Chargeback Accounting: How to Get It Right, and Why It Matters
The life cycle of a chargeback can resemble a heist movie at times, with back and forth reversals of fortune right up to the very end. First the money goes back to the cardholder, then the merchant succeeds in representing the charge, but then the issuing bank takes it all the way to arbitration. First you have the money, then you don’t, and fees start getting tossed in at various points—it’s enough to make your head spin. Now, can you imagine what it’s like for your accounting team to try and make sense of all this activity at the end of the month?
Figuring out how to properly account for chargebacks may not carry the same urgency as figuring out how to fight and prevent them, but if you want to get an accurate handle on how chargebacks are impacting your bottom line, they need to be thoroughly and correctly recorded in your ledger.
Because various banks and payment processors handle chargeback activity in different ways, you can’t just assume that any reasonably competent number-cruncher is going to automatically know how to handle chargeback accounting. As a merchant, it’s important for you to understand how chargebacks impact your accounts at every stage of the dispute process, so that you can communicate effectively with your accounting staff and make sense of chargeback-related financial reporting.
What Is a Chargeback, Exactly?
In order to post accurate accounting entries for chargebacks, you have to understand what, precisely, they are. Not just in a broad conceptual sense, but the exact mechanics of when and how chargeback activity debits and credits your merchant account.
A chargeback occurs when a cardholder contacts their issuing bank to dispute a charge they’ve incurred. If the bank believes that the cardholder has a valid reason for the dispute—fraud or merchant error, typically—they will issue a provisional credit to the cardholder’s account and “charge back” the amount paid to the merchant
The merchant has an opportunity to respond to the chargeback, either accepting it or fighting it by representing the original charge with evidence that the dispute is invalid. Even if the evidence is accepted and the respresentment goes through, the cardholder and their issuing bank can press the dispute further, to pre-arbitration and arbitration procedures overseen by the card network. If this happens, the fate of an individual chargeback can stretch to cover more than one accounting period.
Chargebacks will always come with fees attached, but the exact dollar amounts and fee schedule will vary by card network and payment processor. Review your contracts and documentation so that your accountants will know exactly what fees to look for, and when.
How Do Merchant Account Types Affect Chargeback Accounting?
The type of merchant account you have will affect how you receive notification of your chargebacks and how they are presented on your monthly statements.
If you obtained your merchant account directly from a major bank like Chase or Wells Fargo, you should find your chargebacks listed as individual line items on your month-end bank statement. Chargeback amounts and chargeback fees should be split out as separate amounts, as should chargeback reversals. These accounts tend to be easier to reconcile, as the banks make an effort to organize this information in a logical and readable manner.
Third-party merchant account providers, also known as Independent Sales Organizations or Merchant Service providers, tend to focus on providing account services to small or high-risk merchants. Their practices are less consistent than the big banks, and it’s not unusual to find them lumping chargebacks and fees into a one-line transaction on your bank statement. This can make it very difficult to identify individual chargebacks included in the lump sum, and your accountants may need to contact the account provider directly to get a breakdown.
You should also find out if your account provider uses reserve funds. Some banks will hold chargeback-related fees in a reserve fund and only release them to the merchant account months after the fact, when it may be very challenging to trace all of the included fees back to their originating transactions. Here as well, don’t be afraid to ask your provider for additional details when necessary.
How Should Chargeback Activity Be Recorded?
Posting chargeback activity to the wrong accounts can make your overall financial reporting inaccurate and obfuscate the true extent of your chargeback problem. Chargebacks are not refunds, and they do not fall under the “cost of goods sold” umbrella.
The initial chargeback—the reversal of the transaction the cardholder is disputing—should be posted to an Accounts Receivable account. This positions each chargeback as funds that are owed to you and which you expect to recover. You can create a special designation for this account, like “Accounts Receivable – Chargebacks.”
If you fight the chargeback and win, you can clear the chargeback off the books by debiting cash and crediting Accounts Receivable. If the chargeback reaches the endpoint of the dispute process and is upheld (or if you choose not to fight it at all, which is advisable with true fraud chargebacks that you have no evidence to counter), you can write it off by charging it to a Bad Debts Expense account.
What About Chargeback Fees?
Fees incurred as part of chargeback activity should be treated as operating expenses. If you already have an account designated for bank fees you can post chargeback fees there, but if you’re dealing with a high volume of chargebacks it may be advisable to set up a separate sub-account for chargeback-related fees to make reporting and analysis easier.
Accurate chargeback accounting is necessary for determining the true cost of your chargebacks and the significant of their impact on your business. A chargeback is more than just a reversed transaction—not only are you losing the paid amount and the product sold, you also have to consider the time, labor, and marketing costs associated with selling that product to be lost, and factor in the bank fees as well. The true cost of a chargeback to the merchant can be well more than double the dollar amount the cardholder actually gets back.
Proper chargeback accounting practices can clearly illustrate how much revenue you’re losing to chargebacks and provide other informative details about the nature and circumstances of the chargebacks you tend to receive. Your accounting team has a very important role to play in your overall chargeback defense strategy, so make sure they have the information and guidance they need to do their jobs right.