Credit Memo: A Complete Guide to Credit Memorandums

Everything you need to know about credit memos [explained by a Certified Accountant]

Emilie N.- FCCA, CB, MBS
Emilie N.- FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from corporates, financial services firms - and fast growing start-ups.

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Contents

What is a Credit Memo?

Credit memo, credit memorandum or credit note, is a commercial document issued by a seller or a bank:

1. Seller issues a credit memo to reduce the amount that a buyer owes for a previously issued sales invoice.

2. Bank issues a credit memo to increase a depositor’s account for a certain transaction.

Example of two scenarios in which a credit memo is applicable:

1. Credit Memo in Accounts Payable

When a buyer receives an order that is incomplete, incorrect, damaged, or erroneously invoiced, the seller may need to cancel the invoicepartially or in full.

However, in order to maintain a proper audit trail, many jurisdictions do not allow invoices to be edited after being issued. That is when a credit memo comes in, enabling a seller to reduce the accounts receivable balance by the required amount without deleting the invoice itself from the financial records.

2. Credit Memo in Bank Reconciliation

In bank reconciliations, a credit memo is a statement issued by a financial institution to notify a depositor that an account balance was increased for a transaction, such as:

  • Interest earned on money deposited with a bank
  • Collection of a promissory note receivable
  • Refund of a previous charge

Credit Memo vs. Credit Note vs. Credit Memorandum

Credit memo is a short form of the more formal term “credit memorandum”, which is also known as a “credit note”.

The terms credit memo, credit memorandum and credit note have the exact same meaning and are used interchangeably.

Credit Memo vs. Refund

>> Difference:

Refund means that a buyer receives a certain monetary amount back from a seller, whereas a credit memo indicates that a seller has given credit to a buyer, which either reduces the existing outstanding balance on the buyer’s account or can be used against the buyer’s future purchase invoices.

>> Similarity:

Like a refund, a credit memo is typically tied to a specific invoice that has already been issued and the credit provided by the seller to the buyer can either be partial or for the full total amount of that invoice.

How to Settle a Credit Memo

The debtor (i.e., buyer) can usually choose whether to use the credit memo to offset any future invoice payments to the creditor (i.e., seller) or exchange it for a cash payment instead, depending on:

  • Payment terms agreed between the buyer and seller
  • Whether the buyer has already paid the seller partially or entirely
  • Intention of a buyer to make further purchases from the seller in the future

Top 10 Reasons to Use a Credit Memo

The 10 most common reasons for issuing a credit memo:

Examples: Overstated invoice amount due to a clerical mistake or a discount being incorrectly applied.

Examples: Defective or incorrect product delivered, product does not meet the buyer’s specifications, buyer changes her/his mind.

Example: Goods became faulty or damaged within a warranty period.

Example: Customer was not happy with the service quality.

Example: Buyer made a purchase just before the price was heavily discounted and a seller agreed to match the difference between the original and the sales price.

Example: Clerical mistake on a customer’s end, where a member of the Accounts Payable team made an error when paying an invoice.

Example: Customer requests a decrease in order product quantity after an invoice is issued but before the order is shipped out.

Example: Customer cancels an order within the cooling-off period allowed in the seller’s payment terms.

Tip: Analyzing the reasons why credit memorandums are issued within an organization can help improve business performance by discovering the underlying causes and any reoccurring issues.

For example, misleading product packaging can be labelled more clearly, or an unreliable shipping partner can be replaced with a better delivery provider, in order to reduce the number of credit memorandums issued as a result of customer complaints and product returns.

Top 10 Things to Include on a Credit Memo

The format of a credit memo is similar to that of a standard invoice and should include all of the details required by both the seller and the buyer.

Credit Memo Template: 10 Things to Include
Required Information Examples
1. Reference numbers Credit memo reference number, number of an original invoice, purchase order number
2. Buyer details Customer reference number, business name, billing address, shipping address
3. Seller details Business name and address
4. Contact details Seller and buyer contact details
5. Dates Date of purchase, date of original invoice issue, date of credit memo issue
6. List of items Purchase price and quantity per item and in total
7. Credit details Credit applied per item and in total
8. Credit reasoning Brief explanation of why credit memo is required
9. Terms of payment Payment terms relevant to both the original invoice and the credit memo
10. Tax information Seller's and buyer's tax registration numbers, tax rates, gross and net value of purchased items

Accounting for Credit Memos

In a seller’s double-entry accounting system, a credit memo is recorded as a debit under the appropriate Revenue account and a credit under Accounts Receivable, which is the exact opposite of the original sales entry as the memo reduces the balance that the seller is now owed by the buyer.

Credit Memo – Accounting Journal Entry: Seller
Double-entry to record a credit memo in the books of a seller
Sales Returns (Revenue contra account) Debit
Accounts Receivable (Debtors Asset account) Credit

In a buyer’s double-entry accounting system, a credit memo is recorded as a debit under Accounts Payable (Creditors) and a credit under the appropriate Expense account, which is the exact opposite of the original purchase entry as the memo reduces the balance that the buyer now owes to the seller.

Credit Memo – Accounting Journal Entry: Buyer
Double-entry to record a credit memo in the books of a buyer
Accounts Payable (Creditors Liability account) Debit
Purchases Returned (Expense contra account) Credit

Tax on a Credit Memo

Credit memos must be compliant with any and all relevant tax requirements.

For example, if the original invoice included sales tax (e.g., VAT, GST), the matching credit memorandum should also display the amounts before and after sales tax.

Step-by-Step Credit Memo Example

Company A sold $1,000 worth of goods to Company B on 10 January 202X. When Company B received the goods on 5 February 202X, half of the shipment was damaged. As a compensation for the damaged goods, Company A issued a $500 credit memo to Company B on 10 February 202X.

What are the journal entries in the accounts of Company A for the original sales transaction and the credit memo?

10 January 202X: Sale of goods to Company B

Company A: Record of Sale on 10 January 202X Debit Credit
Accounts Receivable – Company B $1,000
Sales Revenue $1,000

10 February 202X: Credit memo issued to Company B

Company A: Record of Credit Memo on 10 February 202X Debit Credit
Sales Returns (credit memo) $500
Accounts Receivable – Company B (contra) $500

How will Company A’s financial statements look like before and after the credit memo?

Balance Sheet of Company A

Company A: Balance Sheet before and after credit memo
Accounts Receivable before credit memo $1,000
Accounts Receivable after credit memo $500

Income Statement of Company A

Company A: Income Statement before credit memo
Sales Revenue $1,000
Company A: Income Statement after credit memo
Sales Revenue $1,000
Sales Returns ($500)
Net Sales Revenue $500

Internal Controls for Credit Memos

If an organization does not have strong internal controls in place, credit memos can be relatively easily subject to fraud because they reduce debtor account balances without having to record an actual payment.

For instance, an unscrupulous staff member on the Accounts Payable team could potentially issue an invoice with amended bank account details so that a customer sends a payment to the employee’s personal account, while reducing the debtor’s accounts receivable balance with a credit memorandum, so that nobody is any wiser.

Credit Memo vs. Debit Memo

What's the difference between a credit memorandum and a debit memorandum?

Credit memo and debit memo are the opposite of each other:

  • Credit memorandum is a notification of a credit made on a recipient’s account in the accounting records of a sender.
  • Debit memorandum is a notification of a debit made on a recipient’s account in the accounting records of a sender.
Debit Memo vs. Credit Memo: Difference
Entity Debit Memo Credit Memo
Sender Debit receiver’s account in sender’s books Credit receiver’s account in sender’s books
Receiver Credited sender’s account in receiver’s books Debit sender’s account in receiver’s books

Examples:

As an example, let’s consider two scenarios in which a seller undercharges and overcharges a buyer by mistake and then rectifies the billing error with debit and credit memos:

Debit Memo vs. Credit Memo: Example
Example Seller undercharges a buyer Seller overcharges a buyer
Entity Debit Memo Credit Memo
Sender Seller issues a debit memo to correct a billing error of undercharging a buyer, increasing Accounts Receivable Seller issues a credit memo to correct a billing error of overcharging a buyer, reducing Accounts Receivable
Receiver Buyer increases Accounts Payable to seller Buyer reduces Accounts Payable to seller
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Emilie N., FCCA, CB, MBS
Emilie N., FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from large corporates and banks, as well as fast-growing start-ups.

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