Let’s Talk Accruals: Using accruals is a simple and accurate way to spread expenses over multiple months (or periods) or move from one month to another. The idea is to recognize the expense in the same month as the income it produces. An example is payroll for hours worked in March, but not paid until April. To get a truly accurate income statement, you’ll need to move the expense back into March. We can do this using an accrual.
The Problem: Many small businesses expense payroll when paid rather than the period when the work was done. The problem you may have noticed with this is that every few months, there’s an extra payroll in the month which causes that month to look less profitable (and also causes the other months to look more profitable). In fact, if you have a weekly payroll, this will occur every three months, and if you have bi-weekly payroll, every six months.
Our Example: Let’s use a weekly payroll of $5000 for the last week of March. The period worked is March 26th – 30th (assuming a five-day work week). However, the payroll is not paid until the following Friday, April 6th. If we expense this when paid, the entire $5000 hits in April even though that’s not when the work was performed.
Setting up the Journal Entry: We will create two Journal Entries in your accounting software to create and then reverse the accrual. Begin by dating your Entry on the final day of the month. To set up the Journal Entry, the first line is Labor Expense (or Labor COGS, whichever you normally use to record payroll expenses). The second line is Payroll Liability. If you are creating the Payroll Liability account for the first time, this should be classified as an Other Current Liability.
Next, we will enter our amounts. In this case, we will use the entire $5000 for the payroll. Labor Expense is a $5000 debit, and Payroll Liability is a $5000 credit.
In the Memo line, I like to add the following details: Period 03/26-03/30: 5/5 days paid on 04/06. This tells us everything we need to know about the transaction.
Next, let’s Memorize the transaction so it will already be set up for next time. If you are using QuickBooks, there should be an icon towards the top of the Journal Entry box that says Memorize. Click this to save the current entry as a template for next month. This will save time and maintain consistency when you want to recreate the entry next month. Let’s name the entry Payroll Accrual Monthly. Do not set this up for automatic entry since the amounts and memo line will change each month.
Now we are ready to save the entry. In QuickBooks, use the Save icon at the top of the Journal Entry Box (rather than the Save & Close or Save & New at the bottom of the screen). Once saved, with the Journal Entry still up, click the Reverse icon. QuickBooks defaults to the first of the month, but I prefer to change the date on the reverse entry to the date of the payroll, in this case it’s April 6th. You will notice here that the expense has moved to the credit side and the liability has moved to the debit side. Hence the name, Reverse Entry.
Another, Tougher Example: Not all your payrolls will line up perfectly as in the first example. Let’s go a month ahead and look at the end of April. This has two issues. First, there is a full week 04/23-04/27 that will be paid on May 4th. Second, there is another day April 30th that will be paid on May 11th.
For simplicity, we are going to combine these into a single entry. We take the full payroll of $5500 for the week of 04/23-04/27. Notice, there was a fluctuation in the labor amount from our previous example. We can pull up our memorized transaction Payroll Accrual Monthly from the Memorized Transactions List. In QuickBooks, this is under the Lists dropdown menu.
First, let’s update our date to April 30th and begin revising our memo lines. For April, this should read: Period 04/23-04/30: 6/5 days paid on 05/04; 05/11
Let’s explain: we want the period to include all payroll dates included in the accrual. 6/5 days tells us we are accruing an entire period plus one extra day (Monday, April 30th). Because we have accruals from multiple payrolls, we are listing both payroll dates.
For the amounts, we will multiply our week of payroll times the fraction of days. Make the fraction 6/5 into a decimal 6 ÷ 5 = 1.2, and multiply by the payroll total $5500 x 1.2 = $6600. This amount will replace each of the numbers in the entry. Labor Expense debit $6600; Payroll Liability credit $6600.
We are ready to Save and then Reverse. Be sure to change the date of the reverse entry to the first payroll date of May 4th.
Some Slight Variations: We used a weekly payroll and five-day work week in our example, but you will want to adjust this based on how your business pays and operates. For example, if you pay bi-weekly with five-day weeks, your basis for a period would be 10/10 days. You would then count the number of working days within the payroll period that are paid in the following month. Or if you are biweekly with seven-day operations, the basis would be 14/14 days.
Using Accruals places expenses into the period which they occur and will give you a more precise financial picture of your business. I hope applying this method will help you avoid the expense bump of having an extra payroll hit your books every few months.