What Does Arrears Mean in Accounting?
Clarify the nuanced term 'arrears' in accounting. Distinguish between overdue payments and payments for completed services.
The term ‘arrears’ in accounting and finance has a dual meaning: it refers to both past-due obligations and a standard method of payment for services rendered. Understanding these distinct applications helps individuals navigate financial agreements, from personal loans to business transactions.
Understanding Overdue Payments
The most common interpretation of ‘arrears’ relates to payments that are overdue. When an account is ‘in arrears,’ it signifies the payment has not been made by its due date. This situation arises across various financial commitments, including loan installments, utility charges, or rental payments. For the debtor, falling into arrears means failing to meet a financial obligation on time, which can trigger additional costs and negative consequences.
Creditors face delayed revenue and may initiate collection efforts. A missed loan payment typically incurs late fees. Many financial agreements, such as mortgages, often include a grace period, allowing payment without penalty. If payment is not received within this grace period, the account becomes past due.
A payment 30 days or more late can be reported to credit bureaus, significantly impacting an individual’s credit score. Negative marks can remain on credit reports for up to seven years, affecting future borrowing ability and terms. The Fair Credit Reporting Act (FCRA) governs how these late payments are accurately reported. Creditors may also pursue further actions, such as imposing higher interest rates or, in cases of prolonged delinquency, initiating collection proceedings or foreclosure on collateral.
Payments Made After Services
Beyond overdue payments, ‘arrears’ also describes a routine payment schedule where payment is provided after services or goods have been received. This concept, often called ‘paid in arrears,’ does not imply lateness or financial distress. It represents a standard practice where compensation follows the completion of work or the consumption of a service. This method ensures payment is for fulfilled obligations.
A common example of being paid in arrears is employee payroll. Individuals work for a defined pay period and receive their wages at the conclusion of or shortly after that period. This delay allows employers to accurately calculate hours, process deductions, and manage administrative tasks.
Some rental agreements stipulate that rent for a given month is paid at the end of that month. This contrasts with the more common practice of paying rent at the beginning of the month for the upcoming period. In these scenarios, being ‘paid in arrears’ reflects the agreed-upon timing of payment, which follows the delivery or consumption of the service.
Common Accounting Scenarios
When a loan payment, such as a car loan or mortgage, is missed, the account moves into ‘arrears.’ If a payment is not made by its due date and grace period, the account is considered in arrears, attracting late fees and potentially impacting the borrower’s credit standing. The lender will then contact the borrower to resolve the past-due amount.
In corporate finance, ‘dividends in arrears’ applies to cumulative preferred stock. If a company’s board decides not to pay a dividend on cumulative preferred shares, that missed payment accumulates as dividends in arrears. These accumulated dividends must be paid to preferred shareholders before any dividends can be distributed to common stockholders. This protects preferred shareholders by ensuring their dividend rights are prioritized, even if delayed.
Payroll processing is a routine example of payments being ‘in arrears.’ An employee’s paycheck covers work completed during the preceding pay period. This allows for accurate calculation of hours, overtime, and deductions before funds are disbursed. Businesses process and disburse wages after the work has been performed.
For rental agreements, both meanings can apply. If a tenant fails to pay their monthly rent by the due date, the rent becomes ‘in arrears,’ signifying an overdue obligation. Conversely, some lease agreements are structured so that payment is made at the end of the period for which the property was occupied. In such cases, a tenant ‘pays rent in arrears,’ which is a normal contractual arrangement.