recorded properly, the balance sheet dated December 31, 2011 will report a current liability for the total bonus amount owed to the sales manager. On January 15, 2012 (when the company pays the bonus) the company will not have an expense; rather, the payment will reduce the company's cash and reduce the current liability that was established when the bonus was recorded as an expense in 2011.
3. A company has a vacation plan that will provide two weeks of vacation in the year 2012 if the employee worked the entire year of 2011. In the year 2011 (when the employee is working) the company reports the vacation expense on its 2011 income statement. The company's December 31, 2011 balance sheet will report a current liability for the two weeks of vacation pay that was earned by each employee but not yet taken. In 2012 (when employees take the vacations that were earned and expensed in 2011), the company will reduce its cash and its vacation liability.
As you learn about accounting for payroll and fringe benefits, keep the matching principle in mind. As the above examples show, the date on which a company pays wages or fringe benefits is not necessarily the date on which the company reports the expense on its financial statements.
Salaries
Salaries are usually associated with "white-collar" workers such as office employees, managers, professionals, and executives. Salaried employees are often paid semi-monthly (e.g., on the 15th and last day of the month) or bi-weekly (e.g., every other Friday) and their salaries are often stated as a gross annual amount, such as "$48,000 per year." The "gross" amount refers to the pay an employee would receive before withholdings are made for such things as taxes, contributions to United Way, and savings plans. Since salaried employees earn a specified annual amount, it is likely that their gross pay for each pay period is the same recurring amount. For example, if a manager's salary is $48,000 per year and salaries are paid semi-monthly, the manager's gross pay will be $2,000 for each of the 24 pay periods. (If the manager is paid bi-weekly, the gross pay would be $1,846.15 for each of the 26 pay periods.) A salaried employee's work period usually ends on payday; for example, a paycheck on January 31 usually covers the work period of January 1631. This is convenient for accounting purposes if the company prepares financial statements on a calendar month basis.
Wages
Wages are often associated with production employees (sometimes referred to as "blue-collar" workers), non-managers, and other employees whose pay is dependent on hours worked. The pay for these employees is generally stated as a gross, hourly rate, such as "$13.52 per hour." Again, the "gross" amount refers to the pay an employee would receive before withholdings are made for such things as taxes, contributions, and savings plans. Employees receiving wages are often paid weekly or biweekly. To determine the gross wages earned during a work period, the employer multiplies each employee's hourly rate times the number of work hours recorded for the employee during the work period. Due to the extra time needed to make calculations for each employee, hourly-paid employees typically receive their paychecks approximately five days after the work period has ended. When the hourly-paid employees have work periods that are weekly or biweekly, but the company's financial statements cover calendar months, the company will likely have to prepare an accrual-type adjusting entry at the end of the month. If hourly wages are a significant portion of a company's expenses, it is critical that the company report the correct amount of wages expense that pertains to the 30 or 31 days in the month, not the 28 days in a four-week work period.
Throughout our explanation, bonuses paid to employees and sales commissions paid to employees will be considered to be part of salaries.
Overtime Pay
Overtime refers to time worked in excess of 40 hours per week. Whether or not employees are paid for overtime depends on each employee's job responsibilities and rate of paysome employees are exempt from overtime pay and some are not. For example, executives are considered to be "exempt"; their employers are not required to pay them for their overtime hours because (1) their compensation is high, and (2) they can control their work hours. Executives do not need state or federal wage and hour laws to protect them from company abuse. On the other hand, a design technician earning an annual salary of $18,000 per year is probably not in control of her work hours. If she works for an executive who decides to work 60 hours per week, the design technician needs to be protected from having to work 60 hours per week for no more pay than she would receive for 40 hours of work. This employee is considered a "nonexempt" employeeshe is not exempt from being paid overtime compensation. Some unethical companies have been known to classify "hourly wage" employees as "salaried" in hopes of making them exempt from overtime payfederal and state laws exist to prevent such unfair treatment of employees. When processing payroll, don't assume that it's only the hourly paid employees who receive overtime paystate and federal laws require overtime payments to lower-paid salaried employees. It is also possible that some generous employers will give overtime pay to employees who are not required by law to receive it.
Overtime Premium
An overtime premium refers to the "half" portion of "time-and-a-half" or "time-and-one-half" overtime pay. For example, assume an employee in the production department is expected to work 40 hours per week at $10 per hour. If the employer requires the employee to work 42 hours in a given week, the extra two hours are paid at time-and-a-half and the employee earns a total of $430 for the week (40 hours $10 per hour, plus 2 overtime hours $15 per hour). It can also be computed as 42 hours at the straighttime rate of $10 per hour plus 2 hours times the overtime premium of $5 per hour.
2. 3. 4. 5. 6.
Employee portion of Medicare tax Federal income tax State income tax Court-ordered withholdings Other withholdings
5. Court-ordered withholdings
Payroll accounting also involves withholdings for items other than payroll taxes. For example, courts of law may order employers to garnish (withhold money from) an employee's salary or wages for purposes such as paying child support or repaying debts. The amounts withheld from employees for court-ordered withholdings are reported on the employer's balance sheet as a current liability. When the employer remits the amounts to the designated parties, the liability is reduced. Some court orders may include a small fee to be withheld from the employee in order to reimburse the employer for administrative expenses. For example, the court order might direct the employer to withhold $101 from the employee and to remit $100 to a designated agency. The $1 difference will be a credit to the company's administrative expenses or to a miscellaneous revenue account.
6. Other withholdings
In addition to the mandatory withholdings that an employer makes for taxes and court orders, payroll accounting often includes amounts that employers may be willing to withhold at the direction of its employees. These voluntary withholdings can include such things as:
union dues charitable contributions insurance premiums 401(k) and 403(b) contributions U.S. savings bonds purchases payments owed to the company for the purchase of company merchandise
If the voluntary withholdings are to be remitted to places outside of the company (a local charity, for example), the amounts withheld are reported on the employer's balance sheet as a current liability. When the employer remits the withholdings, the current liability will be reduced. If the withholdings are for amounts that are due the company (such as employees' share of insurance premiums or amounts owed by employees for company merchandise), no remittance is required. Rather, the journal entry reflects a credit that reduces the company's insurance expense or reduces the company's receivables from employees. Sample journal entries are provided in Part 5 and Part 6.
Net Pay
Net pay is the amount that remains after withholdings are deducted from an employee's gross pay. Net pay is also referred to as "take home pay" or the amount that an employee "clears." From the company side of the transaction, it is the amount of cash the company will pay directly to the employees on payday.
For an executive with an annual salary of $300,000 in the year 2012, only the first $110,100 is subject to the Social Security tax. This means that in addition to the withholding of $4,624.20, the employer must also pay $6,826.20. The combined amount to be remitted to the federal government for this one employee is $11,450.40 ($4,624.20 + $6,826.20). The employer's share of Social Security taxes is recorded as an expense and as an additional current liability until the amounts are remitted.
Even though the state unemployment tax is based on employee salaries and wages, the entire tax is paid by the employer. There is no withholding from an employee's salary or wages for the state unemployment tax.
Even though the federal unemployment tax is based on employee salaries and wages, the entire tax is paid by the employer. There is no withholding from an employee's salary or wages for the federal unemployment tax.
In the past, many companies included group health, dental, vision, disability, and life insurance in the benefit package provided to employees. Over the past few decades, however, the cost of these group policies has risen significantlyin 2012, it was not uncommon to see an insurance premium for family coverage at $12,000 per year per employee. As a result of these escalating costs, most companies now require employees to pay a portion of the premium cost; this amount is usually collected by means of employee-directed payroll withholding. The employers' net cost (or expense) is simply the total amount of premiums paid to the insurance company minus the portion of the cost the employer collects from its employees.
The concept is that in the years that the employee works, the company will charge Pension Expense and will credit either Pension Payable or Cash. For more specifics on pensions, you are referred to an Intermediate Accounting text or to the Financial Accounting Standards Board's website www.fasb.org.
50.00 1,440.05
* $2,300 x 5.65%
In addition to the wages and withholdings in the above entry, the employer has incurred additional expenses that pertain to the above workweek. These are shown next in Hourly Payroll Entry #2, which is also dated the last day of the work period. The items included are the employer's share of FICA, the employer's estimated cost for unemployment tax, worker compensation insurance, compensated absences, and company contributions for the company's 401(k) plan. The company is recognizing these additional expenses and the related liability in the period in which the employees are working and earning them. Later, when the company pays for them, it will reduce the liability and reduce its cash. (Our journal entry assumes that this company does not provide post-retirement benefitslike pensions or health insuranceto its employees.)
Hourly Payroll Entry #2: To record the company's additional payroll-related expense for hourlypaid employees for the workweek of December 18-24. Date Dec. 24 Account Name FICA Expense: Delivery * FICA Expense: Warehouse Unemployment Tax Expense: Warehouse Worker Compensation Insurance Expense Holiday, Vac., Sick Days Expense: Delivery Holiday, Vac., Sick Days Expense: Warehouse 401(k) Expense: Delivery 401(k) Expense: Warehouse FICA Tax Payable Unemployment Tax Payable Worker Comp Insurance Payable Holiday, Vacation, Sick Days Payable 401(k) Payable Debit 76.50 99.45 4.00 46.00 100.00 130.00 10.00 25.00 175.95 4.00 46.00 230.00 35.00 Credit
* $1,000 x 7.65%
On payday, December 29, the checks will be distributed to the hourly-paid employees. The following entry will record the issuance of those payroll checks. Hourly Payroll Entry #3: To record the distribution of the hourly-paid employees' payroll checks on Dec. 29. (These checks reflect the net pay for the wages earned during the workweek of Dec. 18-24). Date Dec. 29 Account Name Net Payroll Payable Cash Debit 1,440.05 1,440.05 Credit
Some withholdings and the employer matching of FICA were remitted on payday; others are not due until a later date. Some withholdings, such as health insurance, were recorded as reductions of the company's expenses in Hourly Payroll Entry #1. We will assume the amounts in the following Hourly Payroll Entry #4 were remitted on payday. Hourly Payroll Entry #4: To record the remittance of some of the payroll withholdings and company matching pertaining to the hourly-paid workweek of Dec. 18-24. Date Dec. 29 Account Name FICA Tax Payable * Federal Inc Tax Withholdings Payable State Inc Tax Withholdings Payable 401(k) Payable Cash Debit 305.90 300.00 110.00 105.00 820.90 Credit
* $129.95 from Entry #1 + $175.95 from Entry #2 End of Month and End of Year
Let's continue with our example of the payroll for the hourly-paid employees. We'll assume that this distributor's accounting month and accounting year both end on Saturday, December 31. The matching principle requires the company to report all of its December expenses (not simply its cash payments) on its December financial statements. This means the company must report on its income statement the hourly wages and other payroll expenses that the company incurred (and the employees earned) through December 31. Recall that the paychecks issued on December 29 covered the work done by hourly employees through December 24. The company must now record the cost of work done during the week of December 2531 (a week that includes a Christmas holiday plus a number of employees taking vacation days). Let's assume that during the workweek of December 2531, delivery department employees took $300 worth of their holiday and vacation days. Since a portion of the employer's estimated cost of holiday and vacation days was recorded as an expense and liability via each week's Hourly Payroll Entry #2, the $300 associated with the days actually taken this week will not be recorded as an expenserather, the $300 associated with the days taken this week will reduce the liability that is recorded with each week's Hourly Payroll Entry #2. In other words, only $700 of the delivery department's employee gross wages of $1,000 is for the work performed this week. The warehouse department had a similar situation. Of the warehouse department's $1,300 of weekly wages, only $1,050 is the expense for the work performed this week. The wages associated with the days off with pay reduces the company's liability that was provided for each week in Hourly Payroll Entry #2. Except for the holiday and vacation days, the workweek payroll for December 25-31 is similar to the previous week. Hourly Payroll Entry #1: To record hourly-paid employees' wages and withholdings for the workweek of December 25-31 that will be paid on January 5. Date Dec. 31 Account Name Wages Expense: Delivery Dept Debit 700.00 Credit
Holiday, Vacation, Sick Days Payable Wages Expense: Warehouse Dept Holiday, Vacation, Sick Days Payable FICA Tax Payable Federal Inc Tax Withholdings Payable State Inc Tax Withholdings Payable 401(k) Payable Health Ins. Expense: Delivery Health Ins. Expense: Warehouse United Way Payable Garnishment Payable Net Payroll Payable
300.00 1,050.00 250.00 129.95 300.00 110.00 70.00 90.00 80.00 30.00 50.00 1,440.05
In addition to the wages and withholdings in Hourly Payroll Entry #1, the employer has incurred additional expenses that pertain to the above workweek. These are shown next in Hourly Payroll Entry #2, which is also dated the last day of the work period. The items included are the employer's share of FICA, the employer's estimated cost for unemployment tax, worker compensation insurance, compensated absences, and company contributions for the company's 401(k) plan. The company is recognizing these additional expenses and the related liability in the period in which the employees are working and earning them. Later, when the company pays for them, it will reduce the liability and reduce its cash. (Our journal entry assumes that this company does not provide post-retirement benefitslike pensions or health insuranceto its employees.) Hourly Payroll Entry #2: To record the company's additional payroll-related expense for hourlypaid employees for the workweek of December 25-31. Date Dec. 31 Account Name FICA Expense: Delivery FICA Expense: Warehouse Unemployment Tax Expense: Warehouse Worker Compensation Insurance Expense Holiday, Vac., Sick Days Expense: Delivery Holiday, Vac., Sick Days Expense: Warehouse 401(k) Expense: Delivery 401(k) Expense: Warehouse FICA Tax Payable Unemployment Tax Payable Worker Comp Insurance Payable Holiday, Vacation, Sick Days Payable 401(k) Payable Debit 76.50 99.45 4.00 46.00 100.00 130.00 10.00 25.00 175.95 4.00 46.00 230.00 35.00 Credit
On payday, January 5, the checks will be distributed to the hourly-paid employees. The following entry will record the issuance of those payroll checks. Hourly Payroll Entry #3: To record the distribution of the hourly-paid employees' payroll checks on Jan 5. (These checks reflect the hourly-paid employees' take home pay from their wages earned during the workweek of Dec. 25-31). Date Jan. 5 Account Name Net Payroll Payable Cash Debit 1,440.05 1,440.05 Credit
Some withholdings and the employer matching of FICA were remitted on payday; others are not due until a later date. Some withholdings, such as health insurance, were recorded as reductions of the company's expenses in Hourly Payroll Entry #1. We will assume the amounts in the following Payroll Entry #4 were remitted on payday. Hourly Payroll Entry #4: To record the remittance of some of the payroll withholdings and company matching pertaining to the hourly-paid workweek of Dec. 25-31. Date Jan. 5 Account Name FICA Tax Payable Federal Inc Tax Withholdings Payable State Inc Tax Withholdings Payable 401(k) Payable Worker Comp Insurance Payable Cash Debit 305.90 300.00 110.00 105.00 600.00 1,420.90 Credit
The salaried payroll entry for the work period of December 1631 will be dated December 31 and will look like this: Salaried Payroll Entry #1: To record the salaries and withholdings for the work period of December 16-31 that will be paid on December 31. Date Dec. 31 Account Name Salaries Expense: Delivery Dept Salaries Expense: Selling & Admin Dept FICA Tax Payable * Federal Inc Tax Withholdings Payable State Inc Tax Withholdings Payable 401(k) Payable Health Ins Expense: Delivery Health Ins. Expense: Selling & Admin United Way Payable Net Payroll Payable Debit 2,000.00 9,000.00 621.50 1,800.00 400.00 200.00 40.00 200.00 100.00 7,638.50 Credit
* $11,000 x 5.65%
In addition to the salaries recorded above, the company has incurred additional expenses pertaining to the salaried payroll for this semi-monthly period of December 1631. These expenses must be included in the December financial statements, as shown in the next journal entry: Salaried Payroll Entry #2: To record additional payroll-related expense for salaried employees for the work period of December 16-31. Date Dec. 31 Account Name FICA Expense: Delivery FICA Expense: Selling & Admin 401(k) Expense: Delivery 401(k) Expense: Selling & Admin FICA Tax Payable * 401(k) Payable Debit 153.00 688.50 20.00 80.00 841.50 100.00 Credit
* $11,000 x 7.65%
On payday, December 31, the checks will be distributed to the salaried employees. The following entry will record the issuance of those payroll checks. Salaried Payroll Entry #3: To record the distribution of the salaried employees' payroll checks on Dec. 31. (These checks reflect the take-home pay for the salaries earned during the work period of Dec. 16-31). Date Account Name Debit Credit
Dec. 31
7,638.50 7,638.50
Some withholdings and the employer portion of FICA were remitted on payday; others are not due until a later date. Some withholdings, such as health insurance, were recorded as reductions of the company's expenses in Salaried Payroll Entry #1. We will assume the amounts in the following Payroll Entry #4 were remitted on payday. Salaried Payroll Entry #4: To record the remittance of some of the payroll withholdings and company matching pertaining to the salaried employees during the work period of Dec. 15-31. Date Dec. 31 Account Name FICA Tax Payable * Federal Inc Tax Withholdings Payable State Inc Tax Withholdings Payable 401(k) Payable United Way Payable Cash Debit 1,463.00 1,800.00 400.00 300.00 100.00 4,063.00 Credit