Bookkeeping – Estimating Employee Benefits (Lesson 84)

Another required estimate needed in accounting relates to employee benefits. Employee benefits consist of vacation, sick time, retirement benefits, healthcare and other de minimus benefits. As a function of accrual accounting these benefits are estimated and posted as a deferred liability in the accrued payroll section of the current liabilities section of the balance sheet. This lesson explains how to calculate the respective benefits and post this information to the books. In addition, associated taxes and compliance costs are also included in the formula for the accrual. Another section explains the process of adjusting the account balance for actual amounts taken by an employee when they are paid or receive their benefits. Finally, I’ll explain how to reconcile the account at year-end.

Employee Benefits – Accrued Payroll – Two Methods

A standard work year is 2,080 hours calculated as follows:

Standard Work Week –  40 Hours
Weeks in a Year             52
Total Hours per Year    2,080

The problem with this is that many companies do not operate on religious or federal holidays. There are ten widely accepted holidays:

    1) New Year’s Day                      6) Labor Day
    2) Martin Luther King Day         7) Columbus Day
    3) President’s Day                       8) Veteran’s Day
    4) Memorial Day                         9) Thanksgiving
    5) Independence Day                10) Christmas

In addition, many companies pay for additional holidays including Good Friday, the Friday after Thanksgiving and Christmas Eve. When an employee gets paid and the respective holiday falls within the pay period the bookkeeper simply adds that holiday ‘s hours to the employee’s paycheck. The accounting for holidays is included in labor costs as if the employee worked. But it is important to note something here, these 10 days at 8 hours each means that the company is paying 2,080 hours per year for 2,000 hours of actual labor. In effect it is paying for 2,080 gross hours for a net of 2,000 hours. This gross and net is the basis of the two methods.

Gross Method

It is important to differentiate between the two methods. The gross method means all benefits are calculated on the 2,080 hour work year. If an employee is entitled to two weeks of vacation per year, it means the employee is allowed 80 hours of paid time off every 2,080 hours of paid time. Therefore an employee is getting vacation time accruing to him even during a holiday that he is off. To further drive this point home, he is earning vacation time while he is on vacation.   

Net Method

Unlike the gross method, the net method only allows the employee to earn vacation time for physical hours worked. The policy states, ‘Vacation time accrues at the rate of 80 hours for every 2,080 hours physically worked’.  In a typical case, the misunderstanding is not only financially significant, but is also a point of contention between employee and employer.  

To illustrate, assume an employer uses the gross method of accruing benefits and provides (pays) 12 holidays per year and in addition, pays for five sick days per year too. The employer grants 80 hours (2 weeks) of vacation per year and pays his employee $15 an hour. What is the difference between the two methods?

                                                Gross Method                Net Method
Gross Hours Per Year                    2,080                               2,080

     Holidays (Actual)                         96                                     96
     Sick Time*                                   40                                     40
     Vacation*                                      80                                     80
Actual Hours Worked                   1,864                                1,864

Pay @$15/Hr for Actual           $27,960                            $27,960
Pay @$15/Hr for Holidays           1,440                                1,440
Pay @$15/Hr for Sick Time            600                                     –
Pay @$15/Hr for Vacation            1,200                                   –    
Total for Actual & Earned         $31,200                            $29,400
Actual Sick Time Allowed & Paid (1,864 * .01923)                538 *35.85 Hrs Earned Based on Actual Hrs Worked
Actual Vacation Time Allowed & Paid (1,864 * .03846)       1,075 *71.69 Hrs Earned Based on Actual Hrs Worked
Total for Actual & Earned (Net Method)                            $31,013

 * Sick and vacation are earned on physical hours worked at the rate of .01923/hour of work for sick and .03846/hour of work for vacation time.

There is a difference of $187 per year per employee between the two methods.

This may seem a small amount but multiply by 10 employees and the value is significant for a small business. There are other elements of accrual when calculating the payroll.       

Employee Benefits – Employer Taxes and Insurance             

Whenever payroll is processed several employer taxes come into play. These taxes include Social Security and Medicare matching taxes commonly referred to as FICA or Form 941 taxes. In addition federal and state unemployment taxes are due. Finally, workers compensation insurance is based on the gross payroll amount and varies based on the duties of the employee and the respective state of employment. Here is a simple table for reference:

Employer Taxes
Social Security Match                        .062 per  $1.00 of wages 

Medicare Match                                 .0145 per $1.00 of wages
FUTA                                                 .008 per  $1.00 of wages (up to $7,000)
SUTA * varies by state                      .0265 per $1.00 (assumed)
Workers Compensation Insurance     .0114 per  $1.00 Note  ‘A’
Total                                                   .1224 per $1.00 of wages

‘A’  – Workers compensation insurance varies based on the particular job function. For example high-rise metal fabricators or bridge workers may have rates of $18 per $100 of compensation. Office employees are prone to paper cuts and their rates are in the $1 per $100 of compensation range.

The schedule above is adjusted annually based on the changes to SUTA and workers compensation insurance rates. Most employers fall within the 11.5% to 17% range for taxes and insurance. This value is included in the accrual calculation.

Employee Benefits – Accrual Calculation

Generally Accepted Accounting Principles are founded on matching revenue with actual expenses associated with earning that revenue. Each hour of labor for an employee costs more than just the gross wage and associated employer taxes. The employee has earned a right to their benefits based on that hour of service. This benefit has a corresponding financial cost and an obligation to pay it placed on the company. Before continuing with this section, please acquaint yourself with a basic payroll and its reporting requirements. Please read the following lessons:

The core entry for payroll is a debit to labor costs and a credit to either cash and/or accrued payroll. The accrued payroll is a control account with identifiers for each of the respective taxes and benefits.

To calculate earned benefits, I encourage accountants to do this monthly using a simple spreadsheet and set the formulas based on whether the company uses the gross or net method of determining earned benefits. Here is a simple example.

                                                      HARBAUGH LANDSCAPING INC.
                                               Payroll Benefits Accrual Worksheet (Net Method)
                                                                October 2016
Employee/Type    Pay Hrs     Holiday     Actual Hrs/Wrk    Vac Earned@.03846   Rate    Benefits Value
   ‘A’  – Salary         176              8              168                        6.46                        $19.43     $125.54
   ‘B’  – Salary         176              8               168                       6.46                          17.96       116.02
   ‘C’  – Hourly        168              8               160                       6.15                          13.00         80.00
  ‘D’   – Hourly        176              –               176                       6.77                          13.00         87.99
  ‘E’    – Hourly       176               –              176                      Note (3)                        –                  –
                               872            24              848                                                                       $409.55   

(1) Salaried staff automatically accrue rights to holiday pay.
(2) Rate is the equivalent earnings per hour based on compensation for that employee.
(3) Employee ‘E’ has not vested in his/her right to accrued vacation; has yet to have been with the company for a minimum of one year per employment policies.

During the month of October the staff at Harbaugh was paid for 872 hours of which 848 where physically worked (employee ‘D’ worked the holiday and was not entitled to the day off). The rate per hour is the pay rate based on the hourly compensation or the employee’s based rate per hour using the salary as the numerator. The total benefits value reflects the estimated gross pay that will be paid in the future for vacation time. This value must be accrued first.

In addition to the gross wage value, the employer should accrue the associated taxes and insurance items. The simplest method is to develop an employer taxes table as illustrated above. A cumulative rate is generated as the single value to add to the gross wage for the total cost of benefits. Assuming the employer tax rate is in accordance with the table above the total expense is as follows:

Gross Value of Benefits Earned      $409.55
Employer Taxes @ 12.24%                50.13
Total Cost of Benefits Earned         $459.68

Before explaining the entry, let’s refresh ourselves with the account structure for this business. Over in the cost of sales section, the account structure looks like this:

    – Materials
    – Labor    (Parent-Child Structure)
        — Salaries
        — Hourly
        — Payroll Taxes
        — Employee Benefits
    – Subcontracting
    – Equipment
    – Compliance
    – Other

Over in current liabilities the structure is as follows:

   – Accounts Payable
   – Subcontractor Payables
   – Credit Cards
       — Home Depot
       — Lowes
  – Accrued Expenses (sales tax,  income taxes,  insurance, bonding)
– Accrued Payroll  (Parent-Child Structure)
      — Employment Taxes (Control Account)
      — Vacation
      — Retirement
      — Other
– Billings in Excess
– Contract Deposits
– Line of Credit
– Current Portion of Long-Term Debt

Notice that employment taxes are separated from the vacation value? This is to maintain separation of governmental compliance (Lesson 33) and employee agreed amounts. Now let’s make the entry.

Remember, this entry has three distinct dollar values involved; 1) the expected gross wage to be paid when the employee takes a vacation; 2) the associated payroll taxes for those gross wages and 3) the cost of the workers compensation insurance for the gross wages paid when the employee goes on vacation.   Here is the entry:

Payroll Journal or General Journal
Date           ID                    Ledger                 Control ID      Description                             DR         CR  
10/31/16   EOM-PR/Oct   Benefits                    –                Vacation Earned/Oct             $409.55
                 EOM-PR/Oct   PR – Taxes               –                 941/FUTA/SUTA @.111         45.46
                 EOM-PR/Oct   Other                       –                  Est. Workers Comp                   4.67
                 EOM-PR/Oct   Employment Taxes  B                941/FUTA/SUTA                                    45.46
                 EOM-PR/Oct   Other                        –                 Est. Workers Comp                                   4.67
                 EOM-PR/Oct   Vacation                   –                 Vacation Earned in Oct                          409.55   
                                                                                                                                         $459.68    $459.68

A few important insights are warranted at this point in this lesson.

(A)  Notice in the entry above under the current liability, Employment Taxes, the control ID is identified as ‘B’ and not broken out into the respective individual control identifiers for 941, FUTA and SUTA. This actually reduces the workload for the accountant when it comes time to actually disburse monies to the government after the employee actually takes a vacation. Remember, the IRS uses the cash basis for payroll purposes. This is an accrual entry whereby ESTIMATES are being made. The control ID’s for 941, FUTA and SUTA are on the cash basis and are used in reconciling actual amounts owed to the government. At the end of the quarter when reconciling the payroll taxes due (liability account), the bookkeeper can clearly identify the amounts owed on the cash basis of payroll and reconcile these amounts to the government reports. In addition, the bookkeeper has a separate value related to accrued payroll that is due in the future but not yet owed to the IRS.

(B)  Notice workers compensation insurance is posted to other in cost of sales and in current liabilities as a debit and a credit to the books. Typically when the insurance premium is paid there is a debit to cost of sales ‘Compliance’ or ‘Insurance’ and a credit to either cash or accounts payable. A concern arises in how to clear out this accrued estimated amount for insurance when an employee(s) takes a vacation. The answer is relatively simple. At the end of the year, the total value of accrued vacation is reconciled. This dollar value is then multiplied by the workers compensation rate and a balance of expected insurance premium is determined.  Simply adjust the balance in other for workers compensation to match. The offsetting debit or credit goes over to the cost of sales account ‘Other’ to balance the entry.

Another option is to not calculate the cost of workers compensation insurance related to the gross pay assigned to estimated benefits. Why? Look at the dollar value involved. The $4.67 is not going to make or break Harbaugh Landscaping. This is especially true once a company matures, as over time, vacation accruals will begin to equal actual vacation taken effectively nulling out this value. If overall workers compensation rates are less than 3%, I would not include this amount in the formula. Its effective impact is of de minimus value and will not affect management decision models.                                                                                                                                                           

 (C) Another common benefit provided by employers is retirement. Most small business employers pay a fixed percentage on gross wages like a SIMPLE Plan. Since these percentages are less than 3% it is suggested that the accountant ignore this value in estimating benefits. This approach keeps this estimating process simple and basic. Now that the accrual has been posted, how does the bookkeeper pay the amounts at vacation time or when the benefits are payable?

Employee Benefits – Payment of Earned Benefits

The accrual account for any benefits earned including vacation, sick or employee medical insurance is merely an estimate grounded in the spreadsheet updated monthly. An employee’s actual amount of time off earned is tracked within the payroll records (most payroll software programs will track this benefit). When the employee exercises his benefit it is now time to update the accrued liability.

First off, the actual payment of the earned vacation is paid just like a normal payroll and posted to cost of sales as an expense for labor. Immediately, you should realize the value is double counted in the expense section as this benefit has already been accrued. Good payroll software will deduct the number of hours taken from the hours earned by the employee within the employee’s records. 

Secondly, the key is the spreadsheet’s benefits dollar value.   It should match the value posted to accrued benefits under accrued payroll. When the employee is paid for his vacation, simply calculate the value as a negative amount in the earned column or create a ‘Vacation/Sick Time Used’ column and record the negative value there. The total amount will most likely be a negative amount for the month. Simply enter a reverse entry i.e. a credit to benefits in cost of sales and a debit to accrued payroll – benefits. Don’t forget to post a credit for the corresponding payroll taxes to the payroll tax expense account and a debit to the employer taxes account with a control ID of ‘B’. Note how this offsets the actual recorded from the payroll run when the employee is actually paid for his vacation.

The final step is reconciliation of the estimated accrued benefits.

Employee Benefits – Reconciliation of Accrued Benefits

As stated above, the spreadsheet is instrumental in accurately calculating estimated benefits each month. Create the spreadsheet by labeling it ‘Employee Benefits – 20ZZ’ and generate a tab for each month. Generate a cumulative column related to vacation, sick and employer taxes. This cumulative amount is updated each month by the changes during that month including earned amounts and amounts actually paid. The final balance should match both the accrued vacation value at gross wages and the employer taxes value located in payroll taxes due under the respected control identifier, in Harbaugh’s case, the letter ‘B’.

Any small amount of difference is simply adjusted to the income statement as a month end adjusting journal entry. Larger discrepancies are researched to discover where the error was made during the month. Amounts totaling less than $50 are insignificant and usually represent changes in the hourly amounts paid to employees.

For example, Harbaugh gives a raise to employee ‘C’ during the month. The raise is 50 cents an hour. Employee ‘C’ has accrued 65 hours of vacation prior to the raise. In effect, the accrued vacation value at the end of October will need to be adjusted higher for $32.50 (65 X .50) along with the associated taxes. Remember when employee ‘C’ is paid the benefit it will be paid at his higher hourly rate. Therefore the accrual value should reflect this higher rate.

Insights and Summary – Estimating Employee Benefits

In much larger companies (more than 25 employees) this accrual value gets to be a significant dollar amount. As a company grows, management and owners need to understand and accept the fact that there are obligations beyond the current pay period. Imagine this accrual value if dealing with unionized labor contracts. It is an essential value for financial decisions and a critical skill needed for the accountant to estimate the dollar value of employee benefits. Just remember with this accrual it is OK to be off a few dollars. What is not acceptable is to ignore accrual of payroll benefits because the total dollar value is a small percentage of total payroll.

Estimating employee benefits is easy when the accountant understands the difference between the gross and net methods of determining benefits. The gross method calculates benefits on the total year of 2080 hours whereas the net method calculates benefits on actual hours worked.

Use a spreadsheet to calculate the dollar value of the benefits earned and paid each month based on the benefit method used by the company. At the end of each month enter the change in value to both the income statement and the accrued payroll in the current liabilities section of the balance sheet. Separate the employer taxes related to accrued benefits by using a separate control ID to distinguish actual payroll from future estimated taxes.

When accrued benefits are actually paid, adjust the spreadsheet and post the change as a month-end journal entry. Be sure to reconcile the accrued values separately from actual amounts paid. ACT ON KNOWLEDGE.

© 2018 – 2022, David J Hoare MSA. All rights reserved.

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