Introduction to Compensation and Benefit Design: Applying Finance and Accounting Principles to Global Human Resource Management Systems

This chapter is from the book

Compensation and Benefit Design: Applying Finance and Accounting Principles to Global Human Resource Management Systems

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This chapter is from the book

This chapter is from the book 

Compensation and Benefit Design: Applying Finance and Accounting Principles to Global Human Resource Management Systems

Learn More Buy

The Current Accounting for Compensation and Benefit Cost Elements

Now that you know the commonly used terms in compensation and benefits, let’s explore how these compensation and benefits cost elements are reflected in accounting systems.

If an employee’s job entails directly producing a product (as part of a manufacturing operation), accounting systems classify that employee as direct labor. Another common identifier for this grouping is touch labor. Touch labor refers to those people required to touch the product during the manufacturing process. Those employees who are involved in the manufacturing process but are involved in a supporting activity (such as the manufacturing manager or the janitor who cleans the factory floor) are included in manufacturing overhead. A commonly used term for this category is indirect labor. In cost accounting, manufacturing overhead is absorbed into unit product costs through various mechanisms, such as job order costing and process costing. All the specific compensation elements are lumped together by the accounting process into two accounts, normally called direct labor or indirect labor. Both of these account categories become a part of the cost of goods sold cost.

For manufacturing companies, the gross profit is calculated by subtracting cost of goods sold from the revenue. In accounting, therefore, the employees directly involved in making a product contribute toward the achievement of the gross profit of an organization. And in manufacturing, companies’ monetary outlays for those employees not involved in making the product are considered period expenses. Normally these expenses are part of the selling, general, and administrative expense account. The selling, general, and administrative expense and other indirect expenses are deducted from gross profit to derive the net income or loss.

Cost of goods sold in the service industry refers to the cost of the employees or machines directly involved in providing the service. Other items like electricity to run the machines and those employees who are not directly connected to providing the service are usually included as part of selling, general, and administrative expenses. This is an overhead or indirect expense. And as stated before, these expenses are deducted after the gross profit is calculated, to arrive at the net profit or income.

Let’s look at an example for a construction company. In a construction company, the compensation paid to workers directly involved in construction activities is a part of cost of goods sold, whereas employees who support them (estimators, clerks, material handlers) are included in the selling, general, and administrative expenses.

Note that the actual practice of classifying employee expenses either in cost of goods sold or in overhead expenses can vary from company to company.

In a merchandising business, there are no raw materials, work in process, or finished goods accounts. There is only a merchandise inventory account. All purchases of goods bought for resale become a part of the merchandise inventory account. Only when a specific item sells is the acquisition cost of that item then transferred from the merchandise inventory account to the cost of goods sold account. It is then subtracted from sales revenue to derive gross income or profit. In merchandising businesses, all employee expenses are classified into general expenses, which appear on the income statement after the calculation of gross profit or income.

In financial reporting, some employee costs are included in the asset section of the balance sheet. In addition, employee-related monetary transactions are often included in the balance sheet in a liability account called salary or wages payable. This suggests that some earned wages have not been paid to employees.

A case can be made that most HR cost outlays can be classified as assets. This argument might have some merit if you consider that the compensation paid to software engineers, scientists, electronic engineers, and development engineers is a CAPEX. A case can be made that these types of employees are indeed the true assets of a company, especially in high-technology and biotechnology firms. They have rare skills, and losing one of these critical skills might result in a decrease in the value of a business. But current accounting thinking does not concur with this line of thought. Current accounting standards state that expenditures should be included in financial statements only if they are clearly measurable in monetary terms and there is reliability and relevance. The accounting profession asserts that there are problems in determining relevant and reliable values for human assets. Accountants believe that human capital measurements are not up to par on reliability and accuracy. If accurate measurements are found, perhaps human capital values can be included in financial statements. But most likely, they would appear as footnote disclosures.

The point to note here is that the HR and payroll systems are identifying employee expense outlays differently from accounting systems. Accounting systems do not capture the true cost flows for the HR financial outlays.

Exhibit 1-1 summarizes all the compensation and benefit cost flows. In one place, it shows the accounting flows of all total compensation elements and also indicates the accounting classification most likely used to record these transactions.

Exhibit 1-1. A Summary of the Flows

The Accounting of HR Cost Outlays – How Payroll Systems Work

Now that you understand cost and expense classifications in general and the HR designations of employee cost outlays, this section covers how accounting systems currently report employee cost transactions in the accounting cycle.⁷

Payroll departments are responsible for making payments to employees. But not all employee payments are transmitted from the payroll department. Some payments are made as expense reimbursements.

Exhibit 1-2 shows the payment transactions normally disbursed from payroll departments.

Exhibit 1-2. Payment Transactions Made from Payroll Departments

Exhibit 1-3 indicates in summary form how a typical payroll process works, which we explain in more detail.

Exhibit 1-3. Payment Transactions Made from Payroll Departments

In addition, payroll systems track payment transactions differently depending on how pay is recorded in HR processes and systems. Employee designations commonly use designations such as salaried, monthly, weekly, or hourly. It should be noted that these are payroll-related computational designations rather than what is conventionally thought–an employee ranking or status designation. If an employee is designated as an hourly employee, the computations in the payroll system might be as in the following example.

Suppose that John Peters is one of six hourly (non-exempt) employees who work for Bagan, Inc. Bagan has a biweekly payroll process. Let’s also say that the biweekly period starts on March 16 and ends on March 30. The first week of this period started on March 16 and ended March 23. And during this period, John worked for 46 hours. Federal law in the United States stipulates that any nonexempt employee who works for more than 40 hours a week needs to be compensated at a time-and-a-half rate for those extra hours.⁸ In this case, 6 hours are over the 40-hour limit. Suppose John’s hourly rate is $25.20. In that case, his weekly gross pay is calculated in this manner:

• 40 hours @ $25.20 = $1,008.00
• 6 hours @ $25.20 × 1.5 or $37.80 = $226.80
• Total gross earnings for the week = $1,234.80

In the United States, tax is withheld from the gross wage income (which for John Smith is calculated based on his documented deductions on his W-4 form and withholding tax publication–Circular E, provided by the Internal Revenue Service). After that, state income tax withholding is also deducted from gross pay. In addition, the payroll department must withhold Social Security taxes or FICA ( Federal Insurance Contribution Act ). This tax is actually two taxes. One tax is called the Old-Age, Survivors, and Disability Insurance (OASDI), and the other is known as Medicare (hospital insurance). The rates for OASDI and Medicare are, respectively, for 2012, 6.2%⁹ and 1.45% of gross wages. In addition to these deductions, other deductions will be needed, such as the employee portion of an employee health insurance program (if there are any for the organization).

To further illustrate the gross earnings to net earnings calculation, now let’s assume that for the second week, the March 26 to March 30 pay period, John worked 40 hours.

So, here is the gross to net calculation:

Deductions:

Other possible payroll deductions and adjustments include the following:

• City and county taxes, if any
• Before-tax employee contributions
• 401(k) employee contributions (disbursed to TPAs*)
• Health savings account (disbursed to TPAs*)
• Flexible spending accounts (disbursed to TPAs*)

Employer Payments

Also note the potential employer payments made on behalf of an employee:

• Federal Unemployment Tax (FUTA)
• Statement Unemployment Tax (SUTA)
• Employer-matching contributions for 401(k) plans
• Workers’ compensation premiums
• Employer portion of Social Security taxes paid on behalf of an employee

Accounting Record Keeping

In the accounting process, employee payment transactions are journalized, posted to the ledger, and recorded in the financial statements in the manner shown in Exhibit 1-4 .

Exhibit 1-4. Employee Payment Transactions

This is not necessarily the case in manufacturing companies, where employee payments can be a part of work in process, finished goods, or cost of goods sold. Exhibit 1-5 gives a description of the accounting entries recorded for payroll transactions.

Exhibit 1-5. Accounting Entries for Payroll Transactions

Note here that after these transactions are incurred they become payables and remain on the balance sheet until those outlays are paid out from cash. At that point, those transactions become income statement accounts.

Accounting for Payments Made to Salaried Employees

For employees who are classified as salaried, the payroll status is normally stated as a monthly wage. This is not a job-level designation. It indicates that in the payroll system these employees’ compensation payments are recorded on a monthly basis. In the United States, salaried employees are usually exempt from the provisions of the Fair Labor Standards Act. In other words, they do not have to be paid overtime for any hours they work over 40 hours in a week.

Federal law in the United States that governs overtime earnings is called the Fair Labor Standards Act, which is part of the federal wage and hour legislation. All employers engaged in interstate commerce have to adhere to the Fair Labor Standards Act. There are also state wage and hours legislation with which employers must comply.¹⁰

The payroll system pays these employees their fixed monthly salary on each pay date. If the pay period is biweekly, these salaried employees are paid their monthly rate divided by two. The stated salary rate will be gross pay from which the employee’s specific payroll deductions are subtracted. These deductions are similar to those used for hourly employees (as described earlier in this chapter).

Other Technical Payroll Accounting and HR Issues

First, there is the issue of thirteenth- and fourteenth-month payments made in many countries outside of the United States. Normally, in the United States, the workday is 8 hours in duration. In a 52-week year, that makes 2,080 work hours in a year:

• 8 hours a day × 5 days a week × 52 weeks in a year = 2,080 hours

In the United States, the number of hours employees can work is 2,080. But we know that most employees take at least two weeks of vacation during the year. Those two weeks are paid vacation days. Therefore, in the 52-week year, the employee does not necessarily work the entire 2,080 hours. If the employee takes a two-week vacation, he or she actually works 2,000 hours. But, employees are paid their annual stated salary. This is because a salaried employee’s stated salary is an annual amount. It could also be stated on a monthly basis. In the latter case, you just have to multiply the monthly salary by 12 to get the annual stated salary. Therefore, in the United States, paid vacation is built in to the annual or monthly stated salary. Holiday pay is treated in the same manner.

In some countries, the monthly or annual salary covers only hours actually worked. The vacation is paid as an extra month: the 13th month. The 13th-month payment is identified differently in different countries. In some countries, it is a bonus granted to all employees. In other countries the Christmas bonus is a legal requirement. The additional-month payment adds to wage costs. In Greece, which is in economic chaos, the payment of the 13th month has become a political issue.

The main purpose of this chapter was to explain how the accounting process and the HR process classify compensation and benefit elements. As you learned, to accurately understand and record HR financial transactions, processes have to be developed to record these expenditures to better understand their impact on operational and strategic business decisions. For example, the critical strategic and operational decision about workforce reductions is often made based on accounting data, which is much narrower in scope than HR inflows and outflows classifications. If a more broadly scoped HR accounting data-gathering process were adopted, business decision makers might not be as willing to terminate the services of thousands of people so readily. As you know, workforce reduction results in devastating consequences for those employees who lose their jobs and for society as a whole.