Top Payroll Accounting Best Practices Small Businesses Should Follow

Tracking compensation, benefits, and other expenses through an accounting system for payroll can help small business owners monitor their financial health and make better hiring decisions. An effective payroll accounting and processing method delivers paychecks to employees on time and ensures payroll tax compliance.

This guide defines the types of payroll accounting methods and explains what expenses you should track. Go through the best practices for payroll accounting to learn how to set up a system that helps you make smarter financial decisions and comply with payroll tax laws.

What is payroll accounting, and why is it important for small businesses?

Payroll accounting is the process of recording and tracking compensation data, including independent contractor and employee wages, tax withholdings, and benefit deductions. Accountants or small business owners record payroll journal entries in the company's general ledger and use financial reports to understand payroll costs and liabilities.

How payroll accounting impacts financial decision-making

Having an accounting system for payroll is essential for small businesses. Accurate records improve financial forecasts and help evaluate labor costs and company expenses while ensuring federal and state tax compliance.

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Here's how the right payroll practices can enhance decision-making:

• Understand the costs of hiring workers. Payroll accounting uses separate journal entries for each type of labor expense to estimate short and long-term costs of hiring full or part-time employees or freelancers.
• Get a clear view of profitability. You can see how payroll affects net income and profitability, allocate employee wages to specific projects or departments for further analysis, and use payroll accounting to set realistic budgets.
• Manage tax and legal obligations. Along with avoiding fines or penalties, accurate recordkeeping can help you take advantage of tax credits for employee retention or training programs.

Expenses considered in payroll accounting

Small business payroll accounting only looks at expenses related to paying employees and contractors. It doesn't track other types of accounts payable or receivable entries.

When setting up your accounting system, create categories for payroll expenses, such as

• Employee compensation: Taxable income entered on IRS Forms W-2 or 1099 counts as compensation for payroll accounting. These expenses include salaries, bonuses, overtime pay, and commissions.
• Payroll taxes: Journal entries for payroll tax withholdings cover applicable state or local taxes, workers' compensation, federal income taxes, Social Security and Medicare taxes, and FICA (the Federal Insurance Contributions Act).
• Employee benefit payments: The payroll accounting process tracks employee and employer payments for health insurance premiums, 401(k) retirement savings and match, group term life insurance, and other supplemental insurance policies or savings programs.
• Miscellaneous expenses: Your company may offer fringe benefits, like a gym membership, as part of an employee's compensation package, which may show as imputed income on the W-2 form. Tuition reimbursement, wage garnishments, and other expenses could fall under this category.
• Employer payroll taxes: Your payroll accounting system itemizes the business portions of federal income, Medicare and Social Security tax payments, and state unemployment insurance contributions.

Types of payroll accounting methods

There are three basic types of payroll accounting methods for small businesses — initial recording or originating entry, accrued wages, and manual payments. Although many small business owners prefer initial recording because it's straightforward, accrued wages provide precise financial statements, and manual payments are necessary for special cases.

• Initial recording or originating entry: This payroll accounting method is the most common and best for companies with a set payroll schedule. It records expenses and liabilities as they occur (when payroll processes).
• Accrued wages: This approach records transactions when they are earned, not the processing date. It's best for companies that use accrual instead of cash accounting, report to investors, or are seeking loans.
• Manual payments: This is an infrequent payroll accounting method for irregular payments, such as bonuses, missed checks, or unique situations.

How to set up payroll accounting for a small business

You can add basic payroll accounting to your current financial accounting system by setting up accounts for expenses and getting a federal employer identification number. Gather employee I-9, W-4, and direct deposit forms. Then you can determine payment periods, individual salary levels, benefits, and insurance.

The payroll accounting process is time-consuming if you're doing it manually. Low-cost and free accounting tools can automatically categorize expenses, saving time and reducing errors. Many integrate with payroll services, which sync data between your accounting and payroll software.

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