Credit note: How to use it effectively?

Reading time: 5 min.

A credit note plays an essential role in the invoicing process. It aids companies in cancelling out a portion of their previously issued invoices without removing the actual invoice, maintaining a reliable audit trail.

Credit note: Meaning

A credit note is a legal document issued by the seller of goods and/or services to the buyer against a previously recorded invoice. It shows the amount of money owed by the seller to the buyer.

A credit note is issued when a seller locates a discrepancy in an existing invoice, for instance, by charging an incorrect amount or when a buyer returns the goods. It represents the amount that was paid in excess by the buyer and is due to be returned to them by the seller.

A credit note is alternatively called a credit memorandum or a credit memo.

Credit note: Example

To illustrate, consider a scenario where a company, DFG Ltd., sells 10 products worth £20,000 to buyer ‘Z’ and issues an invoice against it. However, on receiving the goods, Z finds manufacturing defects in two products and returns them. Thus, DFG Ltd. then issues a credit note to the tune of £4,000 acknowledging the return of goods.

Credit note: Use cases

A credit note is typically issued in instances of invoicing errors, returns of goods, price disputes, or any offering of an after-sale marketing allowance. We elaborate on the reasons below:

  • Invoicing errors: There may be times when an incorrect amount is charged on the invoice or when a customer may eventually dispute the amount charged—a credit note can reverse such transactions.
  • Goods returned: Buyers may demand a refund on finding a manufacturing defect or fault with the product delivered. Goods may also be returned if the wrong items were delivered or if the delivered goods no longer meet their purpose. In such cases, sellers issue credit notes as proof of return of goods and money owed.
  • Order changes: Credit notes come in handy when a part of the order is changed. For example, if a buyer amends their order of five items to three products, a seller can issue a credit note recording the new changes.
  • Discounts and price disputes: If a seller incentivises early payments by offering discounts, then a credit note can be issued to offset the initial payment expected from the buyer. This shows that the buyer is no longer expected to pay in full the amount ordained in the initial invoice.

Credit note: Settlement

A credit note can be settled in multiple ways. If a buyer has already paid the previously issued invoice in full, then they can use this credit note to offset their future payments to the seller. Alternatively, they can also demand a cash payment based on the credit note invoice.

But if the buyer has yet to make a payment on the original invoice, then a credit memo can only partially offset the original payment. In other words, the buyer must pay the remaining amount after factoring in the amount stated on the credit note.

Credit note: Recording

When a seller issues a credit memo, it is recorded as a reduction from their accounts receivable, as the money is no longer receivable from the buyer. On the other hand, the buyer will also make a credit note entry in their books by reducing their accounts payable account.

Credit note: Benefits

There are several benefits to issuing credit notes, which are listed below.

  • Complete financial records: Issuing credit notes ensures your accounting books are accurate and compliant. This is because, instead of removing an inaccurately issued invoice, a credit note keeps the record of both the previous invoice as well as its offset in the form of a credit memo.
  • Tracking funds: Credit notes facilitate firms in keeping track of their accounts receivables and cash balances. They can also adjust their sales tax records based on the credit memos issued.
  • Complete transparency: A credit note enables both the buyer and seller to stay on top of their account balances. A buyer can accordingly either avail of a cash payment in case of a fully paid invoice or use this memo for future invoice payments.

Is a credit note a refund?

A credit note is not the same thing as a refund. While a refund entails immediate cash back, a credit note stands in as an acknowledgement of the amount due to the buyer. A buyer can either choose to use the credit note to reduce their payment on their unpaid invoice or adjust it towards future payments. Alternatively, they may demand a cash amount if the invoice is already paid in full.

Credit note vs invoice

A credit note is different from an invoice and is generally issued after an invoice has already been issued by the seller in the buyer’s name. An invoice details the amount due to the seller for the products and/or services provided by it to the buyer.

Conversely, a credit note serves as a negative invoice of sorts. It cancels out in part or full the amount due to the seller on the previously issued invoice. So, an invoice demands payments from the buyer, while a credit note shows the amount due to the buyer.

Related article : What is so special about a commercial invoice?

Credit note vs Debit note

A credit note and a debit note are issued by the seller and the buyer, respectively, at the time of the return of goods. To illustrate, if ABC Ltd. bought goods from JKL Ltd. and decided to return a part of their order due to a defect, ABC Ltd. would issue a debit note detailing its returns.

So, a debit note details the reasons for the return of goods and is issued by a buyer. The seller, JKL Ltd., will issue a credit note signalling its acceptance of the return.

Credit note details

A credit note can either be created manually or via accounting software that generates a credit note template. In both cases, the credit note will include the following: quantity issued, memo number, item description, reasons for return, and price.

Key takeaways

A credit note is a financial document issued by supplier companies to reduce the amount owed to them by the buyers. It helps firms maintain a proper paper trail and is issued when the goods are returned, the price is under dispute, or when there are invoicing errors.

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