Understanding how payroll process work (or flows) is a must to those who involve in the payroll issues (from payroll clerk, bookkeepers, accountants, or even IT personnel—who design a payroll system for the first time). If you are one of them, I hope this paper is worth reading.
It could be, also, a good refresher for those who have been involved in payroll issues for a long time, but who have not updated their skills recently. A new control may also need it.
This post discusses two essential topics in the payroll flow process—based on type of system most likely used by companies: (a) computerized; and (b) manual payroll system. But before going to those specific flows, let’s see: how payroll, in general (disregard types of system used), flows from the beginning to end of the process. Although some of the steps may not apply to each of the processes (on a specific system), I do believe it gives a good feel for how a payroll is completed. Let’s start with the first step. Read on…
Payroll Process Flow in General
Irrespective certain type of system used, in general, payroll process works through the follow sequential steps:
- Step-1. Setting Up New Employees – New employees, in the hiring process, must fill out payroll-specific information—such as the W-4 form and medical insurance forms that may require payroll deductions (in the U.S). Copies of this information should be set aside in the payroll department in anticipation of its inclusion in the next payroll.
- Step-2. Collecting Timecard Information – Office staff and managers definitely require no change in wages paid for each payroll, but an employer must collect and interpret information about hours worked for nonexempt employees. This may involve having employees scan a badge through a computerized time clock, punch a card in a stamp clock, or manually fill out a time sheet.
- Step-3. Verifying Timecard Information – Whatever the type of data collection system used in the last step, the payroll staff must summarize this information and verify that employees have recorded the correct amount of time. This, of course, involves having supervisors review the information after it has been summarized, though more advanced computerized timekeeping systems can perform most of these tasks automatically.
- Step-4. Summarizing Wages Due – This should be a straightforward process of multiplying the number of hours worked by an employee’s standard wage rate. However, it can be complicated by overtime wages, shift differentials, bonuses, or the presence of a wage change partway through the reporting period.
- Step-5. Keying Employee Changes – Employees may ask to have changes made to their paychecks, typically in the form of alterations to the number of tax exemptions allowed, pension deductions, or medical deductions. Much of this information must be recorded for payroll processing purposes, since it may alter the amount of taxes or other types of deductions.
- Step-6. Calculating Applicable Taxes – The payroll staff must either use IRS-supplied tax tables to manually calculate tax withholdings or have a computerized system or a supplier determine this information. Taxes will vary not only by wage levels and tax allowances taken but also by the amount of wages that have already been earned for the year-to-date.
- Step-7. Calculating Applicable Wage Deductions – There are both voluntary and involuntary deductions. Voluntary deductions include payments into pension and medical plans, while involuntary ones include garnishments and union dues. These can be made in regular amounts for each paycheck, once a month, in arrears, or prospectively. The payroll staff must also track goal amounts for some deductions, such as loans or garnishments, in order to know when to stop making deductions when required totals have been reached.
- Step-8. Accounting for Separate Manual Payments – There will inevitably be cases where the payroll staff has issued manual paychecks to employees between payrolls. This may be caused by an incorrect prior paycheck, an advance, or perhaps a termination. Whatever the case, the amount of each manual check should be included in the regular payroll, at least so that it can be included in the formal payroll register for reporting purposes, and sometimes to ensure that the proper amount of employer-specific taxes are also withheld to accompany the amounts deducted for the employee.
- Step-9. Creating a Payroll Register – Summarize the wage and deduction information for each employee on a payroll register, which can then be used to compile a journal entry for inclusion in the general ledger, prepare tax reports, and for general research purposes. This document is always prepared automatically by payroll suppliers or by in-house computerized systems.
- Step-10. Verifying Wage and Tax Amounts – Conduct a final cross-check of all wage calculations and deductions. This can involve a comparison to the same amounts for prior periods, or a general check for both missing information and numbers that are clearly out of line with expectations.
- Step-11. Printing Paychecks – Print paychecks, either manually on individual checks or, much more commonly, through a computer printer, with the printouts using a standard format that itemizes all wage calculations and deductions on the remittance advice. If direct deposits are made, a remittance advice should still be printed and issued.
- Step-12. Keying Payroll Information in General Ledger – Use the information in the payroll register to compile a journal entry that transfers the payroll expense, all deductions, and the reduction in cash to the general ledger.
- Step-13. Sending Out Direct Deposit Notifications – If a company arranges with a local bank to issue payments directly to employee accounts, then a notification of the accounts to which payments are to be sent and the amounts to be paid must be assembled, stored on tape or other media, and sent to the bank.
- Step-14. Depositing Withheld Taxes – The employer must deposit all related payroll tax deductions and employer-matched taxes at a local bank that is authorized to handle these transactions. The IRS imposes a rigid deposit schedule and format for making deposits that must be followed in order to avoid penalties.
- Step-15. Issuing Paychecks – Paychecks should, at least occasionally, be handed out directly to employees, with proof of identification required; this is a useful control point in larger companies where the payroll staff may not know each employee by name, and where there is, therefore, some risk of paychecks being created for people who no longer work for the company.
- Step-16. Issuing Government Payroll Reports – The government requires several payroll-related reports at regular intervals, which require information on the payroll register to complete.
Computerized Payroll Work Process
Computerized payroll system is so popular—almost every company has at least a basic one. Why? Payroll software is very inexpensive, as it is now bundled with accounting software that costs just a few hundred dollars. More comprehensive systems that can be used for large numbers of employees are more expensive, but are a cost-effective solution for large entities, of course.
The basic process flow for a computerized payroll process is shown below:
A fully automated process involves the review and verification of hours worked and other changes as entered by the employees, followed by the processing and printing of payroll reports, filing of direct deposit information and payroll taxes, and the distribution of paychecks.
The flowchart assumes a complete automation of all key payroll functions. For example, a computerized timekeeping system is assumed. This system requires employees to run a badge through a time clock that can reject the scan if the employee is clocking in at the wrong time or attempting to work during an unauthorized overtime period.
By using such a system, the payroll process is considerably reduced at the front end, with the payroll staff only having to investigate missing badge scans. Also, the process flow assumes that employees can make their own deduction and address changes through an interface to the payroll software, so that the payroll staff only has to review these changes.
Further, the process flow assumes that the timekeeping database used by the time clock computer feeds directly into the in-house payroll software, which eliminates the keypunching of payroll data.
An in-house system requires the payroll department to file several tax returns (if the payroll process is outsourced then it would be filed by the payroll supplier). These include the quarterly federal tax return, the annual federal unemployment tax return, and annual W-2 forms to employees. There may also be a variety of state reports to file.
Further, an in-house system that uses direct deposit requires the payroll staff to create a database of direct deposit information and send it to the company’s bank, which uses it to process direct deposits to employees; this would have been handled by a payroll supplier. Third, the in-house payroll database must be backed up and stored, which is normally handled by the payroll supplier.
Finally, an in-house system requires the payroll staff to summarize all tax deposits, fill out remittance forms, and file payments with the federal and state governments at regular intervals. Consequently, no matter how much control a company may feel it has by using an in-house computerized system, the payroll staff will have a number of additional tasks to perform.
A computer payroll system, no doubt, would rise the potent of payroll-related fraud. Therefore, a proper internal control—specifically designed for payroll system—becomes ‘must-have’. For example:
If a computerized timekeeping system is being used, then there are no controls required for timekeeping activities, since the computer can spot them. If your company does not have such a system, then you would need to have one or design a strong control system for the area.
There should be an approval process for overtime hours worked, as well as for negative deductions.
Note: Negative deduction is essentially a payment to an employee, and if used repeatedly, even incrementally small amounts could add up to a significant pay increase for an employee.
For larger companies with many employees, one should also compare the addresses on the employee paychecks to see if a fake employee has been added to the system, with the check being mailed to a current employee’s address to be cashed by that person.
Note: You can also issue a list of people receiving paychecks to the department supervisors to see if any fake names or the names of departed employees crop up.
Check stock and signature plates should be securely locked up at all times, only appointed staff would have the access. You would need to review un-cashed checks and performing bank reconciliations. These controls are designed to spot payments made to employees who are no longer with the company and who, therefore, never received the checks (which were probably issued in error).
Finally, fake employees can also be spotted by handing out checks directly to employees and having them show some form of identification before they receive their checks.
Though not all of these controls are necessary, one should select those that make the most sense for a company’s specific circumstances.
Manual Payroll Work Process
An increasingly rare payroll system is the completely manual approach that avoids all use of payroll suppliers or in-house computer systems. This system is most commonly found in very small organizations where the additional labor required to calculate wages and taxes is not too onerous for the small accounting staff.
The manual process requires extra labor in three key areas:
- First Area – Employees are filling out timecards by hand or with a punch clock, so the payroll staff must use a calculator to add up the hours worked, verify the calculations (since this task is highly subject to errors), notify employees about missing time entries, and have supervisors approve any overtime hours worked.
- Second Area – The payroll staff must multiply hours worked by hourly pay rates to determine wages for the nonexempt employees and then use IRS-provided tax tables to determine the amount of taxes to withhold, plus the amount of matching taxes to be remitted by the company. This task is also subject to a high error rate and should be reviewed with care.
- Third Area – The payroll staff must create paychecks from the prior information and manually summarize the results into a payroll register. Since employees want to see all deductions broken out on their paychecks, the paycheck writing process is lengthy.
In comparison to an in-house computer system solution described previously, the manual payroll process is painfully slow and is at risk of so many errors that the payroll staff will find itself taking a disproportionate amount of its time to ensure that outputs from the process are correct.
The manual payroll work process is shown below:
As you can see on the chart, it does not mention the preparation of a direct deposit database that can be forwarded to a bank, since it is most unlikely that a company without means to calculate its payroll on a computer will be able to create the direct deposit database.
Since there is an assumption of having no automated timekeeping system in place, two key controls are verifying total hours worked and obtaining supervisory approval of overtime hours worked.
Other controls later in the process are similar to those found in the computerized in-house system, since some watch over check stock and signature plates must be maintained.
However, some of the reviews for fake employees at the end of the process, such as comparing addresses on checks, can probably be discarded, since this type of process is typically used for companies so small that the payroll staff knows exactly who works for the company.