Everything you need to know about credit memos [explained by a Certified Accountant]
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:
When a buyer receives an order that is incomplete, incorrect, damaged, or erroneously invoiced, the seller may need to cancel the invoice–partially 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.
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:
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.
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.
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:
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.
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|
|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|
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|
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.
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|
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|
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|
|Company A: Income Statement after credit memo|
|Net Sales Revenue||$500|
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.
|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|
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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