What Is Overpayment in Accounting? (2024)

Because invoice overpayments are almost always caused by errors, they don’t happenoften. But as with all aspects of accounting, it’s essential that business ownersunderstand the rules that govern them to ensure that their business’s finances are inorder. While it may seem like a fortunate mistake if a customer sends you too much money, itreally isn’t your money to keep. It’s important to handle overpayments properlyin order to maintain accurate accounting records and avoid any legal or ethical issues. Thisarticle explores what overpayments are and how they should be recorded.

What Is Overpayment?

An overpayment is when an invoice has been settled for more than the outstanding amount— in other words, when an invoice has been overpaid. This usually happens due to amistake, but could also result from an intentional act. It’s also worth noting thatoverpayment can go in either direction: A customer might overpay an invoice from yourbusiness, or you might overpay an invoice to one of your own vendors.

An acquaintance who owns a small business recently shared the following real-life overpaymentincident in which a customer overpaid due to two errors, one his and one thecustomer’s. Like many small business operators with entirely manual processes, thisbusiness owner routinely creates new invoices by “saving as” old invoices andupdating them with current information. Since there are often multiple items per invoice, hestructures the invoices with a “Fee” listed per item and then a “TotalAmount Due” at the bottom. In an early 2023 invoice, he forgot to update the totalamount due, so it carried over from the prior invoice. His customer then paid the totalwithout questioning or reconciling the amount with the other information itemized in theinvoice. He notified the customer about the error when submitting his next invoice, whichincluded a credit for the amount the customer had previously overpaid, a “zero”total amount due, and showed a remaining credit.

Key Takeaways

• Communicate with the customer about the overpayment as soon as possible and confirm howthey would like to proceed.
• Options for handling overpayments are to either refund the amount or establish a creditfor it.
• The receiver cannot keep an overpayment, as it is neither revenue nor income.
• Account credits caused by customer overpayment are recorded as liabilities orcontra-assets on the balance sheet until applied against an invoice.

Overpayment Explained

Overpayment in accountingoccurs more often than you might expect, simply because invoice overpayments, such as theone just described, are among the most common invoicingproblems. But it can also happen for a variety of other reasons, such as amiscalculation. For example, a customer may accidentally pay the same invoice twice or enteran extra zero on the payment amount. Regardless of the reason, it’s important for abusiness to properly record invoice overpayments in its accounting system to ensure accuratefinancial statements.

Because his is a cash-basis business, the owner in the real-life overpayment incidentdescribed above actually followed one of the handful of correct procedures for thesituation, which are outlined below. But he did so without the benefit of accountingknowledge — only by having a modicum of common sense and ethics. Accrual-basisbusinesses are subject to the same common sense and ethics, but the accounting rules andrelevant bookkeeping adjustments are more complex.

What to Do If You Receive Overpayment

If you receive an overpayment, it’s important to handle it promptly and professionally.Communication with the customer is essential, as is accounting for it properly. Here are thekey steps to take, including the relevant bookkeeping actions, where necessary.

• Notify the Payer

  Typically, overpayments are discovered during an account reconciliation, one of thebasicaccounting processes that should be performed weekly or monthly. Once anoverpayment is confirmed, the business should promptly contact the payer or customerto notify them of the error. It’s important to explain the situation clearlyand let the customer choose from among several available remedies. These commonlyinclude applying the overpayment toward another concurrently outstanding invoice,leaving it on their account to apply to the next consecutive invoice or refundingthe amount. You can either call or email them, but make sure to follow up with awritten confirmation of the conversation that outlines the agreed-upon resolution.Some states allow businesses to automatically apply the overpayment as a credit, butyou should still inform the customer.

• Issue a Credit

  Regular customers will often choose to leave the money on account because it’seasiest for both parties. If this is the case, the business must issue a credit tothe customer’s account. The amount overpaid on the invoice is recorded as acredit on the balance sheet, not in a revenue account. If accrual accounting isused, the overpayment represents a future obligation and is recorded as acontra-asset that reduces the accounts receivable balance. If cash accounting isused, the overpayment would be recorded as a liability under customer deposits orprepayments.

  • Credit memo: A credit memo is effectively a credit note, ornegative invoice. It’s a way to acknowledge to a customer that they have acredit balance that will be applied to the next invoice. An actual invoice withthe negative balance can be prepared to document the credit.
  • Credit balance adjustment: Once you enter the overpayment intoa liability account on the balance sheet — preferably in a new accountcreated with the customer’s name, or some other method to ensure that itis easy to identify —the account will have a credit balance. Thiscredit balance is considered a “payment on account,” and is equal tothe amount of the overpayment. When it is applied against the next invoice, acredit balance adjustment will be made.

• Refund the Overpayment

  Alternatively, the customer might ask for a refund. This may be the customer’spreferred option, if the amount is potentially larger than the next invoice or if itis not a regular customer. The refund is usually issued in the same manner as thepayment was made, such as through a credit card or bank transfer, and should beprocessed as soon as possible. However, be wary of overpayment fraud. This may bethe case in scenarios where the customer gets in touch with you soon after an orderis placed to ask to reduce or cancel the order and demands an urgentrefund.Make sure the customer’s original payment clears your bank beforerefunding any money. It’s also considered best practice to confirm the requestwith a different customer representative, preferably someone already known to you.As with all transactions, be sure to document the refund to adhere to good accountingpractices for small businesses.

• Unclaimed Money Laws

  If, for whatever reason, the customer does not use an account credit for a certainperiod of time, it might be considered unclaimed or abandoned property. The timeperiod varies by state, but it’s usually around one to three years. Once thetime period passes, the money must be turned over to the state and will be madeavailable to people searching for unclaimed property. Review your state’sunclaimed property laws to learn the applicable procedures.

  See Also

  What is Over payments? | Meaning & Definition

Tax Implications of Overpayments

Logically, since an overpayment is not recorded as revenue, it should have no income tax orsales tax implications. This is because, for a payment to be considered earned revenue, abusiness must have the legal right to collect the funds from the payer. In the case of aninvoice overpayment, there was no reason to collect the extra money from the customerbecause goods or services were not provided. So, there is no taxable revenue. Is this stilltrue if you end the reporting year with the overpayment credit still on account? Yes. Sincea company reports tax revenue only during the year that the revenue is earned, there is notax due until an actual sale is made. However, when the credit is used against a sale in adifferent tax year, things start to get tricky. Keep reading.

What if you and your customer agree to apply the overpayment to a new order that won’tbe fulfilled for six months? Assuming a contract for the new order is put in place, the“overpayment” now becomes unearned or deferred revenue. Just like an invoiceoverpayment, deferred revenue is reported as a liability on the balance sheet. When theorder is completed, it is entered as income on the income statement. If you pay your taxeson an accrual basis, you can delay paying tax on the revenue until it is reflected on theincome statement. Revenue can be considered earned either at the date of shipment of goodsor once the customer accepts delivery. Either timing is fine, but you must be consistentwith which one you use for tax reporting each year.

But deferred revenue for services is treated a little differently than for goods. Assumingyou can fulfill the agreement for services within the next tax year, then you can deferrevenue recognition for one year. However, if you won’t fulfill the agreed-uponservices within two tax years, then the revenue cannot be deferred and must be reported inthe year you received it. These situations can get confusing, so be sure to review yoursituation with a tax professional.

Overpayment Examples

Let’s look at a simplified example of how to account for an invoice overpayment, fromreceiving the extra money and establishing the credit balance to issuing the next invoiceand making the credit balance adjustment. In this fictional example, the business is a dogfood company. In March, Nina’s Pet Shop accidentally settled its monthly invoice fromyour company twice. The invoice was for Nina’s $500 stock of dog food, plus $25 forsales tax. Since Nina’s buys a roughly similar quantity every month, it chose to leavethe overpayment on account.

The duplicate payment from Nina’s Pet Shop that caused the invoice overpayment requiresa credit to be recorded on your balance sheet. The entry increases the general ledger cashaccount and also increases the liability accounts for Nina and the related sales tax asfollows:

• Debit of $525 to cash.
• Credit of $25 in a sales tax overpayment account.
• Credit $500 as a contra-asset in an accounts receivable account easily identifiable asNina’s Pet Shop.

Next month, April, Nina’s Pet Shop’s invoice is for $600. The standard entry torecord the sale increases revenue, accounts receivable and related sales tax as follows:

• Credit to sales for $600.
• Credit to sales tax of $30.
• Debit to accounts receivable for $630.

But now you must make a credit balance adjustment to the credit on Nina’s account toapply it toward their April purchases. The entry reduces AR, the amount owed to Nina’sand related sales tax, as follows:

• Debit to the Nina’s Pet Shop accounts receivable contra-asset account of $500.
• Debit to sales tax overpayment of $25.
• Credit to accounts receivable for $525.

Nina’s Pet Shop then only has to pay the reduced amount of $105 ($630 – $525) forits April purchases. The journal entries to reflect the increase in cash and reduction in ARare:

• Debit of $105 to cash.
• Credit of $105 to accounts receivable.

The result of the entries is that the invoice overpayment was applied to the next invoiceissued, zeroing out the overpayment liability, and the customer had to pay only the netdifference.

Now let’s look at a refund example. In this example, another fictional customer, WD PetEmporium, sent your company a $1,000 bank transfer toward an invoice of $100 and would likea refund of the $900 mistake.

When the bank transfer was received, the entry to record the increase in cash and decrease inAR is:

• Debit of $1,000 to cash.
• Credit of $1,000 to accounts receivable.

Monthly reconciliation confirms the overpayment, and conversation with the customer confirmsa refund must be processed, so the entry reverses the overpayment amount of $900:

• Debit of $900 to accounts receivable.
• Credit to cash of $900.

The refund is processed in the same manner (bank transfer) in which it was received.

Stop Manual Data Errors With Accounting Automation

The examples above represent overpayments from a customer, which creates a legal andfinancial mess for the seller. Inaccurate data entry is one of the most expensive mistakesthat businesses frequently make. Both overpayment examples were caused by manual data errors— namely, duplicate payments and an extra “0” typo. There are multipleways businesses can avoid manualaccounting errors, such as making sure staff is not overworked and having stringentreview procedures. But the best way to eliminate accounting errors is with accountingautomation, which reduces human error because it follows programmed procedures whenperforming any task. For the two customers, accounts payable automation would likely haveprevented the overpayment errors. For the seller, accounting systems can be programmed toautomatically enter the accounting entries from invoices in accounting software, withbuilt-in rules that dictate how to handle invoice overpayments.

Avoid Overpayment Accounting Errors With NetSuite

If your business is ready to move from spreadsheets or entry-level accounting software to anautomated end-to-end accounting solution that helps eliminate errors like invoiceoverpayment while minimizing the time and effort required to perform routine accountingtasks, consider NetSuite CloudAccounting Software. NetSuite simplifies the process of recording transactions,managing payables and receivables, collecting taxes and closing the books. NetSuiteAP Automation can help businesses save time, reduce risks and improve the accuracyof their financial reports. And since NetSuite Cloud Accounting Software lets you automatetasks like account reconciliations, whenever mistakes like invoice overpayments are made,you can recognize them easier and address them faster. This means better customer service,as well as handling the legal and accounting issues quickly and accurately.

Overall, handling an overpayment on an invoice can be a time-consuming process, but it isimportant to take the necessary steps to ensure that your business’s books remainaccurate and that its relationship with the customer remains positive. By considering theaccounting guidelines in this article, you can effectively manage the accounting involvedand minimize the impact of overpayments on your business.

Overpayment FAQs

What happens if you overpay a vendor or pay the same bill twice?

Overpaying a vendor or paying the same bill twice can result in a credit balance on thevendor’s account, which needs to be corrected in order to maintain accurate accountingrecords. You should immediately contact the vendor and request a refund or credit memo forthe overpayment. You should also record the overpayment in your accounting records in aseparate account for overpayments, so it is easy to identify. If you’re unable toresolve the issue with the vendor, you may need to seek legal advice.

How do you treat a refund in accounting?

In accounting, a refund is treated as a reduction in revenue or a return of acustomer’s payment. It is important to properly record refunds in your accountingrecords to ensure that the business’s financial statements accurately reflect itsfinancial position. The exact accounting treatment of a refund depends on the circ*mstances.Here are a few common scenarios and the corresponding accounting treatment:

• Refund of a sale: If a customer returns a product and receives arefund, the original sale should be reversed in the accounting records. If the originalsale was recorded by a credit to the revenue account and a debit to the accountsreceivable account, then the refund should be recorded as a debit to the sales returnsaccount and a credit to the accounts receivable account.
• Refund of an overpayment: If a customer overpays an invoice andrequests a refund, the overpayment should be recorded as a liability in a separateaccount. When the refund is issued, the liability account should be debited, and thecash account should be credited.
• Refund of a deposit: If a customer pays a deposit for a product orservice and then cancels the order, the deposit should be refunded. The refund should berecorded as a journal entry that credits the cash account and debits the liabilityaccount where the deposit was originally recorded.

Can a business keep an overpayment?

No, a business cannot keep an overpayment. An overpayment is a payment made in excess of theamount owed by the customer, and it does not represent revenue or income for the business.Keeping an overpayment can result in legal or ethical issues, as it would be considered anunauthorized taking of funds. When a business receives an overpayment, it is required tonotify the customer and to offer to refund the excess amount or apply it as a credit tofuture purchases. The business should promptly refund the overpayment or credit thecustomer’s account in a timely manner.

What does overpayment mean?

An overpayment is an amount paid to a business that it was not entitled to receive.

Do you have to pay back an overpayment?

Yes, a business cannot keep an overpayment. An overpayment does not represent revenue orincome for the business — it is a payment made that exceeds the amount owed. When abusiness receives an overpayment, it is required to notify the customer and to offer torefund the excess amount or apply it as a credit toward a future invoice. The agreed-uponresolution should be documented and implemented quickly.

What is an overpayment refund?

An overpayment refund is one of two options available to a business when it receives aninvoice overpayment from a customer. The second option is to apply the overpayment as acredit toward a future invoice.