Paid in Arrears: What Does it Mean?
If you work in payroll or accounting, you’re probably familiar with the phrase “paid in arrears.” But this knowledge shouldn’t be limited to the accounting department. The term has implications for business-wide activities, so it’s essential to understand what it means and how it applies to your business.
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What is “Paid in Arrears”?
To understand the meaning of this phrase, let’s first break it down into parts. “In arrears” is a financial and legal term that refers to a late or overdue payment. If a bill has not been paid by its due date, it’s “in arrears.”
Therefore, “paid in arrears” means paying for something after it has been received. Depending on whether the phrase is used in accounting or payroll, this could refer to goods or services. Either way, paying something in arrears is the opposite of paying in advance.
For individuals, missed bill payments could put their accounts in arrears. This would typically have negative consequences.
However, in business, payments that are in arrears do not necessarily mean that the payment is delinquent. Instead, it could simply mean that two parties agreed upon settling payment after the goods or services were delivered.
Paid in Arrears Meaning in Payroll
Companies often pay employees in arrears. This means the employees are paid for work completed in a previous pay period. For example, employees may receive their monthly salary on February 1 for work carried out throughout January. In this case, they would be getting paid for work already completed. In other words, they would be paid in arrears.
Paying in arrears allows a business time to calculate total wages for the current pay period. This may include wages earned from commissions, tips, or overtime.
However, paying in arrears is not the standard for every industry. Some professions or industries require payment in advance for work that is not yet complete. For example, a manufacturer may demand payment in full before launching production.
Paid in Arrears Meaning in Accounting
In terms of accounting, paying in arrears refers to goods and services received from external vendors instead of employees.
For example, let’s say a restaurant receives a shipment of tomatoes from a supplier. The invoice states that payment should be received in full within 30 days. This means the restaurant has received the goods upfront and must settle payment in arrears. They can now use the revenue gained from food sales to generate cash to pay the invoice.
However, an account in arrears can sometimes refer to an account behind payments. Suppose the restaurant still hasn’t paid the invoice 60 days later. In that case, their account is in arrears, and the supplier may choose to cut off deliveries until arrears payments are settled.
Benefits of Paying in Arrears
There’s a reason why many businesses prefer to issue payments in arrears. The benefits include:
- More Flexible Payments
Paying in arrears is not governed by strict terms. Instead, it’s up to the supplier of goods or services to determine when payment is due. In some industries, 30 days may be standard, while others offer even more flexible arrangements. For payroll, arrears offers employers a more convenient payment schedule.
- More Time To Calculate Payroll
When employers pay employees in arrears, it’s given more time to add overtime, PTO, payroll taxes, commission, tips, or benefits. This isn’t possible when paying in advance.
- Greater Accounting Accuracy
Paying in arrears guarantees that the accounting team has more time to double-check whether the invoices match the goods received. This cuts down on costly errors leading to refunds and overcharges.
- Lower Risk Of Paying For Uncompleted Work
Unlike paying in advance, paying in arrears means you only pay for work already performed. This ensures that your business gets the most out of each dollar spent.
Drawbacks of Paying in Arrears
There are some potential disadvantages to paying in arrears. These may include:
- Late Payments
If a company bills in arrears, it could potentially have a negative impact on cash flow. Since the company is waiting on payment for work already completed, it may have trouble directing enough working capital to immediate operations. In addition, the accounting department may use precious resources to chase down late payments.
- Lost Revenue
There’s always a chance that a client will fail to settle their invoice altogether. This can happen due to a missed payment caused by a temporary lack of funds or going out of business. Depending on the situation, recovering payment from accounts in arrears can be challenging.
- Risk Of Falling Behind On Payments
When paying in arrears, there’s a risk that the accounting workload will pile up and be difficult to handle. When this happens, it’s possible to fall behind on payments, risk penalties, or upset vendors.
Best Practices for Paying in Arrears
If not approached strategically, paying in arrears can introduce challenges for a company’s financial strategy. So, it’s essential to act according to best practices, such as:
- Request down payments from clients to help manage cash flow
- Use accounting software to keep track of payments
- Implement a routine when paying clients or suppliers
- Conduct client credit checks to make sure they’re financially sound
By following this advice, it’s possible to avoid most of the major pitfalls when paying in arrears.
Paid in Arrears vs. Paid in Advance
Paid in arrears is the opposite of paid in advance. Arrears refers to a payment that is issued after goods or services are completed or delivered. In contrast, advance payments are given upfront before goods or services are provided.
Paid in Arrears
Whether a bill should be settled in arrears or in advance depends on the context. For example, employee salaries, utility bills, and taxes are all payments typically settled in arrears. Since these payments depend on calculating amounts that can change over a period, it doesn’t make sense to pay for them upfront.
Restaurants often pay suppliers in arrears. This allows them to issue payments covering multiple deliveries simultaneously rather than dealing with individual invoices.
Paid in Advance
On the other hand, some payments are settled in advance. For example, insurance premiums, prepaid phone bills, and rent are generally paid before the service has been delivered.
Law firms usually demand a retainer for their services. This is a form of advance payment, although it doesn’t cover the services in full. It may only represent part of the final payment due. After the client’s arrangement with the law firm ends, they’ll be billed for the total services rendered minus the retainer.
Example of Arrears
In the classic meaning of the phrase, arrears refers to overdue accounts. So, if you fail to pay your $700 mortgage payment by its June 31 due date, your account will be in arrears for $700 by the following business day. Your account will remain in arrears for $700 until the payment is submitted. If you pay off $500 of the June 31 payment, you’re in arrears for $200.
In terms of payroll, arrears refers to payment after the work is completed. Let’s say a restaurant pays its employees in arrears bi-monthly. After the first two weeks of the month, the employer calculates employee wages for the current pay period. They may add additional wages in the form of tips or other benefits or make deductions for absences. After calculation, they pay employees in arrears on the following business day.
For accounting purposes, arrears refers to settling accounts for goods and services with external vendors. For example, suppose a supermarket receives a new shipment of fresh milk. Since they did not pay for the milk up front, they will settle the payment in arrears. According to the invoice terms, they may have 30 or more days to pay the bill. If the supplier doesn’t receive payments before the pay period ends, the account will be in arrears.
Arrears has several different meanings depending on the context of the financial obligations. In business, it generally refers to paying for goods and services already delivered or completed. In other words, it’s the opposite of paying for something in advance.
Settling payments in arrears is a common practice for many businesses. It carries several benefits, such as allowing for more payroll flexibility and time to conduct accurate calculations. However, it may also introduce complications like delayed payments or lost revenue for suppliers.
When accounting for payments in arrears, staying on top of payments is essential. Otherwise, there’s a risk of too many unpaid bills accumulating and putting pressure on cash flow. Small business owners should use the right accounting software to help keep all their finances organized.
FAQs on Paid in Arrears
What is the opposite of paying in arrears?
Paying in advance is the opposite of paying in arrears. While paying in arrears means settling payment after work is completed, paying in advance means paying upfront for work yet to be completed.
Why do companies pay a week behind?
Arrears payroll has advantages for most companies. It allows them more flexibility when processing payroll and time to generate cash flow to cover the payments. In addition, it gives the accounting department more time to calculate things like payroll deductions or additional wages accurately.
How do you calculate arrears when paying employees?
When calculating arrears payroll, first start with the regular monthly or weekly salary. Then, calculate the amount from the previous paycheck to the current pay period. Finally, subtract any amount already paid for this period, and add extra wages for tips, overtime, or employee benefits.
Does being in arrears affect your credit?
Yes, that’s why it’s crucial to pay bills and mortgage payments on time. Overdue payments remain on your credit report for six years, negatively affecting your credit score. However, the impact on the overall score reduces over time.