An invoice for £1,200 including VAT goes out, and £1,000 arrives. The bookkeeping for the £1,000 is simple. The real work is deciding what the missing £200 is, because that answer determines whether you chase it, issue a credit note, accept it as a cost or wait for the next instalment.
Why customers pay short
Before touching the ledger, find out which of these you are looking at. The remittance advice usually says; if there is none, ask.
- Dispute over part of the work. The customer pays for what they accept and withholds the rest: a damaged item, hours they question, a missing deliverable.
- Deduction for something of theirs. They have set off their own invoice to you, deducted a retention under a construction contract, or knocked off a fee.
- Discount taken. Either a prompt payment discount you offered, or one they have simply helped themselves to.
- Instalment. You agreed, or they have decided, to pay over several months.
- Bank charges. Overseas customers in particular often send an amount net of their bank’s or an intermediary’s charges.
- Error. They keyed the wrong figure or paid an older version of the invoice.
Allocate to the invoice, not on account
Match the £1,000 against the specific invoice so it shows as part-paid with £200 outstanding. Avoid leaving the receipt unallocated on the customer account; aged debtors then shows the full invoice overdue and an unexplained credit beside it, and the next person to look will not know they belong together.
Where one payment covers several invoices and falls short overall, allocate according to the remittance. With no remittance, follow your written payment allocation rules, usually oldest first, and tell the customer which invoices you have treated as settled.
Add a note to the invoice with the reason for the shortfall. The person who chases it next month needs to know whether they are chasing a dispute or a forgotten instalment.
What to do with the remainder
Disputes. If the complaint is valid, issue a credit note for the agreed amount; the credit note reduces both the debt and your output VAT. If it is not, write back explaining why the full amount stands and keep chasing. The invoice disputes and payment holds guide covers how to keep a disputed item separate from ordinary overdue debt.
Discounts. If you offered a prompt payment discount and the customer paid within the terms, the discount is theirs. Since 1 April 2015, VAT is due only on the amount you actually receive, so you either issue a credit note for the discount or rely on invoice wording that sets out the discounted price and the VAT on it. If they took a discount they were not entitled to, decide whether to chase it or concede; if you concede, still issue a credit note so the VAT is correct. More detail in early payment discounts in bookkeeping.
Instalments. Put the schedule in writing, show it on the customer statement, and chase the first missed instalment straight away rather than waiting for the full balance to become overdue.
Bank charges deducted by the payer. These are a cost of being paid, not a reduction in the price, so output VAT on the invoice is unchanged. Write the shortfall off to bank charges, or agree with regular overseas customers that they pay all charges in future.
Set-offs. Only accept a set-off of the customer’s own invoice if you agree it is due. Record it as a contra between the sales and purchase ledgers so both accounts clear.
Writing off small differences
A shortfall of a few pence or pounds costs more to chase than to accept. Set a tolerance in your credit control policy, for example any difference under £5, and write it off in one step when allocating the receipt:
| Account | Debit | Credit |
|---|---|---|
| Bank | £1,196.50 | |
| Small payment differences (expense) | £3.50 | |
| Trade debtors (customer) | £1,200.00 |
Do not use the tolerance for amounts the customer has deliberately withheld; a pattern of small deductions from the same customer is a dispute, not rounding. Larger residual balances are dealt with under the small balance write-off routine.
The VAT effect of money you have not received
What happens to the VAT on the missing £200 depends on your VAT accounting:
- Standard (invoice) accounting. You accounted for the full £200 of output VAT when you raised the invoice. If part is never paid and no credit note is issued, you can reclaim the VAT on the unpaid part through bad debt relief once it is more than six months overdue and written off in your accounts. Keep the records described in VAT bad debt relief records.
- Cash accounting scheme. You account for output VAT only on what you receive. On £1,000 received against a £1,200 invoice, the VAT included is £1,000 × 20/120 = £166.67. The remaining £33.33 is declared when, and if, the rest arrives.
A quick decision guide
| Reason for the shortfall | Ledger action | VAT action |
|---|---|---|
| Valid dispute | Credit note for agreed amount | Reduced by the credit note |
| Unjustified deduction | Leave open, chase | None yet; bad debt relief later if unpaid |
| Prompt payment discount within terms | Credit note or invoice wording | VAT on amount received |
| Agreed instalment | Leave open, track schedule | None under standard accounting |
| Payer’s bank charges | Write off to bank charges | None |
| Difference under tolerance | Write off on allocation | None |