Almost every business has some sort of payroll to pay their employees.  Payroll can become much more complicated than some assume and it often has a substantial impact on financial results.  The largest expense for many businesses is their labor expense, yet it’s often the most misunderstood.  One of the most common errors is derived from posting expenses as cash comes out of the bank.  This typically happens in at least 2 withdrawals; net pay and payroll taxes.  From a cursory look, it would seem simple.  You would post the net pay to a labor expense account and the payroll taxes to a payroll expense account.  This is incorrect and causes labor to be understated and taxes to be overstated. 

Net pay is the end result of what someone is owed.  This can include deductions for Social Security, Medicare, federal and state income taxes, health insurance, 401k, child support, expense reimbursements, and many others.  When posting the net pay as the business’s expense, all those deductions that were paid by the employee are reducing the company’s expense.  Let’s look at a simplified example.

Jason makes $15/hour and works 40 hours per week.

His total pay for the week would be $600.  This is the total labor expense to the company.

Jason has the following deductions:

• $100 federal income tax

• $45 for Social Security and Medicare (or FICA)

• $50 for child support

• $25 reimbursement for required work shoes

His net check would be $430.  This is not the correct expense to the company since there are expenses Jason paid as deductions from his check. They are his personal expenses.  Additionally, recording a reimbursement as part of labor expense is incorrect.  The work shoes would be a uniform or safety expense.

In the same scenario, businesses will often record the cash withdrawal for taxes as a tax expense.  $190 would be withdrawn for taxes. This is made up of Jason’s deductions of $100 for federal income taxes, $45 for Jason’s FICA deduction, and the company’s true expense of $45 for its matching portion of FICA.  Recording Jason’s deductions as a tax expense is incorrect and overstates the expense to the business.  The business’s true expense is only $45.

This can also cause issues with insurance or worker’s compensation audits.  They review the financial statements as part of the audits.  If it does not match the actual expenses to the business it can affect future insurance payments and current audit payments. 

The issue of child support can depend on the state collecting the payments and the payroll company being used.  Sometimes it is a separate cash withdrawal.  Others require the company to send the funds themselves.  Regardless, the child support payment is not an expense of the company and shouldn’t be recorded as it is.  Including the child support deduction in a lump sum payroll expense can also lead to legal issues.  If not separated in the books, it can easily be forgotten.  Even though the employee paid their child support by having it deducted from their paycheck, if the business doesn’t make the proper payments it can cause legal issues for the parent.

Reimbursement expenses need to be posted to the expense account that properly reflects the expense.  If it’s for office supplies, then the expense should be posted to an office expense account.

So, what should a small business do?  Many do nothing.  They wait until the end of the year and let their tax preparer make one large correction.  This is ok for tax purposes but doesn’t give the owners of the business the ability to properly see their labor and payroll tax expenses when reviewing their profit and loss statements or measuring their own goals and metrics.  Some do quarterly adjustments based on quarterly filings.  Others set up their accounting systems to post payroll to the balance sheet as needed for items that are not expenses of the company.  Some others do journal entries to ensure payroll, tax, and reimbursement expenses are all posted to the proper accounts.  There are also a few that update the cash transaction in their accounting expenses to post the correct accounts.  The final decision is based on the owners or management of the company and what is important to them.  It is always our recommendation to post payroll correctly each pay period since it is often the largest expense to any company.