Understanding chargebacks: a guide for small businesses

What is a chargeback in accounting?

A chargeback is a reversal of a payment made on a credit or debit card when the payment could be incorrect or fraudulent.

The chargeback process protects the cardholder from being held liable for charges they didn’t make, and is meant to encourage businesses to improve their quality of service.

Chargebacks can happen due to fraudulent activity, billing errors, and customer dissatisfaction with products or services, for example.

They can affect small businesses acutely, as they pay a fee if a chargeback is granted and risk losing their goods. Chargeback managers have reported a rise of 76% in chargebacks year on year.

Chargebacks vs refunds: key differences

Refunds are dealt with directly between the customer and the business. This is the ideal – the business rights any wrongs, and receives their goods back in return for the refund.

Chargebacks are made directly with the cardholder’s bank, which reverses the transaction and only gives the business the chance to dispute it afterwards. Some customers incorrectly use a chargeback to avoid dealing with the business if they have a complaint.

Refunds and chargebacks differ from each other in four main ways:

Financial: Refunds typically don’t come with extra fees, while chargebacks involve processing costs and potential penalties.

Time: Refunds are much quicker than chargebacks, which take longer to resolve as banks and a dispute process are involved.

Regulation: Refunds depend on a business’s return policy, while chargebacks are governed by strict rules and timelines separate from the merchant’s business.

Reputation: High chargeback rates can affect a business’s standing with payment processors, while refunds don’t carry this risk.

Are chargebacks or refunds better for merchants?

Ideally, your customer is happy with the goods or services they’ve bought so you don’t lose out on income. But if not, a refund helps keep your relationship with the customer alive.

If a chargeback or refund is approved, you’ll need to account for it so your figures are correct.

Common reasons for chargebacks

It’s usually the customer who asks for a chargeback, although the business can request one too. The customer’s bank may also initiate a chargeback if its systems identify fraud.

The typical reasons for a chargeback are fraud and errors.

Fraud

• Unauthorised transactions on a card: The customer’s card details are used without their knowledge, leading to a dispute
• Friendly fraud: A customer intentionally claims a legitimate purchase as fraudulent to avoid payment
• Business fraud: The business intentionally fails to deliver goods or services after receiving payment

Business errors

• Incorrect charges: If there’s a mistake during the financial processing of a charge, the customer or the business will action a chargeback
• Damaged or incorrect goods: The customer receives defective goods, prompting them to file a chargeback (if they’re unable to secure a refund due to a business’s return policy)
• Failure to address customer complaints: If there’s a missed complaint, a customer may request a chargeback if there’s no resolution (eg a refund or adequate communication)

Customer errors

• Unrecognised transactions: If a charge doesn’t have a clear description or the business name is different to the one they know, the customer might not recognise a charge and ask for a chargeback
• Accidental double purchases: The customer might accidentally make multiple purchases or payments for the same item – either they’ll request a chargeback or the business will organise one to cancel the additional transaction

Errors relating to subscriptions and recurring payments

• Unwanted subscriptions: A customer might have signed up to a subscription service unintentionally or forgotten about one – the customer might dispute the charge and call it fraudulent
• Failure to cancel: If the customer asks to cancel a subscription or recurring charge, but the business fails to do so and charges continue, the customer might ask for a chargeback

Who is involved in the chargeback process?

The chargeback process involves:

• The customer (the cardholder)
• The business (the merchant)
• The payment processor connected to the business (the acquirer)
• The customer’s bank or card issuer (the issuer)

Understanding the chargeback process

Customers usually have 60–120 days to request a chargeback, depending on the payment processor’s policy. For instance, some payment processors (like Visa, Mastercard, Amex, and Discover) give cardholders 120 days, depending on the situation. Check your card’s policy to be sure.

Here’s the basic chargeback process:

1. The customer disputes the charge

The customer believes a charge on their card is invalid and contacts their bank to dispute it within the valid timeframe.

2. The issuing bank evaluates the dispute

The issuing bank decides whether the reason is valid. If they find in favour of the customer, they grant a chargeback.

3. The issuing bank gives provisional credit

The bank credits the customer for now and contacts the merchant’s acquirer. This credit will be reversed if the chargeback is denied at a later stage.

4. The acquirer notifies the merchant

The merchant’s acquirer debits the merchant’s bank account and charges them a chargeback fee. The fee covers the payment processor's admin costs.

5. The merchant responds

The merchant then decides whether to accept or dispute the chargeback. They must reply within the allocated time – usually 10–30 days, depending on the payment processor – or they could be charged a non-response fee. For instance, Visa gives merchants 20 days to respond, while Mastercard users have 45 days.

6. The dispute resolution process

If the merchant disputes a chargeback, they must give evidence to support their position, like proof of delivery, communications with the customer that prove they received the item), photographs, and sales receipts. The merchant provides the evidence to the merchant’s acquirer, who passes it to the bank for review. The bank ultimately decides whether to uphold or reverse the chargeback.

If a bank upholds the chargeback, the customer gets to keep the amount and the payment processor may charge the merchant a chargeback fee. But if the dispute is resolved in favour of the merchant, the bank returns the amount and any fees incurred during the process.

The effect of chargebacks on your business and finances

Chargebacks are a financial and administrative headache for small businesses, and can damage your reputation and your relationship with your payment processor.

Frequent chargebacks can also be a significant financial loss. High chargeback rates can lead your payment provider to penalise you or even to terminate your account. A rate of 1% or higher chargeback to all transactions is generally considered the threshold by many payment processors, and exceeding this rate could lead to additional fees or penalties.

Preventing chargebacks from occurring

Prevent chargebacks from happening in the first place by following these tips:

• Communicate clearly with your customers throughout the buying process to prevent customer complaints. Clear billing, return, and refund policies will reassure your customers (and give you leverage if they challenge your policies).
• Use secure payment processors with advanced fraud detection tools.
• Have a strong credit control policy to reduce the number of chargebacks and make sure you get paid for your products or services.

How to dispute and resolve chargebacks

If your payment processor (your acquirer) notifies you of a chargeback request, you can dispute it:

• Respond within the chargeback timeframe:

Contact your payment processor (the acquirer) within the set period of time (typically 10–30 days, as above). The disputed funds will probably be forfeited if you don’t respond.

• Submit your supporting evidence:

You’ll need to provide evidence that the chargeback has no grounds, such as by showing proof of delivery (POD), signed contracts, communication logs, and transactions of receipts.

• Issuing bank evaluates the evidence:

The issuing bank evaluates the evidence and decides whether to reverse or uphold the chargeback. If the dispute is complex, it is escalated to the credit card provider who has the final decision in resolving the chargeback.

Record and manage chargeback fees in accounting

If you don’t win the dispute or decide not to challenge the chargeback, it’s usual practice to record chargeback fees as operating expenses (bank fees). You may need to write off the chargebacks themselves as bad debt expenses

A bookkeeper or accountant can advise you on how to record the transactions and fees.

Why chargebacks are important for businesses

By monitoring chargebacks and recording them correctly, you’ll keep your customers satisfied and make sure you aren’t being taken advantage of. You also won’t lose funds unnecessarily or potentially lose the ability to accept card payments. And you’ll keep your business reputation intact.

Increase customer satisfaction: If you’re dealing with a lot of chargebacks, the problem may be at your end. This is the time to see how you might improve your products or services, or your refund and returns process.

Avoid being ripped off: Investigate each chargeback so you won’t be scammed by a customer or miss out on revenue.

Avoid losing funds: As well as losing money – and your product – you’ll usually be hit with a chargeback fee, even if the chargeback is disputed and cancelled.

Avoid losing a payment processor: If you have too many chargebacks, the issuing bank that processes your payments may not want to work with you any longer.

Protect your business reputation: Ensuring you’re well protected against both preventable and fraudulent chargebacks will keep your reputation intact.

The key to avoiding chargebacks is to follow payment card guidelines, be compliant with payment card industry (PCI) security standards, and keep track of your chargebacks correctly.

Get professional advice for managing chargebacks efficiently

Chargebacks are complex, get a bookkeeper or accountant to help you manage them, and your business finances. Find a financial advisor near you.