What is payroll accounting? A guide for HR and payroll teams

In many ways, HR and payroll professionals are the unsung heroes of the finance world working tirelessly behind the scenes, particularly in small and medium-sized enterprises (SMEs) up and down the country.

They’re not only responsible for paying employees promptly but also for ensuring that every penny and pound are accounted for, every payslip dots all the i’s and crosses the t’s, and every tax form is filed correctly and on time, collectively known as payroll accounting.

In this article, we walk you through what payroll accounting is, how it compares to other forms of business accounting, and how to manage its processes effectively.

Here’s what we cover:

What is payroll accounting?

Payroll accounting is a specialised part of accounting. It’s related to employee compensation and is a process that involves recording, managing and evaluating all financial transactions connected to employee pay, such as:

• Wages
• Salaries
• Bonuses
• Deductions
• Taxes.

It also helps to ensure that your employees are paid accurately and on time, while making sure your business complies with all tax laws and regulations, including Pay As You Earn (PAYE) and National Insurance contributions (NICs).

Payroll accounting focuses on employee-specific expenses.

Other types of accounting include:

• General accounting: this records, summarises, evaluates and reports a company’s financial transactions to provide a detailed picture of its financial health.
• Management accounting: this feeds financial data to people inside the business, such as business managers, who support strategic planning, decision-making and performance management.
• Financial accounting: this reports a company’s financial position in the form of an income statement, balance sheet and cash flow statement, which are provided to people outside the business, such as investors, creditors and regulators.

Payroll accounting entries to be aware of

There are three payroll accounting entries that you need to know about:

• Initial recordings: you’ll deal with these entries on a regular basis. They’re the first record of each transaction and include your employees’ gross wages, any withholdings from those wages, and employer taxes that your business owes on those wages.
• Accrued wages: they show the wages owed to employees that haven’t been paid yet. You record accrued wages at the end of each period of accounting.
• Manual payments: these are used to track adjustments you need to make outside of your usual accounting periods. Say you need to make an unplanned payment, or one of your employees ceases to work for the business, you record these as manual payments.

What forms do you need for payroll accounting?

There are three types of paperwork that you need to be aware of when you’re doing your payroll accounting:

• P45: these are given to employees when they finish working for a business.
• P60: you have to give these to your employees that worked for you on the last day of the tax year by 31 May, following the tax year end (5 April).
• Starter checklist: this form is for new employees. It was introduced as part of Real-Time Information and it’s best practice for new employees, even those with a P45, to complete as it includes additional information.

Payroll accounting examples

To get a better understanding of payroll accounting, let’s take a look at three examples of it in action.

The first one relates to processing employee pay.

Let’s say an employee’s gross salary is £3,500 per month.

The role of the payroll accounting process is to make accurate deductions for PAYE, NICs and pension contributions.

If the total deductions come to £1,000, payroll accounting records the £1,000 deduction and the net pay of £2,500, which are important for the purposes of filing taxes and financial reporting.

The second example relates to end-of-year reporting. At the end of a tax year, as part of payroll year end duties, payroll accounting provides the information needed to produce employees’ P60 forms.

A third example is handling bonuses. An employee receives a £1,500 bonus, payroll accounting calculates the tax due on the bonus and determines that the right amount is deducted and reported to HMRC.

How to do payroll accounting

Payroll accounting may sound a bit daunting, but here’s a straightforward example of how it works.

You work in a small business with just one employee, Jane, whose gross monthly salary is £2,500.

As a payroll pro, you need to work out her take-home pay allowing for deductions, such as PAYE tax and NICs.

Here’s a six-step guide to managing payroll accounting for Jane:

1. Calculate gross pay

Work out Jane’s total earnings before deductions—her gross pay—which can also include bonuses, overtime or commissions:

In our example, Jane’s gross pay is £2,500 per month.

2. Calculate deductions

Based on Jane’s tax code, calculate any compulsory deductions. Be sure to check HMRC’s thresholds and rates because these can change from time to time:

Jane’s PAYE tax is £300 and her employee NICs are £200. Jane’s total deductions are £300 (PAYE) + £200 (NICs) = £500.

3. Calculate net (take-home) pay

Subtract total deductions from Jane’s gross pay to reach her net pay, which is the amount Jane will take home after taxes and contributions:

Jane’s gross pay (£2,500) – total deductions (£500) = £2,000.

4. Record employers’ National Insurance contributions

Jane’s employer is responsible for contributing additional NICs based on her salary. They don’t reduce Jane’s take-home pay, but they are an added cost to her employer:

Employers’ NICs = £250.

5. Allocate payments

It’s always a good idea to invest in reliable, user-friendly HMRC-recognised payroll software to automate payments and keep up to speed with deadlines.

Pay Jane her net salary of £2,000 and send HMRC £500 (which is made up of PAYE tax of £300 and employee NICs of £200) and a further £250 for employer NICs.

6. Record transactions in your accounting system

Then you round up all this information into a journal, which is an accounting record that captures all the financial transactions connected to employee pay over a certain period of time.

A journal entry reflecting Jane’s pay, for example, might look something like this:

• Debit: Wages (expense): £2,500
• Credit: Net pay (liability): £2,000
• Credit: PAYE and NICs (liability): £500
• Debit: Employers’ NICs (expense): £250
• Credit: Bank (total payment to HMRC for PAYE, employee NICs and employers’ NICs): £750
• Debit: Bank (net salary paid to Jane): £2,000

Note gross salary as a wage expense of £2,500, record PAYE and NICs of £500 as liabilities (pending their payment to HMRC) and note employer NICs of £250 as an additional expense.

Payroll accounting tasks to manage

The payroll process is like a well-oiled machine.

To keep it running smoothly, the HR and payroll departments must work together to complete a number of tasks, including the following:

Collection and tracking of employee information

Keep accurate and up-to-date records of salaries, benefits, tax codes and any other changes relating to employee pay.

The input of HR is critical here in terms of updating the payroll department with new employee data, promotions or bonuses, such as when:

• A new employee has been recruited and their salary information and tax code are given to the payroll department for timely and accurate processing
• An employee takes unpaid leave and HR informs the payroll department, so that their salary is adjusted accordingly.

Compliance with UK tax laws and regulations

It’s important to keep abreast of any developments and ensure that PAYE and NICs are filed on time. Failure to comply with HMRC’s requirements can result in hefty fines and penalties.

The role of the payroll department, for example, is to check that regulations, such as the National Minimum Wage, are being adhered to.

For example, a new full-time employee should be paid at least £12.21 per hour, which is the National Minimum Wage for people aged 21 or over.

Generation of payroll reports

Let’s say the business you work for employs 10 people and it wants to review labour costs to improve profitability and pinpoint areas where cost savings can potentially be made.

Using payroll software, the payroll team prepares a report that includes:

• Total monthly gross salaries: £30,000 (total salaries of all 10 employees)
• Total employers’ NICs: £3,000
• Employee benefits costs: £2,000 (includes pension contributions, etc)
• Total monthly expenses: £58,333.

Total labour costs: £30,000 (gross salaries) + £3,000 (employers’ NICs) + £2,000 (employee benefits) = £35,000 / total monthly expenses (£58,333) x 100 = 60%.

Based on this report, the labour costs are 60% of the total monthly expenses, which gives the business an opportunity to manage costs, such as reviewing overtime.

Management of employee benefits

Record pension contributions, health benefits and other benefits to ensure they’re all properly accounted for.

Let’s bring Jane back into the picture. Her gross monthly salary is £2,500:

• Employee contribution: 5% = £125 (deducted from Jane’s gross salary)
• Employer contribution: 3% = £75 (an additional cost to the business).

You should name the following entries in the payroll system:

• Employee deduction: £125 (recorded as a pension liability and subtracted from Jane’s gross pay).
• Employer expense: £75 (recorded as a pension expense and distributed as part of overall labour costs).

Final thoughts

Every employee wants and expects to be paid the right amount, at the right time.

Payroll accounting makes this happen, month in and month out.

Not only that, it’s the guardrail that keeps your business aware of, and fully compliant with, ever-evolving tax laws and regulations.

By maintaining comprehensive records of wages, benefits and deductions, payroll accounting makes reporting to HMRC smoother and also provides your business with a vehicle to find and minimise unnecessary labour costs.

Payroll accounting is more than a tick-box exercise. It’s a powerful tool that saves your business time, increases its efficiency, and drives it towards greater financial health.

With payroll on your side, your business can be confident of a future that is as compliant as it is cost-effective.