The term bank overdraft refers to a withdrawal of money that is greater than the available balance in an account. Banks can provide overdraft protection, which is a service that allows a withdrawal to occur even though there are insufficient funds in the account.
When an overdraft occurs in a business setting, the transaction is typically added to accounts payable, which is a current liability. If an overdraft is material, it should also be disclosed in the notes to the company’s financial statements.
Bank overdrafts occur for a number of reasons, which can be grouped into the following categories:
- Errors: failure of the accountholder to maintain accurate records of deposits and withdrawals, incorrect charges from merchants to a debit card, as well as bank processing mistakes.
- Fraud: stolen cards or identity theft, allowing for unauthorized withdrawals of funds through checks or ATMs.
- Unknown Transactions: unexpectedly high bank fees, deposits placed on hold by the bank, returned checks (insufficient funds).
- Planned: accountholders may use overdraft protection as a means of obtaining a short-term loan.
Companies and individuals can enter into agreements with banks to provide overdraft protection. Transactions involving ATM withdrawals, debit card purchases, checks, and even electronic funds transfers can be covered by this protection. When there are insufficient funds in the account, this agreement will allow for withdrawals up to the overdraft limit; thereby preventing a check from “bouncing.”
Also known as an overdraft line of credit, in exchange for providing this protection, the financial institution will charge a rate of interest on the outstanding balance of the overdraft, or loan.
Banks can also provide what is referred to as overdraft transfer protection. This requires the linking of accounts, and automatic transfers between them, when an overdraft occurs. For example, a company can link their checking account with a savings account. If a withdrawal is greater than the checking account balance, the bank will automatically transfer funds from the savings account to cover the withdrawal.