What is payroll accounting and how does it work for UK businesses?

Payroll accounting is the essential process of recording employees’ compensation, deductions and related tax liabilities in your company’s general ledger.

What is payroll accounting?

Payroll accounting is the system used to track all business expenses related to labour and employment.

This goes beyond just ensuring your team gets paid, requiring a precise recording of gross wages, taxable benefits, employer taxes and other deductions in your financial records.

What does the accounting process involve?

The payroll accounting process involves balancing a complex equation where you must account for what you owe employees, the government (via HMRC), and third-party providers, such as pension schemes and insurance companies receiving deductions made on behalf of your staff.

This process ensures that your financial statements reflect the true cost of your workforce, including all salaries and benefits.

By maintaining a clear audit trail and accurate information, you ensure transparency, build a foundation for accurate financial planning, and make sure you save valuable time during audits.

Why is payroll accounting accuracy important for growing businesses?

Accuracy in payroll is vital since errors can lead to severe financial and reputational damage. If your data is incorrect, you risk underpaying staff and failing to meet HMRC obligations.

Growing businesses, whether small start-ups or established mid-sized enterprises, simply cannot afford the disruption of a tax investigation.

Furthermore, precise records enable better cash flow management. By keeping strict control over your accounts, you will be able to forecast expenses accurately. This is particularly important as we move through 2026 and look towards 2027, where tightening margins will demand robust financial oversight.

How do you record payroll entries?

You record payroll entries by transferring data from your payroll system into the general ledger via specific journal entries.

This acts as the bridge between your HR data and financial reports, ensuring that each and every penny is accounted for.

What is the basic principle of recording payroll entries?

The basic principle is to record gross pay as an expense, and to record your various liabilities as payables until they are actually paid out.

This accrual method ensures costs are recognised when they are incurred, rather than simply when cash leaves the bank. This means it provides a more accurate picture of your company’s financial health at any given moment.

What kinds of accounts are required for payroll accounting?

You generally need three main categories of accounts to track payroll effectively: expenses, liabilities, and cash:

1. Expense accounts capture the gross cost to the business, such as salaries and Employer NI.

2. Liability accounts hold amounts owed to employees and authorities, such as Net Pay and HMRC.

3. Cash accounts reflect the final payment from your bank.

What does a typical journal entry look like?

Making a standard payroll journal entry typically involves three main steps:

1. Debiting gross expenses from the expenses account

2. Crediting resulting liabilities to the liabilities account

3. Recording the cash payment when it leaves the cash account

So, after you have debited the gross wage expenses, you credit your liability accounts for taxes, insurance, and net pay. Finally, when the cash leaves your bank, you debit the liability accounts and credit the cash account.

Example of a payroll journal entry for a UK business:

Ensuring these figures are accurate is the primary responsibility of the finance team. In doing so, you must also take care to ensure that deductions for any student loans, court orders and other similar deductions from pay are captured correctly.

What are common payroll accounting mistakes?

Common payroll accounting mistakes include misclassifying workers and failing to reconcile accounts, both of which can lead to significant financial penalties. Avoiding these pitfalls is essential for maintaining healthy business operations.

Why is worker classification critical?

Misclassifying an employee as a contractor, often referred to as ‘disguised employment’ under IR35 rules, can lead to severe penalties from HMRC regarding unpaid taxes and National Insurance.

Therefore, you must accurately determine the employment status of every worker, to ensure the correct deductions are made and accurately reported.

How do reconciliation errors occur?

Reconciliation errors often occur when there is a disconnect between your payroll data and your bank payments.

Regular checks are necessary to ensure the amount paid to employees exactly matches the net pay recorded in your general ledger.

What’s important for payroll accounting compliance in 2026?

Your regulatory focus for 2026 should centre on managing the ongoing National Insurance rates, preparing for Statutory Sick Pay reforms, and navigating the future of benefits reporting. Managers must stay abreast of these changes to remain compliant.

How has National Insurance changed?

A significant factor for employers in the current tax year is the adjustment to National Insurance Contributions (NICs). The main rate for Employer Class 1 National Insurance remains at 15%. Additionally, the Secondary Threshold, at which employers start paying NI on an employee’s earnings, sits at £5,000 per year. The double whammy change means that the cost of employing staff is effectively higher than in previous years.

Crucially, the UK government has confirmed that the £5,000 threshold will be frozen until April 2031. This long-term freeze means that as wages rise with inflation, a larger proportion of your payroll will become subject to employer NI, effectively increasing the tax burden year on year. Therefore, finance leaders will need to adjust their long-term budgets to account for this.

What is the National Living Wage outlook for 2026/27?

The UK Autumn Budget 2025 confirmed that the National Living Wage (NLW) will rise to £12.71 per hour for the 2026/27 tax year.

While the rate for the 2025/26 tax year will remain in place at £12.21 until April 2026, businesses must prepare for the rise to keep pace with median earnings.

Furthermore, the gap between the 18-20 age rate and the full adult rate is continuing to close. This helps younger workers, but increases the compensation bill for sectors that rely on younger labour.

How will Statutory Sick Pay change?

Statutory Sick Pay (SSP) will become a ‘day one right’ for all employees from April 2026, removing the previous waiting days. The major reform also removes the Lower Earnings Limit for eligibility, meaning even the lowest earners will qualify. Additionally, the standard weekly rate is confirmed to rise to £123.25 from April 2026.

Therefore, employers must update their processes to track sickness absence accurately from the very first day. Successfully navigating these new tax year changes is essential for ensuring your systems are ready for April.

What about reporting benefits in kind?

Reporting benefits in kind is currently transitioning, with mandatory payrolling of benefits now delayed until April 2027.

Until then, you can still use P11D forms to report taxable perks like health insurance or company cars at year-end. However, switching voluntarily to payrolling benefits sooner can reduce administrative admin and prevent potential tax code errors for your staff.

How does payroll software improve financial management?

Payroll software improves financial management by automating complex calculations and ensuring data consistency across your accounts. Managing these complexities manually is fraught with risk and often leads to errors in calculation or data entry.

Why move away from manual spreadsheets?

Spreadsheets do not update automatically when legislation changes, leaving you vulnerable to compliance risks. If you rely on them, you might miss a critical update to tax codes or NI thresholds.

Dedicated software solves this by pushing updates directly to your system, ensuring you are always using the latest figures.

Unlike federal systems found in some other nations where state and local taxes add layers of complexity, the UK system is centralised, yet the volume of data required for Real Time Information (RTI) reporting still demands a robust digital solution.

What features should growing businesses look for?

When selecting professional payroll services, look for payroll software that integrates directly with your general ledger.

Such integration automates the creation of the journal entries described earlier, streamlining the whole reporting process.

You should also prioritise systems that offer electronic payslips to employees, as this enhances transparency, as well as reducing paper waste.

Security is another critical factor. A cloud-based service often provides better security protocols than local files, protecting your company and your staff from data breaches.

Summary of payroll liabilities 2026

To help you plan, here is a summary of the key rates and thresholds affecting your payroll processes right now:

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