If you pay your employees every other week but your income is recognized monthly, your revenue will not be matched to the expenses that helped earn it. On your income statement (P&L), expenses would be understated in some months and overstated in others. As a business owner, this inability to match expenses with income is frustrating because you don’t have an accurate idea of how your organization is doing.
A journal entry at month end works to accrue a liability for the wages your employees earned but you have not yet paid. Here are the four steps to creating an accrual journal entry and solving this problem so that your P&L is more meaningful.
Step 1: Determine the Number of Days for Which Wages Were Earned but Not Paid If your paycheck dates are July 21 and August 4 (blue circles), wages have been earned from July 22-31 but not yet paid to your employees. Without a journal entry, the money earned over these 10 days (red-shaded days) is missing from the July P&L. For the month, this understates your Cost of Goods Sold/Payroll Cost and overstates your Net Income.
Step 2: Determine the Payroll Cost
For the days shaded in red, you must determine the gross payroll cost incurred. If your staff are salaried, calculating the cost is straightforward: salary divided by 365 multiplied by 10= the number of red-shaded days.
For hourly staff, review the timesheets and calculate the hours worked during the red-shaded days. Be mindful of staff earning different hourly rates.
Step 3: Prepare the Accrual Journal Entry
Prepare a journal entry dated the last day of the month with the amounts calculated in step two. The debit in this journal entry will go to a Wages Expense account. More than one debit for wages expense may be needed depending on the detail with which you break down your staff’s earnings (e.g. wages per department, training, vacation, etc.). The corresponding credit will go to a Wages Payable Liability Account.
You may wish to make a similar accrual journal entry for tax expense and tax payable. The calculation for this number is to multiply the gross payroll expense by the employer’s tax responsibility percent. See Video.
Step 4: Reverse Journal Entry in Step 3
On 1st day of the next month, you would reverse the prior entry. See Video.
Step 5: Record Next Month’s Payroll
Now, record the next payroll as you always do. Reversing the prior entry will automatically adjust your Wages Expense for the month the payroll was paid.
At BudgetEase, we love making financial data understandable and useful to small business owners. If you need a more accurate monthly picture of your labor costs and net income or have any other questions about best practices when it comes to tracking the costs to run your business, BudgetEase is here to help!
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