Payroll and Accrual Entries: The Simple and the Complex

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Each week, ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories.

First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.

One of the questions we are frequently asked deals with posting accrual entries for incurred payroll and payroll-related costs not yet processed using your payroll program. In this article, Rob will address this issue providing detailed examples as he works through the process.

As noted in previous articles, small businesses generally gravitate toward the cash (or income tax) basis of accounting when preparing their financial statements for a variety of reasons. First, since most small businesses prepare their income tax returns using the cash method, preparation of the underlying financial statement under the cash method is fairly logical and precludes a necessary method conversion. Second, accrual accounting is more complex than the cash method, and most small business owners want to keep it simple. Finally, if a business owner has outsourced the preparation of financial statements and income tax returns, they want to minimize their exposure to professional fees, and the cash basis is typically more compatible with this goal than the accrual basis of accounting. But, let’s face it, if you are tasked with the job of preparing an accrual-based financial statement, whether you’re an in-house accountant or an independent professional, you’d better know how to get the job done. I’ve been asked to address this issue; in particular, the accrual entries related to payroll and payroll-related items.

The payroll issue is, in almost all cases, financially material in nature and reoccurring. As a result, businesses using accrual-based accounting must identify and record payroll and payroll-related costs as they are earned rather than when actually paid. These accrual entries can take the form of rather simplistic journal entries with corresponding reversing entries in the next period, or can be somewhat complex for those companies wanting to get very specific with their accruals. For the sake of identification, I’ll call the examples used below the “Simple Accrual” and the “Complex Accrual.” We’ll take a look at both methods, and hopefully clear up any basic confusion these entries might hold. Before we go into the examples, it is important to note that these illustrations represent my preference in preparing and recording accrual entries associated with payroll. You may wish to consolidate or expand the line items in your accrual entries, or you may be restricted to the auspices of your chosen accounting software. Whatever your particular circumstances may be, know that that there are a number of ways to accomplish the same end result for these entries. Consequently, if your entries look different than those below, don’t fret. As long as the net effect on the balance sheet and income statement accounts is accurate, how you get there is not necessarily the most important aspect of this lesson.

The Basic Payroll Entry

As you probably know, booking payroll entries involves a multiple-account entry process. That is, when payroll is recorded, not only are expense accounts affected, but so are a number of balance sheet accounts. For instance, a standard payroll entry for a payroll that is paid when declared might look like the following:

The first part of EX. 1 records the payment of the salary/wage expense and the corresponding withholding amounts, while the second part of the entry books the payment of the withholding amounts and the corresponding employer payroll taxes (FICA and Medicare). As previously noted, this set of entries can take many forms, but you get the idea. This entry or some derivation is what you might see on a set of books using the cash basis of accounting. Now, let’s jump into what we face when the books utilize the accrual basis of accounting.

The Simple Accrual

When dealing with unpaid wages to be accrued in your books and financial statements, many companies choose to approximate the amount based on hours worked or percentage of salaries earned for a specific period. These amounts are considered an acknowledgment of the necessary expense to be recognized; as a result, the amount should materially estimate the actual costs to be incurred. Every company will calculate their estimates a bit differently, but for purposes of this accrual, my advice is to set a standard estimation protocol for calculating a payroll accrual, and use it each time you book it.

So, let’s say that ABC, LLC wants to book $3,500 of wages earned in the last week of April to be paid during the first week of May. The Simple Accrual booked the last week of April would look something like the following:

The debit to salary/wage expense represents the cost to the business of the calculated wages/salaries earned for the last week of April. The credit to accrued salary/wages payable is booked as a current liability on the balance sheet and represents the obligation of the company to pay these payroll costs.

In May, when the actual payroll associated with the accrual above is paid, you will need to reverse the accrual entry as follows:

This zeroes out the liability account, and credits the salary/wage expense account for the amount of the salaries/wages earned and recorded the previous week. At that point, your salary/wage expense account contains a credit balance for the month. However, once the entry for the actual payroll is recorded (similar to that in EX. 1), the resulting net balance will be correct for the current month.

This set of entries is considered ‘Simple’ because it only records the estimated salary/wages to be accrued followed by a reversing entry of the exact same accounts and amounts.

The Complex Accrual

Many companies and/or their accountants prefer to be more precise with their accrual entries, and as a result, want to expand the payroll accrual entries. For instance, let’s assume similar facts to the example above, but expand it to make it more exact. ABC, LLC wants to book the salary/wages earned for the week ending Friday, April 22, 2016 to be paid the following week, Friday, April 29, 2016. The entry to accrue this payroll might look like the following:

The set of entries in EX. 4 reflects the actual payroll entries to be paid on April 29, 2016, but which are accrued on April 22, 2016. Note that the 401(k) and insurance withholding is not included in the second part of EX. 4. This comes down to preference. These two items and similar items are part of payroll, but are typically paid via separate check to various vendors. Since they are already recorded as liabilities in the first part of the entry, my preference is to relieve these accounts when I actually remit the amounts to the respective vendors. Others may want to combine these withheld items into the second part of the entry above. My advice? Do it the way that makes the most sense to you and most accurately reflects the effects on your financial statements, but do it consistently.

A point of caution…remember that withholding for FICA, the social security tax, has a ceiling each year (for instance, in 2016, FICA is withheld on salary/wages up to $118,500). As a result, when making your accrual entries, the entry must be properly modified for any employee who has earned salary/wages in excess of the FICA ceiling. The same caution holds true for an employee earning in excess of $200,000 who is now potentially subject to additional Medicare withholding. See more detail on this subject at the IRS website.

On April 29, 2016, the payroll accrued the previous week is now paid, and the following entries are made to reflect the payment(s):

As you can see, the accrued net payroll and payroll tax accounts are reversed and now net to $0, including the 401(k) and insurance withholding items.

At this point, it is important to ensure the entries have been properly calculated and recorded. A simple method to verify your accrual and payment entries is to add the salary/wage expense and payroll tax expense components and compare that sum to the cash payments recorded.

If the amounts match, you should be in good shape. If not, go back and determine your error(s). By walking through this verification exercise, you have ensured the proper balancing of the accrual and payment entries for this particular process.

The Bottom Line

Dealing with an accrual set of books can be difficult and a giant pain, so establish your protocols, run the necessary verification exercises, and perform each step consistently each time you make accrual entries. If you do this, you should have the accuracy within the financial statements you and your company seek.