Salary Arrears Meaning and Calculation

Salary Arrears are the amount of money owed to an employee for a past employment period. Salary arrears occur when salaried pay remains unpaid, including payments for work, annual leave, a leave of absence, sickness, maternity, paternity, or adoption leave pay. A company’s cash flow will benefit from Salary Arrears, although they negatively affect an employee’s financial state. For example, Salary Arrears negatively impact an employee's borrowing capacity for mortgages or other loans linked to their earnings. 

What are Arrears in Salary?

Salary arrears arise from various situations, such as delayed payments, retroactive pay increases, changes in employment terms, and due to legal or contractual obligations. For example, salary arrears due to delayed employer payments occur because of administrative or cash flow issues. retroactive pay increases or new employment terms, including pay adjustments,  lead to arrears. Correcting payroll errors and fulfilling legal obligations (paying the legal minimum wage retroactively), are other common causes of salary arrears.

The Employment Rights Act 1996 (ERA) states that withholding wages is illegal and that salary arrears correct payment discrepancies to comply with legal requirements. Correcting salary arrears versus paying the correct wage in the first instance disadvantages the employee. Arrears in salary cause financial strain on employees, damage employee relations, and lead to administrative complexities or legal issues. Moreover, salary arrears can negatively impact an employee's borrowing capacity for mortgages or other loans, as they can lead to consistency in income records.

Managing salary arrears is essential for smooth business operations and good employee relations. Employers should regularly audit their accounts payable and monitor debtors' payment patterns. Suspending business with clients who fall into significant arrears can prevent short-term losses. Additionally, employees should be aware of the legal implications of not being paid on time and the need to report pay arrears to relevant authorities. When applying for a mortgage, employees should ensure their income, including any arrears, is accurately represented and understood by lenders.


Examples of Salary Paid In Arrears include Delayed Payments, Retroactive Pay Increases, New Employment Terms and Legal or Contractual Obligations.

Salary Arrears due to delayed payments are when administrative issues, cash flow problems, or other operational challenges delay salary payment for any period.

When an employee's pay rate increases, the increase is applied retroactively. For example, when an employee's salary is raised effective from a past date, they are owed the difference between the new pay rate and the actual paid amount for that period. 

Changes in employment contracts or terms, such as promotions or reclassifications, result in arrears if the new salary is to be applied retroactively.

Salary arrears in favour of the employee arise from correcting payroll errors. If an employee was underpaid in previous pay periods due to miscalculation or oversight, the amount owed is paid as arrears. Any Salary Arrears caused by incorrect pay will negatively affect the employee's ability to maximise their borrowing for a mortgage and other loans.

Salary arrears caused by Legal or Contractual Obligations are where the employer must pay the employee for past periods per court rulings, settlements, or contractual agreements. For example, when an employee hasn’t been paid the legal minimum wage for a period, the retroactive sum paid will be as arrears, or when equal pay legislation applies, the employer has to pay arrears.

Salary arrears are primarily used as a corrective measure in payroll management and come with their own set of advantages and disadvantages:

  • Samuel Mbugua, 25, a former Nairobi Metropolitan Services (NMS) officer, is in financial distress due to salary arrears of unpaid wages stretching back seven months Sh171,460 (£907.02GBP)

Advantages of Salary Arrears

Salary arrears are beneficial because they ensure employees receive all the compensation they are entitled to, especially in retroactive pay increases or payroll errors.

By paying arrears, employers demonstrate their commitment to fair compensation, which helps maintain or improve employee morale and trust.

Paying salary arrears is crucial for employers to comply with legal or contractual obligations and avoid potential legal repercussions.

For employers, the ability to pay in arrears provides some flexibility in managing cash flow, as it allows a slight delay in the disbursement of salaries.

Disadvantages of Salary Arrears

Salary Arrears due to incorrect pay will reduce the loan amount of a mortgage, regulated bridging finance or other loan where the loan criteria evaluate earnings to determine the loan amount or rate of finance.

Delayed payments cause financial difficulties for employees, especially those relying on a regular income to meet daily expenses.

Calculating and processing salary arrears add complexity to the payroll process, requiring additional administrative effort and increasing the potential for errors.

If the salary arrears result from the employer's intentional delay or miscalculation, they will lead to legal issues or disputes, damaging the employer’s reputation.

Regular salary arrears lead to dissatisfaction and distrust among employees, potentially impacting their performance and workplace atmosphere.

Receiving a large sum in arrears could impact employees' tax calculations, leading to a higher tax bracket for that period.

Employees must inform the Department for Work and Pensions and HMRC about any pay arrears awards, as these affect their state welfare benefits and tax credits. Failure to do so could result in recovery actions, fines, and penalties due to adjustments in their benefits.

Salary Arrears Interest and Penalties

HMRC charges interest on late PAYE income tax payments, with the decision to act and the interest chargeable from 19 April after the relevant tax year. Under the Finance Act 2009, HMRC can impose penalties for late returns, with the severity based on the frequency of delays in PAYE, NICs, and other deductions. Correct reporting under RTI avoids penalties, but failure to report or pay arrears on time will result in penalties under these regulations.

Correctly tracking payroll

To accurately track payroll hours, keep precise records of the time employees work. Utilising digital time clock software is the most effective method for this. Alternatively, you manually calculate payroll hours by deducting the clock-in time from the clock-out time of an employee and then removing any break durations. 

Employers are not required to record daily working hours but must maintain records to ensure compliance with The Working Time Regulations 1998 Regulation 4. This includes verifying that employees do not exceed the 48-hour weekly maximum (unless opted out), adhering to night work limits, offering health assessments for night workers, and ensuring workers under 18 don't work during restricted periods. These records should be kept for two years and are essential for preventing disputes and safeguarding employee health, safety, and well-being. 

Since April 2019, employees have had a legal right to a payslip, which must be provided on or before payday and includes net pay after deductions. The Employment Rights Act 1996 mandates that all workers receive itemised payslips. These payslips must detail gross wages, deductions (like tax and pension contributions), net pay, and hours worked, if applicable. Additionally, employers must explain any fixed amount deductions, either on the payslip or in a separate statement.

Correctly tracking data supporting payroll, such as work periods, leave and sickness, will help maintain accurate records, adhere to UK legislation, and ensure a company pays employees correctly. High payroll accuracy reflects efficient management of payroll processes in a business, helping to minimise the risk of legal complications and employee dissatisfaction.

Tracking payroll accuracy involves establishing a monitoring process enabling businesses to set a key performance metric (KPI) baseline and identify when that KPI isn’t being met.

To arrive at a payroll accuracy percentage, divide the number of correct payroll runs by the total number of payroll runs. 

Payroll accuracy formula

How to Calculate Arrears in Salary

To correctly calculate arrears payments for employees, follow these steps.

  1. Calculate the Gross Salary of the employee
  2. Determine the salary amount from the end of the last month to the specified arrears date.
  3. Deduct any payments made up to the effective date of the arrears.
  4. The difference is the arrears amount.
  5. Include additional earnings such as overtime, tips, or bonuses.

Due to their delayed payment structure, salary arrears significantly impact business cash flow. Business owners must monitor and control arrears to avoid late fees, payroll inaccuracies, and issues that could diminish liquidity and strain employee relations.

Effective Salary Arrears Management Tips

  1. Implement a Payroll accuracy monitoring system.
  2. Monitor patterns of Payroll accuracy.
  3. Frequent arrears could signal a problem with your payroll administrator, whose performance should be monitored.

Employment contracts often specify payment dates, and failure to pay on time could breach these contracts, leading to costly wage claims. In the UK, compensation up to £25,000 is available for delayed employee salary payments. The Employment Rights Act 1996 deems withholding wages illegal, which applies to one-time and recurring late payments. Missing other payments like pensions and benefits becomes a legal issue only if adjudicated by a court. Employees who believe they've not been paid legally approach HMRC for guidance and legal advice.

When proving employment income for mortgage purposes, most employees validate their earnings with consistent payslips and bank statements, which lenders generally accept as complete income proof. However, showing a few months of stable employment is advantageous for recently employed or on temporary or trial jobs, though some lenders might offer flexibility.

Salary arrears negatively affect a mortgage's potential loan size. Irregular or delayed payments cause income record inconsistencies, making lenders cautious in their loan offerings.

Employees must demonstrate their regularity for inclusion in their total income assessment for additional income such as bonuses, commissions, or overtime. Workers with commission-based pay often have a lower base salary, significantly enhanced by commissions. Those earning regular overtime or bonuses must present a consistent record over several months or years.

The extent to which lenders consider these additional income types varies widely. Some lenders include up to 100% of these earnings, and others cap them at 50% or 75% or only account for the basic salary. The individual's employment situation influences this assessment and the consistency of their income, including any salary arrears and the lender's specific policies.

Does Income Tax deduct Arrears of Salary?

Yes, Income Tax is deducted from Arrears of Salary. Arrears of salary are earnings paid after an employee is entitled to receive them and are usually paid as a lump sum. Arrears of pay are earnings and are treated the same as if they had been paid at the right time.

Legally, an employee's tax liability for arrears of pay is based on the tax year when they were initially due to be paid, not when they are paid. From 6 April 2016, Scottish income tax has been applied to UK residents mainly living in Scotland, as indicated by an 'S' prefix in their tax code. This tax is on non-savings and non-dividend income, and the Scottish tax rates must be used from the 2016-2017 tax year onwards. Similarly, from 6 April 2019, Welsh income tax applies to UK residents primarily residing in Wales, as shown by a 'C' prefix in their tax code, and must be used for tax calculations from the 2019-2020 tax year onwards. These regional tax rates are not retroactive for periods before their start dates.


How to Show Arrears in Salary Slip

In a Salary Slip,  known as a payslip, to show arrears, insert a new row underneath each type of earnings and append ‘Arrears’ to the row label or ‘Arr’ to identify the sum as an arrears payment. After the label, show the amount paid in a decimal format, i.e. 00.00.

For example, to show arrears for Basic Pay, Bonus Pay or Commission Pay, the labels would be:

  • Basic Pay Arrears 00.00
  • Bonus Pay Arrears 00.00
  • Commission Pay Arrears 00.00

Here’s an illustration of how Arrears would be displayed on an example Salary slip.

Payslip example

How do Salary Arrears Affect Bridging Loans?

Salary Arrears negatively impact a borrower’s ability to obtain a regulated bridging loan. Lenders request information on affordability under specific conditions. Obtaining an unregulated bridging loan doesn’t normally require affordability assessments. Regulated bridging loans always do. Bridging loan lenders generally seek to understand an applicant's affordability when the interest is being serviced monthly, when the loan is FCA regulated or when your chosen exit strategy is to refinance with a lender where income evidence will be required.

Salary Arrears create irregularities in your income history, making it harder to demonstrate financial stability, which is a key requirement for a regulated bridging loan. Debt-to-Income ratio is critical in bridging loan assessments. By creating fluctuations in income, salary arrears temporarily inflate the employee's debt-to-income ratio, making them appear as a higher risk to lenders. Employees who suffer salary arrears leading to late payments or defaults on other financial commitments will negatively affect their credit score, impacting their bridging loan approval chances and terms offered. Consistent salary arrears will be viewed by lenders as a sign of unstable employment or financial management issues, leading to a more cautious approach in their lending decisions. A history of salary arrears will lead to higher interest rates or less favourable bridging loan terms due to a higher perceived applicant risk. Lenders will require additional assurance of future income stability. Employees will need to provide evidence of resolving salary arrears or a more stable income stream going forward to improve their ability to get a bridge loan. Salary arrears influence the amount a lender is willing to offer. Inconsistent income will result in the borrower not achieving the maximum bridging loan amount they would have otherwise qualified for. 

To mitigate these effects, it's advisable that employees provide a clear explanation for any salary arrears, along with evidence of a stable income pattern thereafter, and resolve any outstanding arrears before applying for a bridging loan.

Salary Arrears do not benefit employees seeking a mortgage, bridging loan or other loans.


What does Negative Arrears mean in Salary?

Negative Arrears in salary are when a salary overpayment has been made to an employee during a particular period.

Contrary to the preceding question, positive Arrears in Salary refers to paying an employee for work completed in a previous pay period rather than the current period.


Conclusion

In summary, salary arrears refer to the wages owed to employees for work previously done or due to adjustments such as retroactive pay increases and corrections of payroll errors. While arrears ensure employees receive due compensation and assist employers in managing cash flow, they pose significant disadvantages. These include financial strain on employees, potential legal complications, and difficulties in payroll management. Moreover, the irregular income pattern due to salary arrears can adversely affect employees' creditworthiness and borrowing capacity. Therefore, employees and employers must handle salary arrears carefully to avoid legal repercussions and maintain mutual trust and financial stability.

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