Arrearages – Meaning, Example, Uses, and More

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. In terms of meaning, both the terms are very similar, 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 as well as 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, in preference shares, unpaid dividends of the past year (or years) accumulate. And, the firm should pay this dividend before giving new dividends to the preference shareholders and dividends to ordinary shareholders.

Arrearages

Example

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 $30,000 arrearage to the preferred shareholders. Not only it has to pay as well $10,000 preference dividend for the current year.

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, there are many applications of arrearage, 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, rather 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 the completion of the month. This would lead to inaccuracies as the salary would be on the basis of estimates.

Final Words

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)

What is the difference between arrearages and arrears?

Arrears means an actual unpaid obligation to debt, but arrearages mean a condition of being in debt.

What are arrearages?

Arrearages are the amount of any credit instrument that is overdue.

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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