What it is:

The term IOU is the phonetic spelling of the phrase "I Owe You." In bookkeeping, it
signifies an outstanding debt.

How it works (Example):

Usually, an IOU is a signed informal notice of an unpaid debt, sometimes because of partial
payment and an outstanding balance due. For example, Company XYZ may buy raw
materials for its production but until it sells the finished product, it does not have
sufficient cash flow to pay for the raw materials in full. In good faith, Company XYZ makes
a partial payment for the materials and issues an IOU for the balance.

Sometimes, a bond contract, the obligation of a bond issuer to repay bondholders, is referred

to as an IOU. However, in that case, the IOU or bond contract is a formal legal agreement
with specific terms, conditions, and penalties.

An IOU may also be the uncomplicated method of documenting small debts between

employees, friends or even family.

Why it Matters:
An IOU does not have the same legal requirements or standing as a promissory note or other
financial contract. It is usually not witnessed or signed by the lender, nor does it include
specific provisions for how or even when it will be repaid. Because of the limited recourse to
recover debts under IOUs, they are not usually helpful in securing financing or enforceable in
court.
 An advance paid to an employee is recorded as a current asset in the company's balance
sheet. There may not be a separate account in which to store advances, especially if
employee advances are infrequent; possible asset accounts in which to store this information
are:

 Employee advances (for high-volume situations)

 Employee loans (useful if the company intends to charge interest on funds advanced
to employees)

 Other assets (probably sufficient for smaller companies that record few assets other
than trade receivables and fixed assets)

 Other receivables (useful if you are tracking a number of different types of assets,
and want to segregate receivables in one account).

For example, if ABC International issues a $1,000 advance to employee Smith, it may record
the initial transaction as:
  Debit Credit

Other receivables 1,000  

     Cash   1,000

No matter what method is later used to repay the company - a check from the employee, or
payroll deductions - the entry will be a credit to whichever asset account was used, until
such time as the balance in the account has been paid off.

Employee advances require considerable vigilance by the accounting staff, because

employees who have limited financial resources will tend to use the company as their
personal banks, and so will be reluctant to pay back advances unless pressed to do so
repeatedly. Thus, it is essential to continually monitor the remaining amount of advances
outstanding for every employee.

The best approach to handling employee advances is to prohibit them without the permission
of senior management. Ideally, there should be very few employee advances per year.
One situation in which employee advances may be warranted is when the company plans to
shift to less frequent payroll cycles, which means that employees will experience an initial
period when they are not being paid. For example, shifting from a one week payroll cycle to
a monthly payroll cycle will require employees to initially go unpaid for a three-week
period. This problem can be mitigated by granting employees payroll advances for the
unpaid period, until the paychecks associated with the new payroll cycle are issued.