What is a Chargeback in Accounting?

I am not an accountant. If you need financial guidance, seek professional help. I’m here to provide considerations. Because we’re businesses who’ll need to account for chargebacks in our bookkeeping at some point.

I’ll break down what you need to know about chargebacks in accounting, including what to record and some best practices.

Let’s begin with what accounting is with chargebacks.

Key Takeaways

• Chargeback accounting involves tracking disputes and how they impact business revenue.
• Accounts receivable handles funds set aside for disputes.
• Accounts payable manages funds owed to suppliers.
• Treat chargeback fees as operating expenses.
• Chargebacks and refunds are different.
• Write off lost chargebacks as "bad debt expense."

You know what’s easier than dealing with chargebacks in accounting? Not doing it. One way to prevent that from happening, while still following the law, is to prevent chargebacks. Dispute alerts are an excellent way to do this.

Learn how the chargeback alerts we offer have reduced dispute rates by up to 91%.

What is Chargeback Accounting?

Chargeback accounting tracks and reports transaction disputes in financial records. It includes processes for reversal handling, claim investigation, and dispute prevention. This system helps businesses maintain accurate financial data and manage chargebacks effectively.

If you’re not familiar with what chargebacks are, they’re a consumer protection mechanism. They allow customers to file complaints about unfair or fraudulent orders. From there, their bank or issuer will force the merchant to reverse the order.

Merchants can challenge chargebacks through a process called representment. We have a separate guide that does a better job explaining this.

While chargebacks help protect consumers, many take advantage of the system through friendly fraud or chargeback fraud.

Anyway:

This process can take months to complete and cost a lot. We’ll discuss the costs throughout this guide. And you’ll need to record these.

Otherwise, you risk the wrath of the IRS. Or whatever your country’s tax body is.

Which brings us into why this type of accounting is so important.

Summary: Record financial impacts from chargebacks.

Why Chargeback Accounting is Crucial

Chargeback accounting is crucial for tracking revenue losses accurately. Chargebacks cost businesses more than double the original transaction amount. It helps adjust financial records, account for decreased revenue, and manage additional fees effectively.

Unlike regular bookkeeping situations, chargebacks operate differently.

For instance, customers typically have 120 days to dispute a transaction, but Discover allows up to a year if fraud is suspected. Consider these factors when accounting for chargebacks.

Chargeback trends can vary by season or as fraud tactics evolve, making budgeting unpredictable. Payment processors also charge varying fees for handling chargebacks.

Then there are chargeback fees. Most payment processors and issuers will charge them. But their costs will vary.

I have a separate piece that dives deeper into these fees.

Now that’s out of the way, let’s see how chargebacks in accounts receivable versus payable.

Summary: Chargebacks add additional costs.

Chargebacks in Accounts Payable vs. Accounts Receivable

Definitions:

• Accounts Receivable: When a customer disputes a charge, leading to a payment reversal.
• Accounts Payable: When a business disputes charges from a supplier or vendor.

Overview: 

• Accounts Receivable: Owed to the business for goods or services delivered but not yet paid for.
• Accounts Payable: The amounts a business owes to suppliers for goods and services received.

Reasons for Chargebacks:

• Accounts Receivable: Due to unauthorized purchases, merchant errors, or friendly fraud.
• Accounts Payable: Due to incorrect invoices, quality issues, or late deliveries.

Accounts payable holds suppliers accountable. Receivables ensures that sellers have money set aside for disputes.

There’s not much else to cover here. This was to provide context.

Let’s get into dealing with chargebacks in the books.

Best Practices for Chargeback Accounting

Consider the following practices when dealing with chargeback accounting:

• Utilize third-party platforms
• Treat fees as operating expenses
• Chargebacks and refunds aren’t the same
• Accounts receivables and bad debt
• Lower chargeback rates

I’ll provide more context throughout the following sections.

Before following this advice…

Tax laws are constantly updated. Consult a tax professional before following this advice.

Let’s dive in.

1. Use Third-Party Platforms When Possible

Platforms like PayPal often provide 1099-K forms, which help with reporting chargeback fees for tax purposes. Using these platforms simplifies the tracking and reporting process.

2. Treat Fees as Operating Expenses

You’ll need to pay a chargeback fee no matter whether you win, with almost all payment processors and banks. Treat these as bank fees or operating expenses.

If you have high dispute volumes, consider creating a subaccount for chargeback fees. This will simplify reporting.

If you go through Shopify, you’ll want to consider marking chargeback fees as accounts receivable if the chargeback is done via a debit card. If it’s done through a credit card, then still mark it as an operating expense.

We’d do this because the ways banks pull money from merchants during chargebacks differs by payment method.

Why with Shopify?

Because Shopify will reimburse the full chargeback fee if you win a dispute [1]. Check your platform’s chargeback fee policy before dealing with the accounting for this.

If you win the chargeback, record the reimbursement by reversing the chargeback expense.

3. Know the Difference Between Chargebacks & Refunds

Chargebacks are card issuer-initiated fund returns after payment disputes. Refunds are merchant-issued repayments. Chargebacks apply to card payments, while refunds cover all methods. Merchants control refunds, but not chargebacks. Chargebacks incur fees; refunds don't.

Since they differ, you’ll report them separately.

Legitimate chargebacks, such as those due to merchant error, should be reported as a deduction or expense from revenue.

For instance, if a customer receives the wrong product, that qualifies as a legitimate chargeback.

Illegitimate and fraudulent chargebacks should go under accounts receivable. These are treated as amounts owed to the business because there is potential for recovery.

If you can dispute an illegitimate chargeback, recording it this way reflects your expectation to reclaim those funds.

This classification is helpful for audits and financial reporting, showing stakeholders the extent of chargebacks and how you're addressing them.

Now, what’s an “illegitimate” chargeback?

An “illegitimate” chargeback occurs when, for example, a customer falsely claims they didn’t receive a product. If you have proof they did (e.g., a signed delivery receipt), that’s worth disputing.

Fraudulent chargebacks can be harder to fight without proper fraud prevention tools or chargeback insurance, which may reimburse you if you lose a dispute.

Meanwhile, fraudulent chargebacks can be challenging to dispute.

Most are difficult to fight unless you have fraud prevention software that proves otherwise. Or, you could have chargeback insurance (AKA guarantees) that will recover your funds if you lose a dispute.

Consider creating a separate account for these funds. If you win the dispute, the funds can then transfer to your main account.

4. Accounts Receivable & Bad Debt

For illegitimate or fraudulent chargebacks, mark them as accounts receivable. If you lose or accept the chargeback, write off the balance as "bad debt expense."

Writing off bad debt ensures financial statements reflect the actual expected revenue. This results in more accurate profit and loss calculations.

Moreover:

You can deduct bad debt expenses from taxable income. Reducing your tax burden.

Removing uncollectible accounts also keeps your financial records clean and helpful for audits, offering a clearer view of your business’s financial status.

5. Lower Your Chargeback Rates

Reducing chargeback rates is better than fighting disputes. A high chargeback rate (above 0.65%) could place your business in a dispute monitoring program, complicating your bookkeeping further.

I discuss why in this piece.

The best way to lower your chargeback rate is through chargeback alerts.

Here’s how they work:

When a customer raises a dispute with their bank or issuer, the process enters a "pre-dispute" phase. If the bank participates in an alerts program (most do), they check whether you're signed up.

If you're using Rapid Dispute Resolution (RDR), you automatically refund certain transactions based on pre-set criteria. Preventing disputes from escalating into full chargebacks.

With CDRN or Ethoca, you receive a notification of the issue, giving you 72 hours to either refund the customer, review evidence, or dispute the chargeback.

Each alert provider varies by card network support and bank adoption. I provide more detailed comparisons in another guide.

Regardless of what alert you choose, you’d usually need to contact Verifi and Ethoca to access them. This requires you to have separate accounts and potentially pay more for alerts.

That’s when I’d recommend considering a certified reseller (like us). They often offer volume pricing and provide easy access to all the alert providers.

Other ways to keep rates low include:

• Using fraud prevention tools.
• Opting for secure payment methods like Apple Pay.
• Clearly communicating policies, such as your cancellation policy.

This guide would take forever to read if I included every method. That’s why I wrote them all in a separate guide.

Check it out.

Let’s finish this guide off with potential mistakes one could make when dealing with accounting and chargebacks.

Common Mistakes in Chargeback Accounting & How to Avoid Them

Here are some common mistakes businesses make when dealing with chargebacks:

1. Inaccurate Financial Records:

• Mistake: Failing to properly record chargeback transactions leads to incorrect financials.
• Avoidance: Implement a systematic process for recording chargebacks and use reliable accounting software.

2. Misclassification of Chargebacks:

• Mistake: Classifying chargebacks as refunds distorts financial reports.
• Avoidance: Differentiate between chargebacks and refunds in your records by creating separate categories.

3. Lack of Reconciliation:

• Mistake: Not reconciling chargeback entries with bank statements leads to discrepancies.
• Avoidance: Regularly reconcile chargeback records with bank statements to ensure accuracy.

4. Ignoring Fees Associated with Chargebacks:

• Mistake: Failing to account for fees understates costs.
• Avoidance: Track all fees and include them in financial reports to ensure accurate cost reflection.

5. Poor Communication Across Departments:

• Mistake: Lack of communication between finance and sales departments results in errors.
• Avoidance: Discuss chargeback issues and resolutions.

6. Failing to Stay Updated on Regulations:

• Mistake: Ignoring changes in accounting standards related to chargebacks can lead to non-compliance.
• Avoidance: Stay informed about accounting regulations by attending workshops or webinars.

There’s nothing more to cover here. I hope this information helps you with accounting.

Wrapping Up

Chargebacks complicate accounting due to funds moving into accounts receivable and associated fees. Preventing chargebacks is preferable, and using chargeback alerts can help with this.

We provide access to these alerts in a single dashboard. See whether they’re right for your business.

Sources

• [1] Shopify Payments FAQ. Shopify Help Center.