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What are chargebacks in accounting?
A chargeback is when a business has money taken from its merchant account, because a cardholder has disputed a payment. In the context of financial accounting, chargebacks can be hard to classify. Do they go in the income statement? On the balance sheet? The answer ultimately depends on how your business operates, and we’ll go into the specifics in this article.
Generally speaking, accountants recommend putting chargebacks on your balance sheet under the accounts receivable section. Some business owners will put their chargebacks on their income statement as negative income or cost of sales, but this can cause discrepancies between your income statement and the reports from your point-of-sale (POS) system.
How do chargebacks impact revenue recognition, cash flow, and financial statements?
Chargebacks can impact a company’s revenue recognition, cash flow, and financial statements. Let’s talk about each of these elements in detail.
Revenue recognition
Depending on the specific accounting principles that a business follows, there are certain criteria that a transaction has to meet before a business can officially recognize the revenue. The specific criteria you follow may differ based on your industry and the country you operate in. Under GAAP, short for generally accepted accounting principles, companies need to meet certain criteria before recognizing revenue including executing a contract, clarifying contractual obligations, determining the different pricing elements of the transaction (including discounts and return policies), and that the performing party (aka the business) has done what was promised in the contract. Chargebacks impact revenue recognition, because a chargeback can happen after the product has been delivered or service performed and the revenue officially recognized.
Cash flow
Chargebacks can significantly hamper your cash flow if they grow to a large amount. This is because you lose both the money from the sale plus the chargeback fee (which the bank takes regardless of whether you win a chargeback dispute or not).
Financial statements
For most businesses, “financial statements” refer to the balance sheet, income statement, and statement of cash flow. These documents provide an overview of the financial health of your organization. Chargebacks can impact your financial statements by forcing you to reallocate money you originally listed as revenue. Chargebacks are sometimes viewed as a “grey area” in the accounting world, so they can complicate the process of preparing accurate statements.
Managing your general ledger for chargebacks
The general ledger is the single source of truth for a business and contains all of its transactions. That said, companies that experience a high volume of transactions or more complex transactions with granular details may need to set up sub-ledgers. These sub-ledgers record specifics, and they can be a particularly useful tool for tracking your chargebacks.
Setting up distinct chargeback sub-ledgers
There are two common types of general ledger accounts for managing chargebacks. These are the “Chargeback Expense Account” or the “Dispute Reserves Account.”
A Chargeback Expense Account is an expense account where you set aside money for chargeback fees. As most merchants know, chargeback fees are incurred whether you win the chargeback dispute or not. (This is why, by the way, it pays to manage or refund chargebacks before they become disputes by using a chargeback management solution.) Creating a Chargeback Expense Account is what accountants recommend if you have a high volume of chargebacks. If you have a low volume of chargebacks, experts recommend simply recording your chargebacks as operating expenses.
Meanwhile, a Dispute Reserves Account is an account that either a third-party creates on your behalf when you work with them or an account that your business can create itself. When you work with a third-party, such as Stripe, they will create a reserve account which is a temporary hold on a portion of your business’ funds. This money is used by the third-party to provide timely refunds to customers in the case of a dispute.
On the other hand, a business can create its own Dispute Reserves Account for what’s known as an Encumbrance Account. If for any reason the customers dispute transactions, businesses have a set percentage of their money (proportional to the amount of goods or services they have initiated for customers) set aside to deal with the associated fees.
Differentiating between chargebacks, refunds, and returns in accounting
While refunds, chargebacks, and returns may sound similar, they differ in how they’re managed on your financial statements and what they entail. A refund is when a merchant voluntarily returns money to a customer, either at their discretion or because the customer’s refund request is in line with the merchant’s refund policy. Meanwhile, a chargeback is when a merchant is forced to return money to a customer through their bank. Finally, the return of a product may or may not result in the return of funds.
While the specifics may vary by business, generally speaking, you’ll reflect these events in different ways in your financial statements:
- Refund: When merchants issue a refund to a customer, they’ll typically debit their Sales Returns account. This may be named something different depending on how your statements are set up. You would then credit your cash account for the same amount.
- Chargeback: As we discussed earlier, there are multiple ways to deal with a chargeback. Best practice is usually to put chargebacks under the accounts receivable section rather than recording it as negative income.
- Return: In the case of a return, there are generally two routes to follow. If you give the customer their money back, you can follow the best practice for a refund above. If you do not give the customer their money back, you can debit the Sales Returns account to reflect the reduction in sales, however, you would not have to add any information to your income statement. That said, this does depend on your business, and there is the chance that your customers decide to file a chargeback and force your hand, in which case, you’ll need to follow the chargeback best practice.
Recording Chargeback Journal Entries
Journal entries are usually handled automatically by accounting software. When your customer buys something from your online store or payment for an invoice is entered into your system, it’s automatically submitted to your general ledger. Manual journal entries usually only happen when you’re adjusting a previous entry or when there are unique transactions that require human intervention. Chargebacks are a challenging mix of both automatic journal entries (e.g., people buying from your online store) , and potential manual adjustments.
Initial revenue recognition
The initial revenue recognition will happen automatically and be posted to your general ledger by your accounting system. If you’re managing your books manually, you’ll need to enter the information as follows:
- Journal entry number
- Date
- Account(s) (e.g., Accounts Receivable, Sales Revenue)
- Debit amount
- Credit amount
Chargeback disputes and final resolution
A credit card purchase is usually recorded in the Accounts Receivable sub-ledger. When a chargeback comes through, it will typically be automatically recorded as a negative amount here as well. Keep in mind that if your chargeback is still in the dispute stage, you won’t see any negative amounts.
If you do this manually, you will have to perform the process below, adjusting your account to reflect the ones that are affected.
- Journal entry number
- Date
- Account(s) (e.g., Accounts Receivable, Sales Revenue, Dispute Reserves, Chargeback Expense)
- Debit amount
- Credit amount
It’s best practice to use automated tools for tracking and reporting chargebacks
The best practice for reconciling chargeback accounts is to use automated software, since manual bookkeeping is much too time-consuming. It’s a good idea to invest in chargeback management software to help you not only keep tabs on your chargebacks, but to help you avoid more of them – and win the ones that slip through the cracks!
An automated solution can also help you generate accurate monthly and quarterly reports that ensure your chargeback ratio is staying in a healthy place.
Effective chargeback management makes preparing your financial statements easier
Your financial statements offer an at-a-glance view of the health of your company. Chargebacks can throw a monkey wrench into that careful reporting due to the involuntary nature of the returned money and the amount of time it takes to resolve a dispute with the bank. This is where a strategy focused on chargeback prevention, rather than just chargeback management, can be useful. A chargeback management platform can alert you to disputes when they come up, so you can proactively refund customers their money before it turns into a dispute. It can also help you prepare compelling representment packages.
You can book a call with a member of the ChargebackStop team here to learn more.
