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

What is a Credit Note?

Credit note, also known as credit memo or credit memorandum, is a commercial document issued by a seller of goods or services to a buyer, reducing the amount that the buyer owes to the seller under the terms of an earlier invoice.

Credit note is a negative invoice through which a seller notifies a buyer of a reduction in the amount owed that was originally agreed upon at the time of purchase in exchange for either full or partial credit.

Is a Credit Note a Refund?

A credit note (credit memo or memorandum) is different from a refund for two reasons:

  1. Refund means that a buyer receives money back from a seller.
  2. Credit note means that a buyer receives credit from a seller that can be offset against the buyer’s current outstanding balance or future invoices.

Credit Note vs. Credit Memo

Credit note is also known as credit memo or credit memorandum, with all of these terms being used interchangeably.

When is a Credit Note Used?

Why can’t you just simply change or cancel an invoice in an accounting system? Great question!

Many jurisdictions legally mandate that entities keep a full audit trail for their financial transactions, which means that an invoice that has already been issued should never be edited or deleted in an invoicing system.

That is where a credit note comes in, allowing a company to keep the record of sale in its accounts, while clearly indicating that the order was partially or fully cancelled, with the appropriate returned to a customer in the form of credit.

Types of Credit Notes

1. Connected or Independent

Although a credit note is usually linked directly to a specific existing invoice, it can also be issued separately and applied to any future invoice or other income source.

2. Internal Credit Note

In some cases, a credit note is created for internal purposes only and not sent out to a customer, for instance when a seller is writing off an irrecoverable bad debt.

3. Bank Credit Note

Bank credit note, also known as a bank credit memo or memorandum, is a notice issued by a bank which confirms that the institution has increased a depositor’s account balance for a certain transaction, such as a promissory note collected by the bank, interest earned, or a bank charge refund.

Cause Analysis

In any case, it is advisable for businesses to analyse the situations in which they typically issue credit notes, especially if they frequently reoccur, as developing insight into the underlining causes can help remove any issues and inefficiencies in order to improve business performance.

Credit Note Template

Top 8 things to include on a credit note:

1. Reference numbers

  • Credit note number
  • Invoice number (number of the original invoice)
  • Purchase order number (number of the original PO)

2. Buyer details

  • Customer reference number
  • Customer name
  • Billing address
  • Shipping address
  • Contact details (department, contact person, email, phone)

3. Seller details

  • Name
  • Address
  • Contact details (department, contact person, email, phone)

4. Dates

  • Date of purchase
  • Date of invoice issue
  • Date of credit note issue

5. List of goods and service items

  • Price of each item
  • Quantity of each item
  • Total value of the original transaction

6. Credit details

  • Credit applied to each item
  • Credit applied to the total transaction
  • Reasons for issuing the credit note

7. Terms of payment

  • Payment terms of the original invoice
  • Payment terms of the credit note

8. Tax details

  • Tax registration numbers of seller and buyer (e.g., VAT, GST)
  • Tax rates
  • Taxable value of goods and services (gross and net)

Credit Note Double Entry Accounting Journal

The double-entry journal postings into an accounting general ledger from a buyer’s and seller’s point of view are as follows:

Credit Note in Sellers’ Accounts

When a seller issues a credit note to a buyer, the document provides evidence for a Sales Returns journal to be posted against the debtor’s outstanding balance in Accounts Receivable because the buyer is now required to make a reduced or no payment for an invoice that was originally recorded as Sales Revenue.

Credit Note - Accounting Journal Entries: Seller (Creditor)
Transaction Debit Credit
Original Sale Accounts Receivable Sales Revenue
Seller sends credit note to buyer Sales Returns Accounts Receivable
Explanation: Reduction in revenue originally booked as sales Explanation: Reduction in assets as payment from a debtor will be reduced

Credit Note in Buyers’ Accounts

When a buyer receives a credit note from a seller, the document provides evidence for a Purchase Returns journal which decreases the Accounts Payable liability the debtor has to pay to the creditor and decreases the expense originally incurred to make the purchase.

Credit Note - Accounting Journal Entries: Buyer (Debtor)
Transaction Debit Credit
Original Purchase Purchase Accounts Payable
Buyer receives credit note from seller Accounts Payable Purchase Returns
Explanation: Reduction in liability as payment to a creditor will be reduced Explanation: Reduction in expenses incurred to make the original purchase

Settlement of a Credit Note

If the invoice has already been fully paid, the buyer can typically decide whether to use the credit note against any future invoice payments to the seller or exchange it for a cash payment, depending on the agreed payment terms.

Otherwise, the buyer is required to pay the remaining amount owed after the reduction specified in the credit note, if any.

Credit Note Taxation

A credit note should always reflect the tax details of the original invoice, such as the amount before and after sales tax, along with the seller’s sales tax registration number.

Credit Note Fraud & Internal Controls

Since credit notes are almost as susceptible to fraud as cash, it is important to maintain proper internal controls for the process at all times, including:

  • Management review and approval
  • Segregation of duties between record keeping and account receivable duties
  • Audit trail

Top 5 Credit Note Examples

Let’s take a look at the 5 most common situations that may give rise to a credit note in these companies:

Credit Note Example #1: Invoicing Error

1.  Company B purchases $1,000 worth of product from Company A.

2.  Company B informs Company A that it cannot complete the payment for the order because there is an error on the invoice.

3.  Company A realizes that it has, indeed, accidentally overcharged Company B by 10% and sends a $100 credit note to Company B.

4.  Company B pays $1,000 to Company A (= $1,100 original erroneous invoice – $100 credit note)

Credit Note Example #2: Defective Product

1.  Company B orders 40 products items for $25 each from Company A.

2.  On receipt of the shipment, Company B informs Company A that two of the items are defective, perhaps damaged in transit.

3.  Company A issues a credit note for $50 (= 2 damaged items x $25 item price).

4.  Since Company B has already paid the original invoice in full, it will use the $50 credit note towards future purchases with Company A.

Credit Note Example #3: Price Increase

1.  Company B notices that the products it bought from Company A were marked down in price by 20% just one day after Company B made the purchase.

2.  Since Company A and B have a long-standing business relationship, Company A agrees to issue a credit note for the difference between the price Company B originally paid and the new sale price.

3.  As Company B has already paid the original invoice in full, it will use the $200 credit note towards future purchases with Company A.

Credit Note Example #4: Store Product Return (B2C: business-to-consumer)

1.  Company B resells the goods purchased from Company A to the end-consumers in its online and brick-and-mortar stores.

Company B’s return policy is that it accepts returns within 90 days of purchase, no questions asked. However, the reimbursement is in the form of store credit only, no cash.

2.  Sally buys a product from Company B’s online store. In a couple of days after the item arrives to her home, Sally changes her mind about the product as it does not fully fit her needs and sends it back to Company B.

3.  Upon receipt of the returned item, Company B credits Sally’s account with the company with the total amount originally paid for the returned goods so she can use the credit to buy a different product or exchange it for another one of the same type.

Credit Note Example #5: Banking

1.  Company B (buyer and payer) issues a promissory note to pay Company A (seller and payee) for some goods purchased.

2.  Company B’s bank collects the payment from Company A as per the promissory note.

3.  Company B’s bank will send a statement to Company B, which confirms that the financial institution has collected the note receivable on behalf of Company B and increased its account balance accordingly.

Credit Note vs Debit Note

In practice, a common example that illustrates this difference is when a buyer returns goods to a seller, accompanied with a debit note requesting a reduction in debt obligations. In response, the seller issues a credit note to the buyer confirming the approval of the credit or refund for the returned goods.

Credit Note vs. Debit Note: Example with Accounting Journal Entries
Entity Buyer Seller
Document Debit Note Credit Note
Scenario Buyer returns goods to a seller with a debit note. Seller approves buyer’s return of goods and issues a credit note to the buyer.
Debit Accounts Payable Sales Returns
[Decrease in liability as payment to a creditor is reduced.] [Decrease in revenue originally booked as sales.]
Credit Purchase Returns Accounts Receivable
[Decrease in expenses incurred to make the original purchase.] [Decrease in assets as payment from a debtor is reduced.]

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