In the US, it is common practice for businesses to run payroll in arrears. Though the term “in arrears” doesn’t exactly roll off the tongue (and might even sound a little strange when hearing it for the first time), running payroll this way is generally considered a good thing for employers and can even be advantageous for employees.
So in this comprehensive primer, we’ll explore what it means to run payroll in arrears, its pros and cons, and how running payroll in arrears differs from paying vendors or invoicing clients in arrears.
Now that we’ve looked at these three scenarios, let’s discuss why an employer might choose running payroll in arrears over the others.
What does “paid in arrears” mean?
To put it simply, being “in arrears” means that a payment is past due. You may have come across this term on past-due invoices or heard it used in reference to an account that is not current. The meaning is a little different when it comes to employee payroll, though. That’s because “paid in arrears” means a payment is made after the end of the current payroll period. For example, if your payroll period runs from the 1st through the 15th of the month and you pay employees on the 16th of the month — you guessed it — that means you run payroll in arrears.
Running payroll in arrears allows business owners to fully compensate employees for all the work they have completed without having to estimate hours not yet worked. This approach to running payroll has significant advantages for both the employer and the employee, which we will discuss later in this article.
Do you have hourly employees? It’s likely your business runs payroll in arrears. However, if your payroll period runs from the 1st through the 15th of the month and you pay employees on the 15th, you run what is known as a current payroll because payment is made during the current payroll period. This happens most often when a business employs salaried workers whose pay is not contingent upon the number of hours they work.
What if you have a mix of hourly and salaried employees? Some businesses in this scenario run two payroll periods, but others will pay some of their employees — usually the hourly ones — in advance. Running payroll in advance simply means you are paying employees for time they have not yet worked. On the other hand, payroll in advance (or making advance payments) is the opposite of payroll in arrears.
Why would a company run payroll in arrears?
When you run payroll in arrears, your employees complete a full payroll period prior to receiving compensation for that period. Usually, there is an additional lag of at least a few days — and sometimes as much as a month — between the conclusion of the payroll period and the date your employees are paid. This “lag time” gives your payroll clerk the opportunity to verify all the time worked and process the payroll, which in turn ensures the accuracy of the payroll (keeping your team happy and productive).
There is a clear administrative advantage to running payroll in arrears, too. When employees get paid this way, you know you are only paying for the hours they have actually worked. This saves your payroll clerk some time because there’s no need to estimate the hours an employee will work, “true up” that estimate to the actual hours worked, and then make an adjustment for the difference on the next paycheck.
There is also additional lag time to verify the accuracy of the payroll and either process a direct deposit or print a check for the employee’s compensation. The main takeaway? By making sure all this information is accurate before payments are processed saves your company time and money.
But there is another, less obvious reason to run payroll in arrears: cash flow. That’s because:
- There’s often a lag between when a product is sold (or work is done) and
- When you receive the revenue for that product or service
So, being able to run payroll in arrears buys you a bit of extra time to collect that revenue before paying it out to your employees, which can go a long way toward keeping your business’s cash flow under control.
Though most employers probably don’t use the term “payroll in arrears” when discussing paychecks with their employees, the reality is that most companies use this method when running a business. That’s because it’s uncommon for a company — be it a retailer, a manufacturer, or a non-profit organization — to go through the additional administrative gymnastics required to pay hourly employees in advance or even to pay current.
Next, let’s cover some of the pros of this payroll method.
Are there advantages to running payroll in arrears?
When you run payroll in arrears, there are three clear advantages for you as an employer:
- You know you’re only paying for the work that an employee has actually completed. It reduces the risk of overestimating the hours an employee will work, which can put a strain on your cash flow.
- You don’t have to estimate hours that will be worked and then “true up” that estimate to the actual timesheet records in a future payroll period. The truing-up process can be cumbersome and also increases the risk of calculation errors.
- The lag time between the end of the payroll period and payday can improve your cash flow. Your company can use the lag time between the end of a payroll period and the date your employees receive their paychecks to bring in additional cash to cover the payout.
On the other hand, there are also benefits for employees.
- They know their paycheck is completely accurate. By paying employees in arrears, they can easily refer back to their timesheets for the payroll period and verify that they were properly (and correctly) compensated for all hours worked.
- They don’t have to worry about “losing” money to a trued-up payroll calculation. Yes, if you overpay an employee in one pay period and then reduce that overpayment in the next pay period, no one is actually “losing” money, but to the employee, it might seem that way. Paying in arrears gives the employee peace of mind that their paycheck is 100% theirs, allowing them to better budget their income.
- Depending on how far in arrears you run payroll, your employee could receive an “extra” paycheck after employment ends. Even though this isn’t technically a severance payment, getting an extra paycheck during a period of unemployment can can still make a big difference during an employee’s transition.
All that said, there are two sides to every coin, so let’s dive into the drawbacks, too.
Understanding the disadvantages of running payroll in arrears
As an employer, there are two downsides to running payroll in arrears.
- It’s more difficult to match expenses to revenue. When you run payroll in arrears, the expense for the work your employees have completed is sometimes recorded after receiving revenue. This can be managed with accrual accounting techniques, but you will need to engage a bookkeeper who understands how accrual accounting works if matching expenses to revenue is important to you.
- You could create a cash flow crunch for your business. Arrears payroll can either help ease your cash flow concerns — or it could potentially contribute to them. If your payroll varies from period to period and you forget your employees worked overtime (in a period they have not yet been paid for), you may spend the money you should have set aside for payroll on a different business expense. This can be managed with a cash flow management system but it makes sense to engage a bookkeeper for assistance.
For some employees, there could one significant drawback that a company want to consider.
- Payroll in arrears could negatively affect low-income earners. Some employees need to be paid as soon as possible in order to cover basic living expenses, like rent, groceries, and child care. A lag time of a week or more between working and getting paid could negatively affect on these workers, so businesses with a large number of low-income earners will often opt for either a current payroll model or a shorter lag time between the completion of a pay period and the date the employee receives their paycheck.
Now that we’ve covered some of the benefits and drawbacks of using this payroll method, let’s look at how to set it up.
What are some best practices for paying employees in arrears?
Communication is key when using arrears payroll, so making sure your employees know when they will be paid for work is an important consideration. Some ways to do this include:
- Publish a payroll calendar that shows when employees will be paid and which dates make up the pay period. It can also be a good idea to include information on what constitutes a work week for your company so employees can accurately estimate overtime they might work.
- If you pay a week or more after a payroll period ends, make sure new hires are aware when you’re making an offer. Sharing the date they will receive their first paycheck can go long way toward helping the newests members of your team plan accordingly.
- If you need to part ways, make sure an employee knows when they will receive their final paycheck before ending the relationship. Some states require employers to pay final wages immediately, while others allow the final payment to be made on the next regular payroll date. Whatever the case for your company, include a section in your company handbook to avoid unwelcome surprises during what is sure to be a stressful time for a former employee.
When employees have a clear understanding of when to expect their paychecks (and the hours that should be included on them), they typically won’t have any issues about being paid “in arrears.”
Next, let’s take a look at how this works in practice.
What are some examples of a payroll run in arrears?
By now, you’ve likely figured out that your company runs payroll in arrears. But if you run a current payroll, you might be wondering how payroll in arrears could look for your business.
To get a clearer picture, let’s cover a few common examples.
How does paying in arrears and paying in current differ?
Even if S&G had a policy of paying current, there might still be some sour moods in the office on January 15. That’s because either the accountant would have been exhausted after staying up all night calculating payroll after the last shift ended, or the employees would have been unhappy because they disagreed with the estimated overtime hours they were paid for.
This is part of the reason why most companies with hourly employees run payroll in arrears instead of current payroll. A current payroll is manageable for a small business, but as you bring on more employees and run into more complex payroll situations — such as overtime — you might decide to transition to paying in arrears. How can you do this without creating issues for your employees?
As we mentioned earlier, a little communication goes a long way. By following a few simple steps, you can help ease the transition for your employees:
- Communicate the change well in advance. Let your employees know when the change will take effect and how it will impact their paychecks in the short term.
- Tell employees how this change will help them. A simple perk like offering direct deposit can ease the lull of waiting a little longer for a paycheck. Also, if payroll accuracy has ever been an issue, let them know that this change will help alleviate that, too.
- Consider offering advances on a limited basis. This option should be approached with caution, as each company’s situation will be unique. If there are employees who could be affected by a change in how payroll gets processed, a short-term advance — that is immediately repaid via payroll deductions — could help during the transition.
To this point, our attention has been on how paying in arrears payroll. Before we wrap up, we need to at least touch on how managing your finances in arrears can impact other areas of your business.
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What about paying vendors – or invoicing clients – in arrears?
Typically, paying vendors in arrears — or invoicing clients in arrears — is all about cash management. It’s just a question of whose cash you are helping to manage, and your justification for doing so.
Vendor payments in arrears
When you pay vendors in arrears, you are making payments at some point after receiving a product or service from them. This is most often done when a vendor sends you an invoice after the fact, rather than requiring payment in advance or at the point of sale. In addition, some vendors offer extended payment terms — usually allowing you more than 30 days to make a payment — which makes it easier for you to purchase more from them.
The best way to know if a vendor will allow you to pay in arrears is to simply ask. By making it clear that you aren’t asking if you can pay them “late,” they should understand you’re looking to negotiate an extended payment schedule.
Simply put, paying vendors in arrears allows you to sell the products you purchase from them (or reap the benefits of a service they’ve provided) before you are required to make a payment. This can help ease strains on your cash flow.
Keep in mind that once you negotiate payment in arrears with your vendors, it’s important to honor the terms. If a vendor has to start chasing down payments, they may have second thoughts, which could prevent it from being an option.
Invoicing clients in arrears
On the other hand, when you invoice a client in arrears, you bill them for a product or service that’s already been delivered. This is the flip side of paying a vendor in arrears. In fact, you are a vendor to your clients, and so your reasons for offering to invoice a client in arrears will be similar to your reasons for asking a vendor to allow you to pay in arrears.
When you invoice a client in arrears, you offer them the opportunity to experience the benefits of your product or service — generally in the form of increased revenue from sales or increased efficiency from a service — before asking them to pay you. In turn, this reduces the strain on their cash flow and may also encourage them to purchase more from you.
Similar to arrangements with vendors, it’s important to make sure clients stick to the terms you set forth for payment. Once a client’s invoice is past due, the risk that they won’t pay you at all increases. So, make sure your clients don’t take advantage of your generosity, and if they do, you may need to reconsider the privilege of allowing them to pay in arrears.
How can you use paying in arrears to your advantage?
Though each company’s situation is unique, running payroll in arrears can often have a positive impact on a business’s bottom line. It can take some of the administrative to-dos off the payroll staff’s plate and even help stabilize a company’s cash flow. Furthermore, employees will have more confidence in how their payroll is calculated, which will keep them happy and productive while reducing questions when payday comes around.
Paying in arrears is just one way to manage your business’s cash flow. If this is a trouble area for your business, consult with your accountant about different cash management methods that might be useful for your business; it’s likely they will be happy to hear from you and offer suggestions!