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What are Arrears in Accounting?

Posted by Kashoo Team on November 12, 2014 at 2:22 PM

"Your account is in arrears."

What?!?! That can't be good! What does that mean?

Take a deep breath and let's shed light on what exactly arrears means in accounting. For starters, did you know that "arrears" can actually apply to three separate financial situations, not all of them strictly negative?

Payments in Arrears

When a payment is in arrears, such as payment on a utility bill or a payment to a supplier for goods or services, it means that there is a debt owed which is now considered overdue. The amount of the debt that is in arrears is accrued starting from the date of the first missed payment. This can lead to some confusion on the part of the debtor when they're being billed at regular intervals (on a monthly basis, for example) and miss a payment or two, then resume regular payments. Just because you've resumed making regular payments doesn't mean there isn't still an outstanding debt.

Let's look at a quick example. Say you are being billed each month by your phone company for $200. In the past, you've paid your bill on time each month, but then in April you miss your payment. In May, you make your payment on time, and continue doing so in the following months. However, from the phone company's perspective, your account is still in arrears for $200, the amount of your missed payment from back in April.

Missed payments like this definitely reflect poorly on your company's financial standing in the eyes of creditors and investors, so it's in your best interest to avoid falling behind on your bill payments (known in accounting as Accounts Payable). Some common situations that can lead to payments falling into arrears include disputes with suppliers, not having a solid accounting system in place, or an invoicing mix-up, such as the supplier forgetting to send one or the buyer forgetting to record it. (Want to learn about best practices for invoicing? Check out our recent blog post, The Art of an Effective Invoice.)

Annuities in Arrears

While having payments in arrears is far from being an ideal situation, having annuities in arrears is actually not a negative thing. An annuity is a financial transaction that occurs in equal amounts and at equal intervals over time, such as repayment of a loan. When the annuity occurs at the end of each fixed interval rather than at the beginning, it's known as an annuity in arrears. One example would be a loan with installments due at the end of each calendar month. Another example would be a salary paid at the end of each month, after the work being paid for has already been completed.

Dividends in Arrears

Another case where arrears comes into play is when a publicly-traded company issues dividends (funds paid out on a regular basis to the company's stockholders). If the company is late on paying cumulative dividends to its preferred stockholders (a type of dividends that must be paid out regardless of the company's profits), there is often a legal agreement in place that will prevent the company from issuing dividends to its common stockholders. The company's use of cash may also be restricted so long as the cumulative dividends are in arrears.

See? Arrears isn't so bad all of the time. Have more questions? Give us a shout at answers@kashoo.com, and stay tuned for our next post!

Topics: Accounting Basics