A critical part of any organisation’s internal control system is the reconciliation process; the most well-known of these is the monthly bank reconciliation. However, the reconciliation of the payroll system and ensuring the critical steps are covered should be part of every organisation’s internal controls. So in today’s accounting tutorial, we will take you through what we believe these seven steps are. We have also included a few journal entries to help with the debits and credits.
Purpose of Payroll Reconciliation
When talking about the reconciliation of payroll, we are talking about the reconciliation of up to three systems, depending on how complex the organisation is.
Payroll Register
The first system is the payroll register or sometimes called the employee register. This system maintains employee name, position held, salary or hourly rate, tax number, postal address and other contact details. This system is typically integrated into human resources, who even may maintain it.
Payroll Sub-Ledger
Beyond a few employees, there are benefits in maintaining a sub-ledger for payroll – taking the process and posting away from the general ledger system. The sub-ledger enables detailed individual payroll record processing to occur for each employee. For example, details would include gross pay, pension contributions, local and national payroll taxes, income taxes, etc. Many sub-ledgers may well be operated to speed up and better manage large volumes of data in a large organisation. For example, a separate sub-ledger may be maintained for operational or geographical divisions.
General Ledger
And of course, the third system required in all of this is the general ledger itself. In smaller enterprises, without a payroll sub-ledger, this is where all of the payroll postings are made. But if sub-ledgers are operated, then they post aggregate data up into the general ledger. Examples of totals posted include gross wages, federal income tax, 401(k) contributions (for our Australian friends, this is like superannuation), etc. In the operation of sub-ledgers, the reconciliation of a system like a payroll becomes even more critical.
Payroll Reconciliation Steps
Set out below are the seven steps essential to the reconciliation of any payroll system. Because they vary in the software being used and the internal controls and procedures in place at each organisation, one can’t be too prescriptive. However, specific guidelines can be developed from these six general steps. And from which strengthen internal controls around payroll records, sub-ledger operation and maintenance of the general ledger.
1. Review of Payroll Register
Before we even get to calculating hours worked, and taxes we need to ensure the core employee data is correct. This step may be done each month manually as part of the payroll reconciliation, or there may well be an ongoing integrity check on this. Whatever system is in place, it needs to be checking changes in employees joining or leave, tax code changes, postal addresses (if, say, payslips/payments are posted out). Other data that needs to ensure it has been correctly processed include name changes and bank deposit details.
2. Pay Period Days/Hours Worked
Having reviewed the base data as correct, the next step will be to ensure the days or hours of work are valid. For instance, this step would look at holidays taken and any public holidays worked that may involve extra pay, overtime worked or any sick leave taken.
3. Salary and Hourly Wage Changes
Of course, we need to make sure that any salary changes or hourly rates have been processed correctly. These changes can arise from performance reviews, employment anniversary dates, say for those on pay ladders, regulatory minimum pay changes, collective wage negotiation changes and bonus payments (perhaps for performance or, say, Christmas holidays).
4. Taxes and Pre and Post Tax Deductions
Mistakes can still happen, even with automated tax calculations. For example, in the United Kingdom, they use personal tax codes that HMRC advise employers of changes periodically. These codes tell the employer how much of the annualised salary or wage should be zero-rated for income tax. Changes also need to be checked in income tax marginal rates and the thresholds these rates are applied at.
In addition to the tax-related deductions, an employee may have pre-tax deductions being made from their paycheque. For example, they may have pre-tax retirement deductions being made. In the United States, this would be a 401(k), in the United Kingdom a pension, in Australia a superannuation plan, and in New Zealand, it would be KiwiSaver.
Another common deduction for many is student loans, an all too common sight in the west on payslips.
After step four, we have all of the data we need to produce the entries for individual payroll postings. This ledger may not be maintained in small organisations, so steps five and six below merge. Whatever system is operated, posting of individual payroll data is now made.
5. Payroll Sub-Ledger Posting
So let’s look at an example for our trusty ABC Ltd. The employee is on £36,000 pa – yes, Brian works in the United Kingdom for ABC Ltd (they are branching out). Brian’s payment details are as follows:
- monthly gross pay is £3,000;
- personal pension contributions of 5 per cent monthly, and;
- has a student loan to repay.
Journal Entry
ABC Ltd (UK) Ltd would make the following payroll sub-ledger journal entry to account for these transactions.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Oct 25 | Salary and Wages | 3,312.34 | |
| Pay As You Earn (PAYE) | 390.50 | ||
| National Insurance – employee | 264.32 | ||
| National Insurance – employer | 312.34 | ||
| | Student Loan Repayment | | 65.29 |
| Personal Pension Contribution | 150.00 | ||
| Salary Payable (net) | 2,129.89 |
Analysis
So a few things to work through in how this journal entry was put together. Most countries will have something similar to the accounts we have used. Let us work through credits first and then come back to the debit:
- PAYE means Pay as You Earn – personal income tax;
- national insurance in the United Kingdom is a bit like a payroll tax. It is meant to durectly fund things like the National Health Service, but instead feeds into the consoldiation revenue fund;
- not only do employees pay National Insurane, employers also have to pay this tax;
- the student loan repayment will be common to many people;
- the personal pension contribution (like your 401(k) in the Untied States) helps Brian defer income tax; and
- the net amount is what Brian will receive out of his £3,000 at the end of the month.
The debit of £3,312.34 comprises Brian’s gross monthly salary of £3,000 plus the £312.34 National Insurance – Employer tax. Although this tax has no direct “benefit” to Brian, his employment costs more because his employer has to pay it.
6. General Ledger Posting
Aggregates are posted to the general ledger after sub-ledger postings are completed. You probably wouldn’t bother with this extra step in a small organisation as you won’t be running sub-ledgers. But you can see it wouldn’t take many employees to start to build up quite a few debits and credits. For a larger organisation, the posting from the payroll sub to the general ledger is a vital monthly reconciliation process.
The format of the general ledger journal entry would look similar, something like shown below. We assume ABC has 15 Brian’s on the United Kingdom payroll with the same student loan and personal pension contributions.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Oct 25 | Salary and Wages | 49,685.10 | |
| Pay As You Earn (PAYE) | 5,857.50 | ||
| National Insurance – employee | 3,964.80 | ||
| National Insurance – employer | 4,685.10 | ||
| | Student Loan Repayment | | 979.35 |
| Personal Pension Contribution | 2,250.00 | ||
| Salary Payable (net) | 31,948.35 |
7. Payroll Generation and Payment
There are a couple more steps in the reconciliation of a payroll system. The first of these steps is payslip generation and the payment of the liabilities generated from the posting journals. Most common nowadays is the electronic generation of payslips available for download or printed directly to the employee.
From an accounting point of view, the monthly journal entry for payment of payroll might look something like this:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Oct 30 | Pay As You Earn (PAYE) | 5,857.50 | |
| National Insurance – employee | 3,964.80 | ||
| National Insurance – employer | 4,685.10 | ||
| | Student Loan Repayment | 979.35 | |
| Personal Pension Contribution | 2,250.00 | ||
| Salary Payable (net) | 31,948.35 | ||
| Bank | 49,685.10 |
Many employers process payroll a day or two before payday in case of delays or problems. For example, if payday falls on a public holiday or a weekend, this might delay funds reaching the employee’s bank. Although employers know the importance of ensuring payroll is on time, not all employers are this considerate.
Conclusion
We hope you have found this seven-step guide to the essential tasks of a payroll system reconciliation helpful. In the end, we never heard back from the student for the tutorial. However, we are grateful to them for prompting us to write this accounting tutorial.