As your business grows, better accounting and bookkeeping starts to become a lot more important. Keeping the books straight makes it easier to understand your cash flow and profitability, and it’s essential if you ever want to borrow money or bring in investors. But once you’re done paying employees, payroll accounting can provide a few wrinkles (and acronyms) that may be unfamiliar.
If the thought of juggling general ledgers and journal entries together with wages, FUTA, FICA, and gross wages seems a little daunting — or if you don’t feel confident with what some of those things are — don’t worry! This simple guide for small business owners explains all the payroll accounting basics and show you how to correctly add paydays to your books.
Payroll accounting is the process of recording all your business’s employment-related expenses in your general ledger. It requires you to classify different payroll expenses that you incur as you calculate net pay from gross pay (like wages, unemployment taxes, and benefit payments) according to the appropriate expense (and liability) categories.
Doing a good job of recording these numbers helps you stay organized, project your cash flow, and analyze your business operations. Plus, it will be easier to prepare your taxes at the end of the year. Bottom line, you should pat yourself on the back for taking the time to figure this out!
Terms like expenses and liabilities can be confusing, and the accounting world hasn’t done a great job simplifying the verbiage for small business owners. Rather than getting caught up in all the jargon, it’s best to think about it this way: Payroll expenses are the cost of employee wages and all related employer taxes. For example, wages paid to your employees and your portion of employment taxes to the IRS are expenses for your business.
When you do your bookkeeping, payroll expenses shouldn’t fall into a single expense category in your general ledger. Instead, it should be broken up into journal entries that loosely parallel all the line items on your employees’ pay stubs, plus any costs you incur for things like the employer’s share of taxes and any benefits you offer.
The biggest expense item you will need to include on your books is probably your employees’ salaries and wages. Commonly, wage expenses are segmented by pay types or departments but you can choose what makes sense for your business. For example, you can combine salaries and wages into one expense category or break them down by wage expenses (hourly workers) that are changeable based on the number of hours worked each week and salaried expenses for employees paid by salary.
Taking a more granular view will help you understand fixed vs. variable employment costs, but it can also make your general ledger more complex.
Other expenses you’ll want to track include things like the employer portion of social security and medicare (FICA), employer share of federal and state unemployment taxes, 401(k) matching, annual bonuses, expense reimbursements, per diems, etc. We suggest using a different account in your general ledger for each item.
Think of a liability as an IOU — an expense that you haven’t paid cash for yet. For example, think about the items you purchase using your credit card. If you bought a stapler for $10 and charged it to your credit card, it’s an expense that your credit card company paid for. It’s a liability on your card until you pay off the balance.
In the same way, payroll liabilities are items that are owed by your company but haven’t been paid yet. Most commonly, these are federal and state taxes that are withheld, but not yet paid to the different agencies. This category also includes deductions withheld from an employee’s paycheck. Like you would for expenses, we suggest having a payroll liability account for each item. This allows you to more easily reconcile when the liability is paid.
Here’s where we get into the nitty-gritty of accounting jargon — everyone’s favorite: debits and credits. For reference, a debit decreases a liability account or increases an expense account. A credit increases a liability account or decreases an expense account. Also, remember that debits and credits have to balance each other out. If they don’t, then you know at least one entry was booked incorrectly.
Let’s break it down. Say you pay an employee a salary of $5,000 monthly.
For the sake of keeping the math simple, we will assume that the employee’s federal income taxes are 20%, state taxes are 10%, and FICA taxes are 5%. The employee does not pay health insurance or contribute to a 401(k) plan.
But remember, you also have additional expenses as an employer. Let’s assume your FUTA taxes are 5%, and you fully cover your employee’s health insurance premiums at a cost of $400 per month. Your employer portion of FICA taxes will be the same amount that your employee pays.
On your books, you would:
|Account Name||Account Type||Debit||Credit|
|Salaries & Wages||Expense||$5,000|
|Employee Federal Income Taxes Payable||Liability||$1,000|
|Employee State Income Taxes Payable||Liability||$500|
|Employee FICA Taxes Payable||Liability||$250|
|Employer FICA Tax Expense||Expense||$250|
|Employer FUTA Tax Expense||Expense||$250|
|Health Insurance Premiums||Expense||$400|
|Employer FICA Taxes Payable||Liability||$250|
|Employer FUTA Taxes Payable||Liability||$250|
|Health Insurance Premium Payable||Liability||$400|
Add everything up, and your business expense for paying this employee comes out to $5,900, including the $900 in benefits and employer taxes in addition to the $5,000 in gross wages. On the credit side of your balance sheet, your employee takes home $3,250, and the rest is owed to the insurance company and various taxes.
While it’s easy to view payroll as a single line item,.payroll accounting is important to make sure you truly understand your expenses — and to make sure you have a clear view of how much money you’re still on the hook for once those paychecks are written. While it can look daunting, once it’s broken down into bite-sized chunks and recorded properly, your finances will make a lot more sense.
Since there are a lot of moving parts, manually calculating payroll for your employees can take a considerable amount of time and attention. If you want to save precious hours on payroll accounting — and make end-of-month reconciliation a lot easier — there are a number of affordable payroll service providers that can help you with the calculations and remitting payment to the IRS. Make sure to find one that guarantees accuracy, so if Uncle Sam ever does come knocking on your door because you underpaid your taxes, the payroll software provider can handle those conversations and any fines or additional expenses.