Work Week Definition

An important concept in the calculation of employee compensation is the definition of a work week. A work week is any period of 168 consecutive hours that recurs consistently. Thus, management can set any start and ending dates and times as being the official corporate work week – but it must apply that work week consistently.

To prevent confusion among employees, it is best to retain the same work week definition in perpetuity, barring a justifiable reason for changing it. It is useful to list the beginning and ending dates and times for the company work week in the employee manual, so that everyone knows the time period over which they are being paid.

The definition of a work week is important for two reasons:

• Pay day. If a company lets a certain number of days pass from the end of a work week until the day on which paychecks are handed to employees, then pay day is derived from the ending date of the work week.
• Overtime. If overtime is based on the number of hours worked in a work week, then it is possible that the work week can impact the calculation of overtime pay.

If a company buys another business, mandate the same work week for both entities. Otherwise, it will be inefficient to track differing work periods, probably with different payroll cycles.

Wage Exemption Guidelines

A knowledge of the wage exemption guidelines is useful for deciding whether an employee should be entitled to payment in wages or on a salaried basis. Doing so can avoid complaints at a later date, if an employee believes that he or she was unfairly compensated.

The essential guidelines for designating an employee as eligible for salaried compensation are:

• Administrative position. This person is responsible for an administrative department, even if there is no direct supervision of anyone. This classification also applies to anyone who assists with long-term strategic decision-making.
• Executive position. This person is responsible for managing more than half the time, and supervises two or more employees.
• Professional position. This person spends at least half of his or her time on tasks that call for knowledge that is obtained through a four-year college degree program; this requirement can include systems analysis, design, and programming, even in the absence of a four-year degree program. Someone classified as a professional must be able to exercise independent decision making, and require only a minimal amount of close supervision.

Wage Accrual

It is quite common to have some amount of unpaid wages at the end of an accounting period, so you should accrue this expense (if it is material). The accrual entry shown below is a simple one, because you typically clump all payroll taxes into a single expense account and offsetting liability account. After recording this entry, you reverse it at the beginning of the following accounting period, and then record the actual payroll expense whenever it occurs.

A sample transaction follows:

	Debit	Credit
Direct labor expense	xxx
Salaries expense [by department]	xxx
Accrued salaries and wages		xxx
Accrued payroll taxes		xxx

Companies with predominantly salaried staffs frequently avoid making the accrued wages entry, on the grounds that the wages due to a small number of hourly personnel at the end of a reporting period have a minimal impact on reported financial results.

The information for the wage accrual entry is most easily derived from a spreadsheet that itemizes all employees to whom the calculation applies, the amount of unpaid time, and the standard pay rate for each person. It is not necessary to also calculate the cost of overtime hours earned during an accrual period if the amount of such hours is relatively small.

Social Security Tax Rate

Social Security Tax Overview

The social security tax began with the passage of the Social Security Act in 1935, which established Old Age and Survivor's Insurance. The insurance was to be funded by compulsory deductions from the pay of wage earners. Initially, these deductions were set at 1% of gross wages, and were to be paid by both the employer and the employee, and would continue until retirement age, which was set at 65. By 1948, the amount of these deductions had increased to 3%. Employers have been and continue to be responsible for withholding the social security tax from employee pay.

The tax rate for social security is now governed by the Federal Insurance Contributions Act (FICA). Because of this association, social security taxes are now closely associated with the acronym "FICA".

In addition, the Social Security Act also created the Federal Unemployment Trust Fund. This fund was supported by additional withholdings from employee wages, and was designed to assist the states with their unemployment insurance plans. Later updates have increased the coverage of the unemployment fund, from its original coverage of only those employees engaged in industrial or commercial occupations.

Social Security Tax Rates

The following table can be used to determine the social security tax rate, as well as the upper limit on the amount of taxable earnings to which the tax applies. For example, on earnings of $150,000 in 2010, the amount of employer tax paid would be $6,621.60, which is calculated as follows:

6.2% Tax rate x $106,800 Wage cap = $6,621.60

Tax Year	FICA Tax Rate	Wage Cap
2012	4.2% Employee / 6.2% Employer	$110,100
2011	4.2% Employee / 6.2% Employer	106,800
2010	6.2%	106,800
2009	6.2%	106,800
2008	6.2%	102,000
2007	6.2%	97,500
2006	6.2%	94,200
2005	6.2%	90,000
2004	6.2%	87,900
2003	6.2%	87,000
2002	6.2%	84,900
2001	6.2%	80,400

Note that Social Security is matched by the employee, so the total tax amount paid to the government by the employer is 12.4% (with the exceptions of 2011 and 2012, as noted in the preceding table). A self-employed person is responsible for paying the full amount of the 12.4%.

Piece Rate Pay Calculation

Piece Rate Pay Overview

A piece rate pay plan can be used by a business that wants to pay its employees based on the number of units of production that they complete. Using this type of pay plan converts compensation into a cost that directly varies with sales, assuming that all produced goods are immediately sold. If goods are instead stored in inventory for a time and then sold at a later date, there is not such a perfect linkage in the financial statements between sales generated and piece rate labor costs incurred.

Use the following method to calculate wages under the piece rate method:

Rate paid per unit of production × Number of units completed in the pay period

If a company uses the piece rate method, it must still pay its employees for overtime hours worked. There are two methods available for calculating the amount of this overtime, which are:

• Multiply the regular piece rate by at least 1.5 to arrive at the overtime piece rate, and multiply it by the hours worked during an overtime period. You can only use this method when both the company and the employee have agreed to use it prior to the overtime being worked.
• Divide hours worked into the total piece rate pay, and then add the overtime premium (if any) to the excess number of hours worked.

Piece Rate Pay Example

October Systems manufactures customized cellular phones, and pays its staff a piece rate of $1.50 for each phone completed. Employee Seth Jones completes 500 phones in a standard 40-hour work week, for which he is paid $750 (500 phones × $1.50 piece rate).

Mr. Jones works an additional 10 hours, and produces another 100 phones during that time. To determine his pay for this extra time period, October Systems first calculates his pay during the normal work week. This is $18.75 (calculated as $750 total regular pay, divided by 40 hours). This means that the overtime premium is 0.5 × $18.75, or $9.375 per hour. Consequently, the overtime portion of Mr. Jones’ pay for the extra 10 hours worked is $93.75 (calculated as 10 hours × $9.375 overtime premium).

If October Systems had instead set the piece rate 50% higher for production work performed during the overtime period, this would have resulted in the overtime portion of his pay being $75 (calculated as $0.75 per unit × 100 phones produced).

The difference in the payout between the two overtime calculation methods was caused by the lower productivity level of Mr. Jones during the overtime period. He assembled 25 fewer phones during the overtime period than his average amount during the normal work week, and so would have earned $18.75 less ($0.75 overtime premium × 25 phones) under the second calculation method.

Payroll Internal Controls

General Payroll Controls

Consider using a selection of the following controls for nearly all payroll systems, irrespective of how timekeeping information is accumulated or how employees are paid:

• Audit. Have either internal or external auditors conduct a periodic audit of the payroll function to verify whether payroll payments are being calculated correctly, employees being paid are still working for the company, time records are being accumulated properly, and so forth.
• Change authorizations. Only allow a change to an employee’s marital status, withholding allowances, or deductions if the employee has submitted a written and signed request for the company to do so. Otherwise, there is no proof that the employee wanted a change to be made. The same control applies for any pay rate changes requested by a manager.

• Change tracking log. If you are processing payroll in-house with a computerized payroll module, activate the change tracking log and make sure that access to it is only available through a password-protected interface. This log will track all changes made to the payroll system, which is very useful for tracking down erroneous or fraudulent entries.
• Error-checking reports. Some types of payroll errors can be spotted by running reports that only show items that fall outside of the normal distribution of payroll results. These may not all indicate certain errors, but the probability of underlying errors is higher for the reported items. The payroll manager or a third party not involved in payroll activities should run and review these reports.
• Expense trend lines. Look for fluctuations in payroll-related expenses in the financial statements, and then investigate the reasons for the fluctuations.
• Issue payment report to supervisors. Send a list of payments to employees to each department supervisor, with a request to review it for correct payment amounts and unfamiliar names. They may identify payments being made to employees who no longer work for the company.
• Restrict access to records. Lock up employee files and payroll records at all times when they are not in use, to prevent unauthorized access. Use password protection if these records are stored on line. This precaution is not just to keep someone from accessing the records of another employee, but also to prevent unauthorized changes to records (such as a pay rate).
• Separation of duties. Have one person prepare the payroll, another authorize it, and another create payments, thereby reducing the risk of fraud unless multiple people collude in doing so. In smaller companies where there are not enough personnel for a proper separation of duties, at least insist on having someone review and authorize the payroll before payments are sent to employees.

Payroll Calculation Controls

The following list of possible controls address such issues as missing timesheets, incorrect time worked, and incorrect pay calculations. They are:

• Automated timekeeping systems. Depending on the circumstances, consider installing a computerized time clock. These clocks have a number of built-in controls, such as only allowing employees to clock in or out for their designated shifts, not allowing overtime without a supervisory override, and (for biometric clocks) eliminating the risk of buddy punching. Also, you should send any exception reports generated by these clocks to supervisors for review.
• Calculation verification. If you are manually calculating payroll, then have a second person verify all calculations, including hours worked, pay rates used, tax deductions, and withholdings. A second person is more likely to conduct a careful examination than the person who originated the calculations.
• Hours worked verification. Always have a supervisor approve hours worked by employees, to prevent employees from charging more time than they actually worked.
• Match payroll register to supporting documents. The payroll register shows gross wages, deductions, and net pay, and so is a good summary document from which to trace back to the supporting documents for verification purposes.
• Match timecards to employee list. There is a considerable risk that an employee will not turn in a timesheet in a timely manner, and so will not be paid. To avoid this problem, print a list of active employees at the beginning of payroll processing, and check off the names on the list when you receive their timesheets.
• Overtime worked verification. Even if you do not require supervisors to approve the hours worked by employees, at least have supervisors approve overtime hours worked. There is a pay premium associated with these hours, so the cost to the company is higher, as is the temptation for employees to claim them.
• Pay change approval. Consider requiring not just one approval signature for an employee pay change, but two signatures – one by the employee’s supervisor, and another by the next-higher level of supervisor. Doing so reduces the risk of collusion in altering pay rates.

Check Payment Controls

When you pay employees with checks, several controls are needed to mitigate the risks of fraud and various errors. Key controls are:

• Hand checks to employees. Where possible, hand checks directly to employees. Doing so prevents a type of fraud where a payroll clerk creates a check for a ghost employee, and pockets the check. If this is too inefficient a control, consider distributing checks manually on an occasional basis.
• Lock up undistributed paychecks. If you are issuing paychecks directly to employees and someone is not present, then lock up their check in a secure location. Such a check might otherwise be stolen and cashed.
• Match addresses. If the company mails checks to its employees, match the addresses on the checks to employee addresses. If more than one check is going to the same address, it may be because a payroll clerk is routing illicit payments for fake employees to his or her address.
• Payroll checking account. You should pay employees from a separate checking account, and fund this account only in the amount of the checks paid out. Doing so prevents someone from fraudulently increasing the amount on an existing paycheck or creating an entirely new one, since the funds in the account will not be sufficient to pay for the altered check.

You may find that several controls buttress each other, so that there are overlapping effects resulting from multiple controls. In these cases, you may be able to safely eliminate a few controls, knowing that other controls will still mitigate the risk of loss.

Payroll Fraud

Types of Payroll Fraud

There are several ways in which employees can commit payroll fraud. They are:

• Advances not paid back. The most passive type of fraud is when an employee requests an advance on his payroll and then never pays it back. This works best when the accounting staff does not record advances as assets (instead charging them directly to expense), or never monitors repayment. Thus, the non-payment of advances requires inactivity by the recipient and inadequate transaction recordation and follow-up by the accounting staff. A monthly procedure to review advances will eliminate this issue.

• Buddy punching. An employee arranges with his fellow employees to have them punch his hours into the company time clock while he takes the day off. Supervisory reviews and the threat of termination are the best ways to avoid this risk. A more expensive alternative is to use biometric time clocks, which uniquely identify each person who is signing into the time keeping system.
• Ghost employees. The payroll staff either creates a fake employee in the payroll records or prolongs the pay of an employee who has just left the company, and alters the payment record so that the direct deposit or check is made out to them. This works best in large companies where supervisors have very large staffs and so do not usually track compensation in sufficient detail. It also works well when a supervisor has left the company and has not yet been replaced, so that ghost employees can be inserted into their departments until a new supervisor is appointed. Periodic auditing of the payroll records is needed to spot ghost employees. Another way to spot a ghost employee is when there are no deductions from a pay check, since the perpetrator wants to receive the maximum amount of cash.

• Pay check diversion. Employees could take the paycheck of another employee who is absent, and then cash the check for themselves. This can be avoided by having the paymaster retain all unclaimed checks in a locked safe, and by requiring that everyone receiving a pay check prove his identify with a driver's license or some similar document.
• Pay rate alteration. Employees collude with the payroll clerk to increase the amount of their hourly pay in the payroll system. A more clever clerk will then return the pay rate to its original level after committing this fraud for just a few pay periods, so that the issue is less easy to spot. This can be detected by matching pay rate authorization documents to the payroll register.
• Unauthorized hours. Perhaps the most common type of payroll fraud is the padding of time sheets by employees, usually in small enough increments to escape the notice of supervisors. This is a particular problem when supervisors are known to make only cursory reviews of time sheets. The best control over this type of fraud is the supervisory review.

In short, there are many ways in which the amount of payroll paid out can be fradulently expanded. This is difficult to spot when the amounts involved are small, so you must consider the cost of prevention activities in relation to the amount of savings that will be generated.

Payroll Entries

Types of Payroll Journal Entries

When a business pays its employees, it records the payment transaction with a payroll journal entry, which is incorporated into its financial statements through the general ledger. The key types of payroll journal entries are:

• Initial recordation. The primary payroll journal entry is for the initial recordation of a payroll. This entry records the gross wages earned by employees, as well as all withholdings from their pay, and any additional taxes owed by the company.
• Accrued wages. There may be an accrued wages entry that is recorded at the end of each accounting period, and which is intended to record the amount of wages owed to employees but not yet paid. This entry is then reversed in the following accounting period, so that the initial recordation entry can take its place.
• Manual payments. A company may occasionally print manual paychecks to employees, either because of pay adjustments or employment terminations. 

All of these journal entries are noted below.

Primary Payroll Journal Entry

The primary journal entry for payroll is the summary-level entry that is compiled from the payroll register, and which is recorded in either the payroll journal or the general ledger. This entry usually includes debits for the direct labor expense, salaries, and the company's portion of payroll taxes. There will also be credits to a number of accounts, each one detailing the liability for payroll taxes that have not been paid, as well as for the amount of cash already paid to employees for their net pay. The basic entry (assuming no further breakdown of debits by individual department) is:

	Debit	Credit
Direct labor expense	xxx
Salaries expense	xxx
Payroll taxes expense	xxx
Cash		xxx
Federal withholding taxes payable		xxx
Social security taxes payable		xxx
Medicare taxes payable		xxx
Federal unemployment taxes payable		xxx
State withholding taxes payable		xxx
State unemployment taxes payable		xxx
Garnishments payable		xxx

There may be a number of additional employee deductions to include in this journal entry. For example, there may be deductions for 401(k) pension plans, health insurance, life insurance, vision insurance, and for the repayment of advances.

When you later pay the withheld taxes and company portion of payroll taxes to the IRS, you then use the following entry to reduce the balance in the cash account, and eliminate the balances in the liability accounts:

	Debit	Credit
Cash		xxx
Federal withholding taxes payable	xxx
Social security taxes payable	xxx
Medicare taxes payable	xxx
Federal unemployment taxes payable	xxx
State withholding taxes payable	xxx
State unemployment taxes payable	xxx
Garnishments payable	xxx

Accrued Payroll Journal Entry

It is quite common to have some amount of unpaid wages at the end of an accounting period, so you should accrue this expense (if it is material). The accrual entry, as shown next, is simpler than the comprehensive payroll entry already shown, because you typically clump all payroll taxes into a single expense account and offsetting liability account. After recording this entry, reverse it at the beginning of the following accounting period, and then record the actual payroll expense (as just described under the "Primary Payroll Journal Entry" section whenever it occurs.

	Debit	Credit
Direct labor expense	xxx
Salaries expense	xxx
Accrued salaries and wages		xxx
Accrued payroll taxes		xxx

Manual Paycheck Entry

It is quite common to create a manual check, either because an employee was short-paid in the preceding payroll, or because the company is laying off or firing an employee, and so is obligated to pay that person before the next regularly scheduled payroll. This check may be paid through the corporate accounts payable bank account, rather than its payroll account, so you may need to make this entry through the accounts payable system. If you are recording it directly into the general ledger or the payroll journal, then use the same line items already noted for the primary payroll journal entry.

The volume of manual paycheck entries can be reduced by continual attention to the underlying causes of transaction errors, so there are fewer payroll errors to be rectified with a manual paycheck.

Payroll Accounting

Overview of the Payroll Accounting Process

The following discussion shows the beginning-to-end processing of payroll. Though some systems that incorporate more or less automation may not include all of these steps, the general process flow will apply to most payroll systems:

1. Set up new employees. Have new employees fill out payroll-specific information as part of the hiring process, such as the W-4 form and medical insurance forms that may require payroll deductions. Set aside copies of this information in order to include it in the next payroll.
2. Collect timecard information. Salaried employees require no change in wages paid for each payroll, but you must collect and summarize information about the hours worked by non-exempt employees. This may involve having employees scan a badge through a computerized time clock.
3. Verify timecard information. Summarize the payroll information just collected and have supervisors verify that employees have correctly recorded their time.
4. Summarize wages due. Multiply the number of hours worked by the pay rate for each employee, also factoring in any overtime or shift differentials.
5. Enter employee changes. Employees may ask to have changes made to their paychecks, usually to the number of tax exemptions or pension withholdings. You may need to record much of this prior to calculating taxes, since it impacts the amount of wages to which taxes are applied.
6. Calculate taxes. Use IRS tax tables to determine the amount of taxes to be withheld from employee gross wages.
7. Calculate wage deductions. There may be a number of additional deductions to take away from employee net income, including deductions for medical insurance, life insurance, garnishments, and union dues. You must also track the goal amounts for these deductions, so that you stop deducting once the goal totals are reached.
8. Deduct manual payments. If manual payments have already been made to employees, such as advances, then deduct these amounts from the remaining net pay.
9. Create a payroll register. Summarize the wage and deduction information for each employee in a payroll register, which you can then summarize to also create a journal entry to record the payroll. This document is automatically created by all payroll software packages.
10. Print paychecks. Print employee paychecks using the information in the payroll register. You normally itemize gross wages, deductions, and net pay in a remittance advice that accompanies the paycheck.
11. Pay by direct deposit. Notify your direct deposit processor of the amount of any direct deposit payments, and issue remittance advices to employees for these payments.
12. Issue paychecks. Have a paymaster issue paychecks to employees, requiring employee identification if there are a large number of employees.
13. Deposit withheld taxes. Deposit all withheld payroll taxes and employer matched taxes at a bank that is authorized to handle these transactions.

Payroll Journal Entries

The primary journal entry for payroll is the summary-level entry that is compiled from the payroll register, and which is recorded in either the payroll journal or the general ledger. This entry usually includes debits for the direct labor expense, salaries, and the company's portion of payroll taxes. There will also be credits to a number of accounts, each one detailing the liability for payroll taxes that have not been paid, as well as for the amount of cash already paid to employees for their net pay. The basic entry (assuming no further breakdown of debits by individual department) is:

	Debit	Credit
Direct labor expense	xxx
Salaries expense	xxx
Payroll taxes expense	xxx
Cash		xxx
Federal withholding taxes payable		xxx
Social security taxes payable		xxx
Medicare taxes payable		xxx
Federal unemployment taxes payable		xxx
State withholding taxes payable		xxx
State unemployment taxes payable		xxx
Garnishments payable		xxx

When you later pay the withheld taxes and company portion of payroll taxes to the IRS, you then use the following entry to reduce the balance in the cash account, and eliminate the balances in the liability accounts:

	Debit	Credit
Cash		xxx
Federal withholding taxes payable	xxx
Social security taxes payable	xxx
Medicare taxes payable	xxx
Federal unemployment taxes payable	xxx
State withholding taxes payable	xxx
State unemployment taxes payable	xxx
Garnishments payable	xxx

It is quite common to have some amount of unpaid wages at the end of an accounting period, so you should accrue this expense (if it is material). The accrual entry, as shown next, is simpler than the comprehensive payroll entry already shown, because you typically clump all payroll taxes into a single expense account and offsetting liability account. After recording this entry, you reverse it at the beginning of the following accounting period, and then record the actual payroll expense whenever it occurs.

	Debit	Credit
Direct labor expense	xxx
Salaries expense	xxx
Accrued salaries and wages		xxx
Accrued payroll taxes		xxx

Overtime Pay Calculation

Overtime Pay Calculation Overview

Overtime is a 50% multiplier that is added to an employee’s base wage for hours worked over 40 hours in a work week. This calculation is subject to some variation by state, so review your local regulations to see if there is an overriding overtime calculation in place. Here are two rules to consider when calculating overtime pay:

• Do not include in the 40 base hours such special hours as holidays, jury duty, sick time, or vacations.
• Add the shift differential to the base wage, and then calculate overtime based on this combined figure.

There may be situations where an employee is paid different rates at different times during the work period. This situation may arise when the individual works on different jobs that have differing rates of pay associated with them. In these cases, you have three possible options for calculating overtime, which are:

• Base the overtime rate on the highest wage rate paid during the period
• Base the overtime rate on the average wage rate paid during the period
• Base the overtime rate on the wage rate paid after the 40th hour

The last alternative for calculating overtime requires the prior approval of the affected employee.

How to Calculate Overtime Pay

In general, follow these steps to calculate the amount of overtime pay owed to an employee:

1. Determine whether the individual is eligible for overtime. The person might not qualify as an employee, or may instead be paid on a salaried basis, in which case overtime rules do not apply.
2. Determine the hourly rate of pay, which is the total amount paid in the period divided by the number of hours worked.
3. Multiply the hourly rate of pay by 1.5x.

Overtime Pay Calculation Example

Alfredo Montoya works the evening shift at Electronic Inference Corporation, which adds $1 of shift differential per hour to his base wage of $15 per hour. In the most recent work week, he worked 50 hours. The overtime premium he will be paid is based on the combined $16 wage that includes his shift differential. Thus, his overtime rate is $8 per hour. The calculation of his total compensation for that week is:

50 hours × aggregate base pay of $16/hour	=	$800
10 hours × overtime premium of $8/hour	=	80
Total compensation	=	$880