What is an Unapplied Credit?

Unapplied Credit Definition

An unapplied credit (also known as unapplied payment or unapplied cash) in financial and accounting terms refers to a sum of money received by a company but not yet designated for a specific invoice or charge. 

When do Unapplied Credits Occur?

• Overpayment by a Customer: A customer could accidentally pay more than the amount due on an invoice. The excess amount becomes an unapplied balance until it's refunded or applied to future invoices.
• Prepayments: A customer could make an advance payment (or partial payment) before receiving goods or services. This payment is initially recorded as an unapplied credit until it's linked to an outstanding invoice.
• Credit Memo: If a company issues a credit memo (for returns, discounts, or allowances), the value of this unapplied credit memo can be held as an unapplied credit amount until the total amount is applied against an open invoice or outstanding balance.
• Accounting Errors: Sometimes, errors in accounting processes can lead to payments that don't match any specific invoice or charge. These are temporarily held as unapplied credits until the discrepancy is resolved.

Applied Payment vs. Unapplied Credit

Applied payment refers to a payment that has been received and correctly matched or linked to a specific invoice or charge. It accurately reflects a transaction where a customer's payment has been allocated to their outstanding debt, reducing the balance owed.

Drawbacks of Unapplied Credits 

Having many unapplied credits can pose several downsides and challenges for a business. These include:

• Cash Flow Disruptions: Unapplied credits can distort the accurate picture of cash flow, making it challenging to understand the actual financial position of the business. This can lead to difficulties in managing operating expenses and making informed financial decisions.
• Inaccurate Financial Reporting: The presence of unapplied credits can lead to inaccuracies in a financial statement. This affects the reliability of accounts receivable aging reports, balance sheets, and income statements, complicating financial planning and analysis.
• Increased Administrative Burden: Managing and reconciling unapplied credits requires additional administrative effort. This can be time-consuming and resource-intensive, diverting staff from other important tasks.
• Customer Relationship Issues: Unapplied credits can lead to confusion and disputes with customers. If credits are not applied correctly or promptly, customers can become dissatisfied, potentially harming business relationships.
• Risk of Bad Debts: If unapplied credits remain unresolved for extended periods, they can eventually be written off as bad debts, affecting the company's profitability.
• Compliance and Audit Concerns: For companies subject to financial audits, unapplied credits can raise red flags with auditors, showing potential issues in financial control and accounting practices. This can lead to compliance issues, especially if the unapplied credits are significant.
• Opportunity Cost: The time and resources spent on resolving unapplied credits could be better used for more productive activities, such as business development or customer service improvements.
• Difficulty in Forecasting: Unresolved unapplied credits can complicate cash flow forecasting and budgeting processes, as they obscure the true revenue picture.
• Delayed Payment Recognition: In some cases, unapplied credits represent delayed recognition of payments, which could affect the timing of revenue recognition and, thus, financial performance metrics.
• Potential for Fraud and Errors: A high volume of unapplied credits can increase the risk of accounting errors and potentially conceal fraudulent activities, as they create a more complex and less transparent financial environment.

How to Fix Unapplied Credits

Fixing unapplied credits in accounting requires identifying and appropriately applying these credits to the correct invoices or accounts. 

Here are the steps typically involved in resolving unapplied credits:

• Identify the Unapplied Credits: Begin by reviewing your accounting records to identify any unapplied credits. These can be listed under a specific ledger (or subledger) account designated for such entries.
• Determine the Reason for the Unapplied Credit: Investigate why each credit remains unapplied. It could be because of overpayment, prepayment, a credit memo, or an accounting error.
• Communicate with the Customer (if applicable): If the unapplied credit is because of customer action (like overpayment), contact the customer to determine their preference for handling the excess funds. They will want it applied to future invoices or refunded.
• Apply the Credit to an Outstanding Invoice: If there are outstanding invoices for the same customer, you can perform cash application to apply the unapplied credit to these invoices. Ensure to document the application for your records with information such as bank account, payment method, customers account, invoice number, receipt, and more.
• Issue a Refund: If the customer prefers a refund or if there are no outstanding invoices to apply for the credit, process a refund. Record this transaction in your accounting system.
• Create an Adjustment Entry: In cases where the unapplied credit is because of an error, create an adjusting journal entry to correct the original transaction. This can involve debiting or performing credit balance to the accounts to reflect the transaction.
• Update Accounting Records: After applying for the credit or processing a refund, update your accounting records to reflect these changes. Ensure that the unapplied credit account is adjusted accordingly.
• Review and Reconcile Accounts Regularly: Regularly review your accounts for unapplied credits and perform accounting reconciliation on them promptly. This practice helps maintain accurate financial records and can prevent issues related to unapplied credits from accumulating.
• Implement Preventative Measures: To prevent future occurrences of unapplied credits, you will want to review and update your accounting processes. This could include better invoice matching systems, improved customer communication protocols, or enhanced training for your accounting staff.