What Is Overpayment in Accounting? How to Record Overpayments

Because invoice overpayments are almost always caused by errors, they don’t happen often. But as with all aspects of accounting, it’s essential that business owners understand the rules that govern them to ensure that their business’s finances are in order. While it may seem like a fortunate mistake if a customer sends you too much money, it really isn’t your money to keep. It’s important to handle overpayments properly in order to maintain accurate accounting records and avoid any legal or ethical issues. This article 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 a mistake, but could also result from an intentional act. It’s also worth noting that overpayment can go in either direction: A customer might overpay an invoice from your business, 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 overpayment incident in which a customer overpaid due to two errors, one his and one the customer’s. Like many small business operators with entirely manual processes, this business owner routinely creates new invoices by “saving as” old invoices and updating them with current information. Since there are often multiple items per invoice, he structures the invoices with a “Fee” listed per item and then a “Total Amount Due” at the bottom. In an early 2023 invoice, he forgot to update the total amount due, so it carried over from the prior invoice. His customer then paid the total without questioning or reconciling the amount with the other information itemized in the invoice. He notified the customer about the error when submitting his next invoice, which included 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 how they would like to proceed.
• Options for handling overpayments are to either refund the amount or establish a credit for it.
• The receiver cannot keep an overpayment, as it is neither revenue nor income.
• Account credits caused by customer overpayment are recorded as liabilities or contra-assets on the balance sheet until applied against an invoice.

Overpayment Explained

Overpayment in accounting occurs more often than you might expect, simply because invoice overpayments, such as the one just described, are among the most common invoicing problems. But it can also happen for a variety of other reasons, such as a miscalculation. For example, a customer may accidentally pay the same invoice twice or enter an extra zero on the payment amount. Regardless of the reason, it’s important for a business to properly record invoice overpayments in its accounting system to ensure accurate financial statements.

Because his is a cash-basis business, the owner in the real-life overpayment incident described above actually followed one of the handful of correct procedures for the situation, which are outlined below. But he did so without the benefit of accounting knowledge — only by having a modicum of common sense and ethics. Accrual-basis businesses are subject to the same common sense and ethics, but the accounting rules and relevant 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 the key steps to take, including the relevant bookkeeping actions, where necessary.

• Notify the Payer

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

• Issue a Credit

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

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

• Refund the Overpayment

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

• Unclaimed Money Laws

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

Tax Implications of Overpayments

Logically, since an overpayment is not recorded as revenue, it should have no income tax or sales tax implications. This is because, for a payment to be considered earned revenue, a business must have the legal right to collect the funds from the payer. In the case of an invoice overpayment, there was no reason to collect the extra money from the customer because goods or services were not provided. So, there is no taxable revenue. Is this still true if you end the reporting year with the overpayment credit still on account? Yes. Since a company reports tax revenue only during the year that the revenue is earned, there is no tax due until an actual sale is made. However, when the credit is used against a sale in a different 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’t be 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 invoice overpayment, deferred revenue is reported as a liability on the balance sheet. When the order is completed, it is entered as income on the income statement. If you pay your taxes on an accrual basis, you can delay paying tax on the revenue until it is reflected on the income statement. Revenue can be considered earned either at the date of shipment of goods or once the customer accepts delivery. Either timing is fine, but you must be consistent with which one you use for tax reporting each year.

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

Overpayment Examples

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

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

• 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 as Nina’s Pet Shop.

Next month, April, Nina’s Pet Shop’s invoice is for $600. The standard entry to record 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 to apply it toward their April purchases. The entry reduces AR, the amount owed to Nina’s and 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) for its April purchases. The journal entries to reflect the increase in cash and reduction in AR are:

• 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 invoice issued, zeroing out the overpayment liability, and the customer had to pay only the net difference.

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

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

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

Monthly reconciliation confirms the overpayment, and conversation with the customer confirms a 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 and financial mess for the seller. Inaccurate data entry is one of the most expensive mistakes that businesses frequently make. Both overpayment examples were caused by manual data errors — namely, duplicate payments and an extra “0” typo. There are multiple ways businesses can avoid manual accounting errors, such as making sure staff is not overworked and having stringent review procedures. But the best way to eliminate accounting errors is with accounting automation, which reduces human error because it follows programmed procedures when performing any task. For the two customers, accounts payable automation would likely have prevented the overpayment errors. For the seller, accounting systems can be programmed to automatically enter the accounting entries from invoices in accounting software, with built-in rules that dictate how to handle invoice overpayments.

Put a Stop to Overpayment Today

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Avoid Overpayment Accounting Errors With NetSuite

If your business is ready to move from spreadsheets or entry-level accounting software to an automated end-to-end accounting solution that helps eliminate errors like invoice overpayment while minimizing the time and effort required to perform routine accounting tasks, consider NetSuite Cloud Accounting Software. NetSuite simplifies the process of recording transactions, managing payables and receivables, collecting taxes and closing the books. NetSuite AP Automation can help businesses save time, reduce risks and improve the accuracy of their financial reports. And since NetSuite Cloud Accounting Software lets you automate tasks 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 is important to take the necessary steps to ensure that your business’s books remain accurate and that its relationship with the customer remains positive. By considering the accounting guidelines in this article, you can effectively manage the accounting involved and 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 the vendor’s account, which needs to be corrected in order to maintain accurate accounting records. You should immediately contact the vendor and request a refund or credit memo for the overpayment. You should also record the overpayment in your accounting records in a separate account for overpayments, so it is easy to identify. If you’re unable to resolve 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 a customer’s payment. It is important to properly record refunds in your accounting records to ensure that the business’s financial statements accurately reflect its financial position. The exact accounting treatment of a refund depends on the circumstances. Here are a few common scenarios and the corresponding accounting treatment:

• Refund of a sale: If a customer returns a product and receives a refund, the original sale should be reversed in the accounting records. If the original sale was recorded by a credit to the revenue account and a debit to the accounts receivable account, then the refund should be recorded as a debit to the sales returns account and a credit to the accounts receivable account.
• Refund of an overpayment: If a customer overpays an invoice and requests a refund, the overpayment should be recorded as a liability in a separate account. When the refund is issued, the liability account should be debited, and the cash account should be credited.
• Refund of a deposit: If a customer pays a deposit for a product or service and then cancels the order, the deposit should be refunded. The refund should be recorded as a journal entry that credits the cash account and debits the liability account 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 the amount 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 an unauthorized taking of funds. When a business receives an overpayment, it is required to notify the customer and to offer to refund the excess amount or apply it as a credit to future purchases. The business should promptly refund the overpayment or credit the customer’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 or income for the business — it is a payment made that exceeds the amount owed. When a business receives an overpayment, it is required to notify the customer and to offer to refund the excess amount or apply it as a credit toward a future invoice. The agreed-upon resolution 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 an invoice overpayment from a customer. The second option is to apply the overpayment as a credit toward a future invoice.