Paid in arrears might sound like a complicated accounting term, but the definition of arrears is pretty straightforward.
“In arrears” (pronounced as /əˈrɪrz/ or /əˈrɪəz/) simply means a payment is behind.
This can be intentional (how the contract was written and expectations were set ahead of time) or unintentional (you or a customer missed a due date for a payment).
In arrears can apply to both billing and paying. These example sentences show usage:
- If you bill in arrears, you bill something after you’ve provided goods or services.
- If you pay in arrears, you pay for an item or service after you receive it.
What does arrears mean when it comes to payroll?
In the world of payroll, paying in arrears usually refers to paying an employee for work completed from a previous pay period instead of the current pay period.
For example, let’s say you paid your employees on January 20 for the January 1 – 15 pay period. Since your employees received their paychecks after they completed the work, you paid them in arrears.
The biggest impact paying in arrears has on employee payroll is that people aren’t paid immediately for their work. Instead, employees will usually get paid three to five days after the end of a pay period.
Why would a paycheck be paid in arrears?
Paying in arrears makes it easier to calculate and run your payroll schedule—especially if you have commissioned or tipped employees. That’s why most small business owners pay their team in arrears.
Paying your employees after they do the actual work gives you time to calculate the following things:
- Number of regular or overtime hours worked
- Tips collected
- Commissions and sales earned
- PTO taken
Paying in arrears lets you factor all of the above into your employees’ paychecks.
What’s the difference between paying in current and paying in arrears?
When you pay in current, you pay employees for a projected number of hours worked, such as what’s calculated for employee salaries. Instead of relying on an employee’s record of work performed, like a timesheet, you forecast the number of hours you think your employee will work for accounts payable.
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There’s no gap between the end of a period and payday (like there is when you pay in arrears). Instead, you pay employees at the end of the period, on the day the pay period ends or even while the pay period is still active.
For example, let’s say you pay your employees every Friday afternoon for the current week, which runs Monday through Sunday. This means you need to project the number of hours each employee will work on Friday, Saturday, and Sunday to distribute their paychecks on time.
What are the pros and cons of paying employees in arrears?
The biggest benefit of paying workers (such as hourly employees) in arrears for the previous week is that you don’t have to project employee hours and run the risk of your estimates being wrong. In other words, it makes running payroll more straightforward.
Imagine this. Your business pays in current every Friday for a Monday through Sunday workweek. With this type of payment, you project that Rhonda will work one eight-hour shift on Saturday and Ray will work one eight-hour shift on Sunday. But Rhonda gets sick on Saturday, and Ray is the only person available to cover the shift. Now Ray is working two eight-hour shifts over the weekend, and that puts him at overtime.
|Scheduled shifts||Hours each employee actually worked|
|Rhonda||8 hours on Saturday||0 hours on Saturday|
|Ray||8 hours on Sunday||16 hours on Saturday and Sunday|
Next week, when you run payroll, you’ll need to subtract eight hours from Rhonda’s paycheck and add eight hours to Ray’s paycheck. Plus, you’ll need to figure out Ray’s overtime pay.
When you pay in arrears, you avoid all of this work because you know ahead of time how many hours Rhonda and Ray worked.
Paying your team is less labor-intensive and it gives you more time to calculate things like employee benefits and PTO before running payroll.
While paying in arrears is pretty common, some employees prefer to be paid immediately for the work they perform. Paying in current gets employees their paychecks faster, which many see as a benefit.
Here’s a breakdown of how paying in arrears and paying in current compare, when it comes to payroll:
|What it means (when it comes to payroll)||Pros||Cons|
|Paying in arrears||Paying employees and contractors after they’ve completed their work||It makes running payroll easier since you don’t have to estimate hours||Your employees may not appreciate getting paid later|
|Paying in current||Paying employees and contractors while the pay period is still active or right when it ends||Employees get paid faster, which makes them happier||You have to forecast how many hours each employee will work—and fix future paychecks if your estimate is wrong|
What does paying in arrears mean when it comes to accounting?
Paying in arrears doesn’t just apply to payroll—it also means paying for goods or services after you receive them.
If you work with a vendor or service provider who gives you a payment term of net 60, you’ll be billed in arrears, since you have 60 days to pay for the items you received. This means that you pay the vendor after you receive the goods or services, so you’re paying in arrears. Another example is paying a contractor’s invoice for services already rendered.
In these scenarios, your vendors have agreed to be paid in arrears as opposed to upfront. This practice can be beneficial for your cash flow because it gives you extra time to come up with the money to pay bills. If you have a 90-day period of time to pay for merchandise, you can use that time to sell merchandise and generate cash to pay back your vendor.
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However, sometimes paying in arrears means that you’re behind on bills. In this case, your business is “in arrears” until the missed payment is made.
Here’s an example. Imagine that that you have a $500 monthly recurring payment.
- You pay September and October’s monthly payments on time.
- You miss November’s regular payment due to an accounting mistake.
- You pay December’s payment.
December’s amount is applied to November, January’s payment is applied to December, and your account is never current. Instead, it is “in arrears” until you make two payments to make up that overdue payment.
Paying in arrears isn’t always right for your business (unless it’s unavoidable with how you pay hourly workers or freelancers), because it means that you’re behind on your bills and are a certain amount in short-term debt on your financial statements until the arrearages are paid. Your vendors may make you pay a fee for a late payment, increase your interest rate, shorten the amount of time you have to pay in the future, or even refuse to do business with you.
Those are all the details you need to know about the definition and use of arrears. Now you have one more not-so-intimidating accounting term to add to your word-of-the-day or word list covering small-business knowledge that may prove useful to how you run your operations.