For many businesses, especially service companies, labor costs comprise the largest part of operating expenses. Many labor costs are a result of various complex government regulations, and thus, the payroll accounting system can be quite complex.

We are going to look at a simple example of payroll accounting. First of all, it is important to distinguish between employees and contractors as payroll accounting applies only to employees of an organization.  Independent contractors are not considered to be employees, and hence, they are not accounted for under a payroll system. Generally speaking, independent contracts render services for a fee and are not under supervision or control of the company. Examples of independent contractors may include: construction workers, CPAs (Certified Public Accountants), lawyers, advertising agents, etc.  Secondly, in our example we are going to show a manual calculation of payroll expenses whereas most businesses use a computer to process payroll. Finally, we are going to look only at general employer payroll liabilities: a) liabilities for employee compensation; b) liabilities for employee payroll withholdings; and c) liabilities for employer payroll taxes.

Liabilities for employee compensation refer to wages and salaries. Wages are payments for employee services at an hourly rate or a project basis whereas salaries are payments for employee services at a monthly or yearly rate.  Salaried employees often are professional, administrative, executive, managerial, supervisory, computer, or outside sales employees. Sometimes salaried employees are referred to as ‘exempt employees’ as the federal Fair Labor Standards Act (FLSA), also called the Wages and Hours Law, does not regulate their compensation including overtime pay (i.e. usually salaried employees are not entitled to overtime pay, with some exceptions). Detailed information about the FLSA can be found at the United States Department of Labor website. Important to note, some states might have a different from the federal minimum wage requirement.

For example, let us assume Friends Company, an Indianapolis-based company, manufactures industrial valves. It is engaged in interstate commerce and has an annual dollar volume of sales of $10,000,000.  The company employs 1,000 people: 900 wage- and 100 salary-based employees. In 2009 the company paid a minimum wage of $7.25 (in accordance with FLSA and state regulations). For work over 40 hours a week (i.e. over 8 hours in any weekday), the company paid one-half times the regular rate. The company also paid twice the regular rate for work on weekends (Saturdays, Sundays) and holidays. Let us assume John Smith, an assembly-line mechanic, worked the following hours during the week of January 23, 2009: 1) 40 regular time hours; 2) 8 overtime hours; and 3) 8 weekend-holiday hours.  Smith’s wage would be calculated as follows:

The amount paid to employees, however, is less than gross earnings because employers are required by law to withhold certain amounts of taxes, which employers directly send to according government agencies. The liabilities for employee payroll withholdings are discussed below.