Understanding the Credit Card Payment Lifecycle
For CPA firms handling client payments via credit cards, understanding the full lifecycle of a transaction is essential for proper accounting, dispute resolution, and fraud prevention.
This lifecycle consists of three key stages: Authorization, Clearing, and Settlement. Each step involves multiple financial institutions and verification processes that ensure secure and accurate fund transfers.
1. Authorization: The First Step in Payment Processing
The payment lifecycle begins when a customer provides their credit or debit card to make a payment. This step, known as Authorization, involves verifying the transaction details before the funds are approved.
How Authorization Works
When a card is used, the merchant sends the payment request to their Acquiring Bank (the financial institution that processes transactions for the business).
The Acquiring Bank forwards the request to the Issuing Bank (the customer’s bank).
The Issuing Bank evaluates the request based on:
Available Funds – Ensuring the customer has enough money or credit.
Fraud Detection – Identifying unusual transaction patterns.
The transaction is either approved or declined, with an authorization record stored for reference.
Pre-Authorizations: Holding Funds for Later Adjustment
Some businesses, such as hotels or gas stations, use pre-authorizations to hold a set amount on a customer’s card temporarily. This amount may be adjusted before final payment. For example:
A hotel may place a pre-authorization for incidentals and later adjust it based on the actual charges.
A gas station may pre-authorize a fixed amount before determining the final purchase total.
If the transaction is approved, it moves to the next phase: Clearing.
2. Clearing: Finalizing the Transaction
At this stage, the merchant confirms the authorized transaction and submits it for processing. This step ensures that the funds are set to be transferred from the customer’s bank to the merchant’s account.
Key Aspects of Clearing
The merchant converts the authorization into a formal transaction request.
This transaction request is forwarded to the payment network and issuing bank for final confirmation.
Transactions that have been cleared are stored in financial records and can be retrieved via transaction logs.
Single vs. Dual Message Transactions
Single-message transactions: Authorization and clearing occur at the same time (e.g., debit card purchases at grocery stores).
Dual-message transactions: Authorization happens first, followed by a separate clearing process (e.g., credit card payments that merchants batch-process later).
Once cleared, the payment is ready for settlement.
3. Settlement: Transferring Funds to the Merchant
In the final stage, funds are officially moved from the customer’s Issuing Bank to the merchant’s Acquiring Bank through the card payment network. This process ensures that merchants receive their money, minus applicable processing fees.
How Settlement Works
The acquiring bank submits the final transaction batch to the card network.
The card network processes the payment, deducts fees (e.g., interchange fees), and transfers the net amount to the merchant’s account.
This final movement of funds into the merchant’s account is called Funding.
Fees Deducted During Settlement
Interchange Fees – Fees paid to the card network (Visa, Mastercard, etc.).
Processing Fees – Fees charged by the acquiring bank/payment processor.
Merchant Account Fees – Additional fees depending on the payment provider’s terms.
Settlement is usually completed within a few business days after the clearing stage.
Why This Matters for CPA Firms
As a CPA, understanding the credit card payment lifecycle is crucial for:
Accurate Revenue Recognition – Knowing when a transaction is finalized helps in recording revenue correctly.
Dispute Management – Recognizing where a payment stands in the lifecycle aids in handling chargebacks and fraud claims.
Cash Flow Planning – Knowing the timing of settlements helps businesses manage liquidity and forecasting.
Fee Analysis – Understanding the breakdown of fees helps in reconciling financial statements and advising clients on cost-effective payment solutions.
By keeping these processes in mind, CPAs can help businesses optimize their payment processing strategies and ensure smooth financial operations.