Everyone loves payday. Waking up to a direct deposit in your bank account is a good feeling! But to make that direct deposit happen, employers need to go through the complex task of running payroll. It isn’t just about cutting checks, either—it’s about managing records of wages, deductions and net pay for all workers and employees.

Of the many financial operations of a company, payroll is one of the most nuanced and complicated. It only gets more complex the more workers you bring on or the more locations a business operates in. Moreover, the accuracy of this accounting practice plays a major part in the financial transparency of a company’s fiscal reporting. All this is to say that payroll—like any accounting task—is paramount to get right. 

The Chief Components of Payroll

Much of the payroll process happens behind the scenes, automated by software or outsourced to an accountant. For example, there’s a substantial number of moving parts, including:

• Employee tax and identification information (Form W-4)
• Salary, wage and bonus information, as well as overtime pay
• Employee time and hours
• Deductions and withholdings
• Benefits, including health insurance and retirement matching
• Taxes, including social security, Medicare, disability, etc.

All this information factors into several key end results. Employees get a paycheck. Tax authorities gain revenue. Governments gain employment verification information. Companies disburse cash and fund retirement plans. Payroll is an essential cog that keeps the company churning along month after month.

Understanding Gross Pay vs. Net Pay

Through payroll, an employee’s gross pay becomes their net pay. Specifically, it’s the amount they see on their paycheck. The difference between the two is everything withheld or deducted during the process: taxes, contributions, premiums, etc. 

For example, an employee might accept a job that makes $80,000 annually. However, if taxes amount to $15,000, that employee’s take-home is $65,000. This might drop even further to $50,000 if that employee also contributes $15,000 to their 401k each year. To calculate (run) payroll, employers follow a simple formula: 

Net Pay = Gross Pay –Taxes, Withholdings and Deductions

In general, gross pay vs. net pay is an important concept for employers to keep in mind. And it’s something prospective hires will negotiate on. In fact, a firm grasp on payroll helps both sides better-understand the position. 

Payroll for Employees vs. Contractors

Many businesses employ a mix of hired employees and contracted staff. As a result, payroll operations are different for these two groups.

• Employees who fill out a W-4 and receive standard wages have taxes and withholdings taken out of gross pay. The net pay on their paycheck is their take-home amount. 
• Companies don’t take any taxes out of payments made to contractors. Instead, they get a 1099 at the end of the year, which reports all payment amounts made to them. It’s up to the contractor to pay taxes accordingly. 

Payroll can become very tricky as staff diversifies. Companies working with out-of-state contractors or that have international employees face a much more rigorous process, to ensure the final payment amount is an accurate one—and that taxes are handled appropriately. 

How to Process Payroll

There are three options for processing paychecks and income taxes each month. And each comes with pros and cons. The best option depends on the size of the business, the complexity of its payroll operations and cost considerations. 

• In-house. Companies with an in-house bookkeeper, controller or accountant can perform this action in-house. Overall, this saves the cost of outsourcing. However, it brings liability in-house, as well. In-house payroll tends to be best for larger organizations with a larger staff. 
• Outsourced. Outsourcing involves contracting an accountant or accounting firm to handle complete tax, bookkeeping and payment duties. This partner performs all calculations, recordkeeping and execution of payroll. Therefore, you are taking the task completely out of the hands of the company. Examples include companies like Bench or Gusto.
• Software. A simple intermediary between in-house or outsourced payroll is the use of software. There’s no shortage of applications out there, designed for businesses big and small, each with features and tools to simplify and automate the process. QuickBooks, FreshBooks, Sage and Zoho are popular examples.

Many businesses also opt for hybrid solutions, which allow them to use software to automate while a third-party accountant executes payroll actions. 

Why is Payroll so Important?

Payroll doesn’t just keep people paid on time—it also keeps businesses out of tax trouble. In fact, it represents a record of employment and fair wage disbursement. Moreover, it also serves numerous other purposes.

• Keeps employers protected against accusations of unfair wages and payments
• Protects employees by ensuring they’re eligible for unemployment and other benefits
• Ensures reporting compliance with state and federal tax authorities
• Creates a paper trail for business operational expenses related to wages and taxes

Without payroll operations, businesses wouldn’t be able to pay taxes, pay employees, contribute to retirement plans or healthcare premiums. Specifically, every paycheck represents the culmination of a business’ accounting due diligence.

Payroll is a Critical Business Function

On the surface, payroll is important for getting checks out to employees on-time and in-full. Behind the scenes, it’s also about maintaining transparent records for the purpose of company tax and bookkeeping. Ensuring accurate tax withholdings, retirement contributions and more all factor into paying workers the right wages and keeping the business tax compliant. 

To say payroll is a critical business function is an understatement! However, you can learn more about financial reporting with Investment U. Sign up for the Investment U e-letter below to receive daily investing tips and financial insights!