Small business owners have to deal with multiple various tasks. One of the most important tasks is handling finances. Such aspects as paying for rent and utilities, taking care of payroll, and properly maintaining inventory are just some of the expenses business owners have to handle.
Logically, business owners must organize billing and payments properly. It’s critical since employees and customers won’t tolerate payment problems. Company owners may choose between two payment methods — arrears payment or payment in advance. There is also a similar term — billing in arrears.
This article will explore these payment and billing methods and their advantages and disadvantages.
What Are Arrears?
Arrears, or in other words, arrearage, are payments used in many parts of the financial and even legal industries. Typically, arrears are used in banking, credit, and investment industries.
Arrears refer to an overdue amount after the payment due date, usually for accounts such as loans or mortgages. In simple words, it means that the payment is late. Arrears are used in car payments, child support, and utilities in the business world.
Understanding The Term Paid In Arrears
Paid in arrears means a payment for services or goods made after a due term. The payment may occur because the payee is missing the due payment time. It may also occur because the payment was scheduled after the service period. Arrears payments also sometimes occur because of the payment being missed mistakenly.
It’s also worth mentioning that arrears payment may be:
Intentional is when the company included the late payment in the contract. Unintentional occurs in all the cases mentioned above. In business, arrears mainly refer to two different processes:
- paying in arrears;
- billing in arrears.
Small businesses often pay their employees or vendors in arrears. Overall, employee payroll is typically a payment in arrears. It means that the employee gets paid for their work hours spent on the previous day, week, or month.
Billing In Arrears
Billing in arrears means your company charges clients upon you have provided services or goods. Typically, small businesses and service/goods providers choose to bill in arrears since it makes sense. For instance, it’s logical to ask a client for payment after repairing their PC. Usually, clients want to pay for services or goods upon seeing the results.
Small businesses choose this type of payment method since it helps avoid specific miscalculations. Suppose you’ve agreed to fix someone’s car. It’s logical to bill the client after providing the service since you don’t know what’s broken. It may be just the breaks, but there might be another problem.
As a result, companies don’t have to deal with the problems of overcharging the client and having to issue a refund. Moreover, you avoid the problem of undercharging clients and having to ask to pay more.
Why Do Companies Choose To Pay In Arrears?
Businesses prefer paying their service providers and employees in arrears because it’s common and makes the most sense. Paying at the end of a pay period gives a company the time to secure financing.
It could be by getting money from businesses that owe money or generating more sales. This payment method enables businesses to meet immediate needs with the promise to cover financial obligations afterward.
Payroll in arrears means the company pays its employees for the previous week’s work. The alternative option is paying on the current day when the worker gets paid at the end of the pay period.
Pros And Cons Of The Method
Before choosing a payment method, you should learn about the benefits and downsides.
The pros of the method include:
- Better flexibility. The good news is that companies can get more clients thanks to this method. Not all clients want to pay upfront, especially if these customers are new. With arrears payment type, businesses can offer convenient terms and conditions.
- Accurate payments. Businesses don’t always know how much their services will cost. Billing in advance may cause overcharges and refunds or undercharges and the need to charge more. But paying after providing services gives more freedom to businesses.
Even though the method has significant advantages, it has some disadvantages. You need to consider the following downsides before choosing the method:
- Risk of losing payments. Billing in arrears means your clients can have issues with paying. For instance, you may not receive payments if the client fails to receive an invoice. The customer may also have insufficient funds to pay or forget to cover the payment.
- Cash flow issues. Not all businesses can afford to wait for money because of cash flow. If your company can’t afford a cash-flow shortage, it’s not a convenient method.
- Risk of falling behind on payments. It could be difficult to balance the budget if the company has too many bills in arrears. There are high chances of falling behind on payments.
Consider the benefits and downsides of the payment and billing method before choosing it for your business.
Paying In Arrears In Accounting
No matter what payment method a business uses, it is critical to take into account the company’s budget and finances. When the company pays for services or goods after receiving them, the method is called paid in arrears. For instance, the company buys products from a local vendor with 20 payment terms. It means the business has to submit the payment within 20 days after the date of receiving the products.
In accounting, this method gives more time to the business to generate cash. As a result, paying later means the company can make more sales to cover their bills. Overall, paying in arrears is a more flexible method.
On the other hand, paying in arrears could refer to late payments. If a company is behind its bills, it means they are in arrears before the business covers the payment.
Paying In Arrears In Payroll
Typically, payroll is considered a paid in arrears type of payment given that employees receive money after completing the job. Arrears payroll means that a company has to pay a worker for the job they have done during the previous pay period. It is the opposite of the current pay model.
A simple example is when the company has to pay an employee on May 5 for the work they have already done during April. Given the worker gets their money after the work has already been done, the payment will be registered in accounting and payroll as paid monthly in arrears.
Companies using this method prefer setting up a calendar with notifications to make the process smoother and according to all requirements. The good news is that companies may use various accounting software types with calendars.
Setting up a calendar to pay in arrears allows companies to calculate everything included in the employee’s salary. The payment may include tips, commissions, overtime pay, etc.
There is one more alternative to this method, and it’s called pay “in current.” The method implies the company has to pay an employee for the projected number of hours they’ll work. The method is rather encouraging and allows building trust, but it could be extremely difficult in accounting.
Example Of The Method
Suppose John and Mark joined the team in an Example Company. John started work on June 1 and Mark on June 22. Even though Mark joined the team three weeks later, their pay period ends at the same time on June 30.
John and Mark will be paid for their work at the company during that month during the first week of July. The company won’t make Mark wait until July 22 for his first paycheck.
If John and Mark work at a company that pays for two weeks of work, it will pay them one week after the pay period.
Author: Charles Lutwidge