What is an overdraft?

Definition of Overdraft

An overdraft (also known as a bank overdraft) generally means that the amount of a company's checks being presented at the bank for payment exceeded the amount on deposit. If the checks were to be paid by the bank, the bank checking account will have a negative balance.

The negative balance in the bank account will likely result in one of the following actions by the bank:

  • The checks being presented are returned to the endorser/payee marked insufficient funds or not sufficient funds (NSF). This is done so that the account balance will not have a negative balance. This will also result in bank fees for the company and the endorser/payee. It also signals to the endorser/payee that the company has a cash flow problem.
  • The checks being presented are not returned to the endorser/payee. There will also be a bank fee for the customer unless there is an overdraft protection agreement.

Many companies write checks for more than the amount on deposit in their checking accounts, but the checks do not cause a bank overdraft. The reason is the delay between the time when the checks are written and the time the checks are presented for payment at the bank. Taking advantage of this time delay, but not overdrawing the bank account balance is referred to as playing the float.

Example of Overdraft

Assume that on May 27, a company's checking account has a bank balance and a general ledger account balance of $300. The company, knowing that its checking account will receive an electronic deposit of $1,000 on May 31, decides to writes checks of $100, $250, and $400 and mails them to the payees on May 27. The company expects the checks to clear its bank account after June 1. Unfortunately, the checks for $250 and $400 reach the bank account on May 30, causing the May 30 bank account balance to be a negative $350. If the bank is eager to earn fees, its computer will process the $400 check first, followed by the $250 check. This will cause the company to incur two bank fees for the bank returning the two checks to the endorsers/payees. The company will then have to pay the endorsers/payees the amounts on the checks plus any fees their banks charged for handling the NSF checks. The payees may require the company to pay for future transactions with cash since it displayed a lack of money in the bank.