Processes

Accounting for Benefits (an Operational Accounting Overview)

By October 31, 2019 No Comments

By Lahiru Ganegoda

 

Typical Benefits Package of a US based company includes the following;

  • Health Insurance
  • Dental and Vision Insurance
  • Life and Disability Insurance
  • 401K

While some companies provide extended benefits like commuter benefits, gym reimbursements and childcare, the purpose of this blog article is to cover the ‘behind the scene’ general mechanics of the main benefits.

So, let’s understand the stakeholders involved, before we dive deep. For all benefit types above, the following parties play a role.

 

Stakeholder

Role

Employer Arrange and contribute full or partial cost of the benefit
Employee Beneficiary of benefits plans (including Family members). In most cases, responsible for a partial contribution
Carrier / Provider The actual provider of the benefit. (Insurance Companies like Anthem or Kaiser, 401K Trustees like Vanguard or Fidelity)
Benefits Broker The middleman that brokers benefits between carrier and employer

 

Most employers contribute a certain percentage of the benefits cost. This could be 50% – 75% for Health benefits. There is a recent trend of providing 100% of the health benefits in start-ups, just to attract the best talent. For retirement plans, it could be zero to a ‘full match’.

The actual cost for each employee depends on what health plan they pick, number of dependents etc.

Now, let’s take up an example to understand the components of a typical benefit and accounting mechanics that follows.

For ease of reference, let’s pick “Medical Benefits”. (For any other, just replace the word ‘medical’ with the name of the benefit and you can apply the same principles for accounting.

Example:

Insurance Premium for the Pay period                 :                       $1,000

Employer Contribution (75% employer)                :                       $750

Employee Contribution (The payroll deduction) :                       $250

 

The pay-period company contribution and employee deduction may not line up with how the carrier bills the employer for total cost (Premium). For example, almost all carriers bill by calendar month, while the pay period could be bi-weekly (say, every other Friday). The benefits broker will do the math and come up with pay-period deduction and contribution amounts. (Most modern payroll and HR systems also play the role of the benefits broker, and in these cases, the deductions are fully automated and accurate).

There are two commonly used methods to account for benefits.

 

Direct Method:

The carrier bill is recorded as direct expense and employee deductions care recorded as a credit to the health expense account.

When carrier bill (Say $2,000 for a full month) is recorded;

 

Dr. Medical Benefits Expense         $2,000

Cr. Accounts Payable (or Cash)                $2,000

 

At each payroll:

Dr. Payroll Clearing**                       $250 (The amount deducted from employee)

Cr. Medical Benefits Expense                     $250

 

** (Payroll clearing account is usually an account used to balance our various payroll components to cash paid out for a payroll period. In this example, effectively it is a reduction of $250 from employee gross pay)

After 2 payroll periods for the month (assuming the pay dates are 15th and last day of the month, for example), the “Medical Benefits Expense” account will show $1,500 ($2000 – $250 x 2). That is 75% of the insurance premium that employer agreed to bear.

This method is more convenient. However, if an error happens at carrier end, or if you miss a payment, it is not immediately visible by looking at the financials. So, the convenience comes at the expense of accuracy. Also, the expenses may not match with the correct period, as timing of the bills may not be aligned with the payroll frequency, as mentioned above.

 

Indirect Method:

 

At each payroll:

Dr. Payroll Clearing**                       $250 (The amount deducted from employee)

Dr. Health Benefits Expense             $750 (The amount contributed by employer)

Cr. Medical Benefits Payable                     $1,000 (This is a balance sheet liability account)

 

After 2 payroll periods, the “Medical Benefits Payable” liability will be $2,000 ($1,000 x 2)

 

When the bill is paid:

Dr. Medical Benefits Payable         $2,000

Cr. Accounts Payable (or Cash)                $2,000

 

In most cases, carriers bill in advance, so it is not unusual to have a negative balance in the “Medical Benefits Payable” account from time to time.

This is the more error proof method. If the balance in the “Medical Benefits Payable” grows with all other factors remaining the same (like; no new employee sign ups), it is an automatic red flag that a payment has not gone through. Similarly, if a negative balance keeps growing, it is indicative of incorrect employee deductions or missing entries. Indirect method also does not depend on “when” the bill is received or paid, and it enforces accrual basis accounting as a by-product of the process.

You may pick the best method based on the internal mechanics within your organization depending on systems and processes specific to you.

 

 

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