Arrearages are the amount of loan, preference share, or any other credit instrument that is overdue. Arrears or arrearage sound very similar, and many use them interchangeably as well. Both the terms are very similar in terms of meaning, but there is one little difference between the two. Arrears means an actual unpaid obligation to debt, but arrearage means a condition of being in debt.
Understanding Arrearages with Example
For instance, in the case of a preference share dividend, if a firm is unable to pay a dividend, then this dividend accumulates. So, the firm will have to pay it in the near future, resulting in an arrearage. Thus, the firm will have to pay this dividend (arrearage) first before paying a dividend to the common shareholders.
An important point to remember is that all due and unpaid dividends may not qualify as arrearages. For a dividend to be arrearage, it must have a “cumulative” feature, and the quantum or percentage should be fixed. Such a feature is not there in the dividend to the common stockholders; rather, preference share dividends have this feature. Thus, unpaid dividends of the past year (or years) accumulate in preference shares. And the firm should pay this dividend before giving new dividends to the preference shareholders and dividends to ordinary shareholders.
For example, Company A has cumulative preferred stocks that offer a dividend of $10,000 in a year. However, Company A was not generating profits for the past three years and thus, was unable to pay the dividends. So, if Company A plans to give a dividend in the current year, then it needs to clear the past years’ arrearages of the preference shareholders. This means Company A will have to pay a $30,000 arrearage to the preferred shareholders. Not only does it has to pay as well $10,000 preference dividend for the current year.
Also Read: Preference Shares and its Features
Such an arrangement, however, is not there for the common shareholders. So, if a company does not pay dividends to common shareholders in any year, then this dividend is lost. And it does not accrue as an arrearage. However, common shareholders enjoy other types of advantages over preference shareholders. These are voting rights, sharing of surplus on business dissolution, etc.
Uses of Arrearage
Well, it has many applications, but two of the most common ones are discussed below:
Almost every business, whether big or small, use the arrearage policy to better manage their operations. For instance, a company may have an agreement with the suppliers to make the payment in 30 or 45 days after receiving the delivery or after receiving the invoice from the supplier. Such an arrearage arrangement generally gives enough time to the company to get its payment from debtors and then make the payment to the creditors.
We also see arrearages in the payroll. Usually, when companies pay the salary, they do not pay for the current period instead of the past. For instance, the salary for July will get credited in the first week of August or later. Such an arrangement in payroll results in more accurate tracking of payroll.
In the absence of such a policy, the employees will have to give their timesheets even before completing the month. This would lead to inaccuracies as the salary would be on the basis of estimates.
Also Read: Cumulative Preferred Stock
Arrearages are very crucial for every business as it helps to smooth out operations. However, to ensure such an arrangement runs smoothly, it is very important that companies do proper accounting to track these arrearages. In the absence of proper accounting, a company will not be able to keep a tab of its arrearages and thus, may fail to deliver expected results.
Frequently Asked Questions (FAQs)
Arrears means an actual unpaid obligation to debt, but arrearages mean a condition of being in debt.
Arrearages are the amount of any credit instrument that is overdue.