Billed in Arrears: What Does Arrears Billing Mean?
Being billed in arrears is an awkward-sounding term, and it’s that semantic clumsiness that makes it more confusing than it should be. It’s a noun, and it really feels like you should add “an” before it, but you don’t.
Unfortunately, we don’t have the ability to rename arrears, but we can explain it in a way that makes sense.
What does billed in arrears mean?
Billed in arrears (also "invoice in arrears", "paid in arrears", or "arrears billing") refers to billing and payments that occur after a service is completed, as opposed to up-front or in advance. "Arrears" may also refer to payment that is late or overdue.
Being paid in arrears isn’t inherently bad, it’s just a way of categorizing payments that occur after a service has been provided. There are two main categories for payments in arrears:
- Paying a company after they’ve completed a service for you.
- Receiving a customer’s payment for a bill that is overdue.
If a payment happens after a service is completed, then that’s considered in arrears. If a payment is late, then that’s also considered in arrears.
Other reasons why a payment could be in arrears:
- An invoice wasn’t delivered correctly.
- An invoice was never made at the time of the service.
- There is a dispute over the goods or services.
- The customer thought they paid but didn’t.
Considerations for billing in arrears
One of the few times a payment being in arrears is a bad thing is when a customer is refusing to pay or when you fear that a customer is so far into arrears (meaning they have multiple payments they are behind on), that you will never receive the money you’re owed.
It can also be frustrating when you have multiple invoices in arrears and cannot use that cash even though the customer has the intention of paying. If you consistently run into this issue, you could tack on extra fees for invoices older than 30 days to provide additional incentives to pay on time.
On the business side, it’s smart to keep as many of your accounts payable out of arrears as possible. Having a lot of outstanding invoices can affect your credit and ability to receive financial assistance.
Companies also have less incentive to prioritize you since you already owe them money, and you will likely receive better service if the company knows you pay often and on time.
When does arrears billing make sense?
Arrears billing is extremely useful for businesses who pay their employees hourly, companies that bill in cycles or periods, restaurants who need to add tips to paychecks, and businesses that have sales commissions.
In each of these scenarios, the final bill or paycheck amount can’t be determined until the designated period is completed. Businesses aren’t sure how many hours their employees will work, and it doesn’t make sense to pay a period in advance when the final number of hours could change. Since it’s easier to pay after a period, or after the service provided by an employee is completed, then that payment is considered a payment “in arrears”.
For example, if you have a workforce of 40 employees all on hourly wages and you project 20 hours for each of them, that would be a total of 800 hours that you’re paying for in advance if you’re not using arrears. If a water line broke and you had to close for two days, then you’d have to either adjust all of those paychecks or take them out of a future paycheck. It would be an accounting mess for everyone involved.
It’s also common in contracting and other service-based businesses. Customers can hesitate to pay large bills for service in advance, so typically a business charges a percent upfront or requests a down payment. After the service is finished and both parties are satisfied, the customer pays the remaining balance. Because the customer is paying after the service has finished, this is also considered in arrears.
When is billing in arrears most common?
Being billed in arrears is common in a variety of industries and financial situations, including:
- Companies that pay their employees hourly wages.
- Restaurants that need to add tips to regular wages.
- Businesses that pay sales commissions.
- Independent contractors.
- Annuities and other loans that you pay on a monthly basis.
- When preferred stockholders are owed dividends.
- Utilities like electricity or water. Essentially any business that collects charges and bills them on a rolling basis.
This isn’t a complete list, but these situations are where you will see arrears billing most often. Whether or not it’s best for your business depends on the structure and logistics of your company.
Billing in arrears vs. billing in advance
Billing in arrears always includes a payment that is occurring after the service or product has been delivered. Billing in advance is requesting payment before the service has been completed.
The pros of billing in arrears
There are three main benefits of billing in arrears:
- Offers flexibility and accuracy. Changes in invoices for services provided won’t require a new invoice because the invoice hasn’t been finalized. There’s no guesswork involved because the amount isn’t known until the end of the period. The same goes for hourly wages. There’s no guesswork or refunds necessary because you wait until you have all of the information needed to pay an employee.
- Helps prevent refunds and chargebacks. Because you aren’t performing any sort of estimate, you are less likely to have incorrect invoices delivered to customers.
- Allows you to get paid in full. If you agree to a set fee upfront for a job and the scope changes substantially, you have to renegotiate to get paid for what you’ve done. With arrears, you wait until the service is completed before settling the bill.
The risks of billing in arrears
The two main risks of billing in arrears include:
- Delays cashflows. Since your business and employees have to wait for the period to finish before getting paid, your business will be operating a week or two behind from a payroll perspective. This isn’t a big deal once you adopt a system that relies on billing in arrears, but it does mean you won’t get paid or payout in real-time.
- Risks not getting paid at all. The frequency of this occurrence will vary dramatically by industry and customer base, so look at your historical data and see what makes the most sense to you. If people rarely refuse to pay, then arrears could work for you.
Should your business use arrears billing?
That depends. If you fall under the industries or frequently interact with the situations we outlined above, then billing in arrears could be your best friend.
If you haven’t switched over yet but are considering it, you can also try it with a smaller portion of your client base, observe the results, and then decide to make it a company-wide policy afterward.
Be methodical and create contingency plans, and you’ll be just fine!