How to Process Payroll and Payroll Taxes

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Learn all about how to process payroll and payroll taxes in just a few minutes! Fabio Ambrosio, CPA, instructor of accounting at the Central Washington University, details accounting for payroll, accounting for unremitted payroll liabilities, and payroll internal controls that ensure payroll expense is accurate, valid, timely and fraud-free.

Accounting for Payroll

Paying employees involves determining the type of compensation, computing payroll deductions, preparing payroll records, and issuing paychecks.

The first step in preparing and processing a payroll is to determine the nature of each employee's compensation. There are two basic types of compensation: salaries and wages. Salaries are based on an annual rate of pay, and wages are based on an hourly rate multiplied by the hours worked. Wages may also include overtime when employees work more than a specified number of hours, such as 40 hours per week.

The next step is computation of payroll deductions, which may include government-required amounts and other withholdings from each employee's pay. A government-required amount is the Federal Insurance Contributions Act (FICA) tax, whose rate varies each year with yearly maximums for Social Security taxes. Federal and state income taxes and possibly city taxes are also withheld. The amount of income tax to withhold is based on a combination of an employee's number of withholding allowances (listed on Form W-4 completed by the employee at hiring) and an amount derived by using government withholding tables. Health insurance, life insurance, charitable contributions, union dues, retirement contributions, and other amounts are also payroll deductions.

Once the payroll has been calculated, a series of payroll records must be prepared. The company then prepares paychecks. Attached to each paycheck is a statement of the employee's gross earnings, the total amount an employee earns before deductions or withholdings, whether from a salary or wages. There is also a listing of each item that has been deducted from the gross earnings. Gross earnings less total deductions result in net pay. This information is provided on the pay stub, which also includes the employee's year-to-date gross earnings and deductions.

Employee Pay Stub

Employers provide pay stubs with paychecks for employees. The pay stub shows a pay rate of $20 per hour for 40 hours with gross pay at $800. Deductions include health insurance, income tax, and FICA, paid by the employer to the appropriate agencies. Before being paid, the deductions are current liabilities.

The company then prepares a record of the payroll for the period. A record of every employee's gross earnings, deductions, and net pay is called a payroll register. The company uses this to track and record the payroll in accounting records. For example, gross earnings are debited to a payroll expense, such as "wages and salaries expense." The amounts withheld are credited to various liability accounts, such as wages and salaries payable. Other liability accounts may be federal income tax withholding or FICA taxes payable.

Employers must also record the payroll taxes when processing a payroll. All unremitted payroll taxes, including employer taxes, such as matching FICA or state unemployment taxes, are recorded in an additional journal entry with a debit to the tax expense and credit to a liability account.

Each year, employers are also required to prepare and submit Form W-2 to the federal and state tax agencies and to the employee. The W-2 form reports the employee's taxable income and tax withheld and paid and also lists benefits the employee received during the year. Employers may also have to file a W-3 form that includes the total of their employees' earnings, Social Security wages, and Medicare wages for the year to be forwarded to the Social Security Administration.

Unremitted Payroll Liabilities

Employees typically have earned salaries not yet paid by the end of each accounting period, because of the difference in timing of the payroll cycle and pay cycle end date. The unpaid salaries are accrued current liabilities.

Businesses normally set a payroll cycle, such as weekly, biweekly, or monthly, to facilitate the cutoff of salaries and wages to be paid and to ensure that employees are paid at preset dates. The cutoff date could be a few days before the actual payment date when the paycheck is issued or when the electronic funds transfer is made into the employee's bank account. There will be a portion of the employee's earned salary that will be owed at the end of a reporting period. This shortfall or gap in the days is known as the stub period, and the amount owed will need to be accrued. Unpaid salaries are reported as an accrued current liability on the balance sheet.

Payroll Calendar with Highlighted Stub Period

The four highlighted days - January 26, 29, 30, and 31 - are the "stub period" for the month of January, the period when a portion of earned salary will be owed by the employer at the end of a reporting period.

For example, Jay Company pays its employees on a weekly basis every Friday. The January 26 pay period would cover the hours worked from January 19 to 25. The next payday would be on February 2. When preparing the financial statements for the month ending January 31, 2018, Jay Company needs to accrue wages for 4 days (January 26, 29, 30, and 31). The total amount of wages for 4 days is $15,000, so an adjusting entry is made at month end to reflect this.

Accrued Salaries Journal Entry

Debit Salaries Expense	$15,000
Credit Salaries Payable		$15,000

This amount will be shown as a current liability on Jay Company's January 31 balance sheet.

On an employee's paycheck stub, net pay equals gross earnings minus payroll taxes and deductions. Employers act as the intermediary and remit the taxes and deductions that are withheld to be paid to the appropriate government agencies, such as the Internal Revenue Service, and other organizations, such as insurance companies and unions, on behalf of their employees.

Unremitted payroll deductions are considered as current liabilities for the employer and recorded on the employer's balance sheet. These amounts that are withheld can include a portion of the gross wages and salaries expense that the employer must send directly to the tax authorities rather than pay to the employees. Such withholdings are current liabilities until sent to the appropriate authorities and organizations. Therefore, an employer will have current liabilities related to amounts withheld on an employee's paycheck, as well as for payroll taxes that the employer is obligated to pay, such as Federal Insurance Contributions Act (FICA) tax and unemployment taxes.

Journal Entry Example 1:
Jay Company's gross payroll before withholdings is $100,000 for the month of January. There is $10,000 of income tax withheld, $8,000 of FICA taxes payable (based on a hypothetical flat rate), and $5,000 for union dues. The remainder, $77,000, is paid to the employees. The accounting entries for the unremitted payroll deductions are made.

Unremitted Payroll Deductions Journal Entries

Debit salaries expense	$100,000
Credit income tax withheld payable		$10,000
Credit FICA payable		$8,000
Credit union dues payable		$5,000
Credit cash		$77,000

There is an increase in expense and a decrease in shareholders' equity of $100,000 because of salaries expense. There is an increase in current liabilities of $23,000 and a decrease in cash of $77,000.

Journal Entry Example 2:
Jay Company's employer portion of FICA tax is an $8,000 matching contribution, and the company's unemployment taxes total $1,500 (based on a hypothetical flat rate). The journal entry to accrue for this liability is made.

Accrued Liabilities Journal Entry

Debit payroll tax expense	$9,500
Credit FICA payable		$8,000
Credit unemployment taxes payable		$1,500

Operating expenses for the payroll tax would increase by $9,500 on the income statement. Current liabilities on the balance sheet would also increase by $9,500.

Payroll Internal Controls

The payroll payment process requires internal controls to ensure that payroll expense is accurate, valid, and documented in a timely manner, and that no payroll fraud occurs.

An internal control system is required to ensure payroll errors or documentation misstatements do not occur, to pay employees in a timely manner, and to prevent and detect fraud (fictitious payroll). Internal controls for payroll should incorporate the following elements:

All payroll transactions should be preapproved and verified as valid (that is, there is no fictitious payroll). There should be an adequate segregation of duties to ensure that the person hiring and approving the hiring of employees is different from the person processing the payroll and paying employees with either checks or electronic funds transfers.
Access to payroll records should be limited and restricted to authorized personnel for privacy, security, and prevention of fraudulent transactions, such as setting up fictitious employees.
All payroll transactions should be recorded in a timely manner so payroll expenses and payroll liabilities are accurately reflected in the ledgers and financial statements.
There should be a clear process established for the timely remittance of deductions and amounts withheld from employee pay and for the remittance of employer-related payroll taxes.
There should be periodic reconciliation of payroll-related liabilities, accounts with remittances, and remittance statement of accounts.

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