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What Is a Credit Note (& How Does It Work)?

What is a Credit Note blog image

Credit notes are an important part of invoicing. In many countries, they are also a legal requirement. 

In an ideal world, no errors or issues with orders and invoices would ever take place… 

But as we all know, in business, circumstances and orders change a lot. Credit notes help us manage this and maintain a clear bookkeeping record. 

What is a credit note? 

A credit note (sometimes known as a credit memo) is a receipt-like document issued when invoices or orders have errors or just need to be changed. 

It can be used for the entire or partial value of an invoice. Its purpose is to correct the credit record between parties without deleting an existing invoice and creating a new one. 

It helps maintain an accurate invoice sequence and audit trail. 

Is a credit note a refund? 

A credit note is similar to – but not exactly the same as – a refund. A credit note is both acknowledgement and proof of credit owed, whereas a refund is a direct repayment of credit. 

A credit note is also more likely to implicitly signify further transactions between the two parties, whereas a refund does not. 

Credit notes are issued for a variety of practical reasons. These are not necessarily related to quality issues, though may include them. Refunds are generally issued for simpler reasons of dissatisfaction with services or goods. 

What’s the difference between a credit note and debit note? 

Credit and debit notes are similar but not the same. The main difference is that credit notes are issued by the seller, whereas debit notes (sometimes called debit memos) are issued by the buyer. 

Debit notes are usually sent before an invoice is received, whereas credit notes are sent because an invoice has been received. 

The former also represents a formal request for credit to the seller (who might yet dispute it), but the latter signify the seller’s acknowledgement of credit owed.

Why and when is a credit note used? 

A credit note can be issued before or after a payment has been made. The timing reflects what point in the invoicing process the issue arises. 

It is usually issued for one of the following reasons: 

Invoice error 

This can be simply be an incorrect price listed on the invoice, incorrect products or orders, or a mistake related to discount or VAT. 

Order error 

If the customer’s order is damaged or incorrect. This can vary from a totally wrong order to simply a few minor issues with it. 

Change of order 

Whether for internal reasons (e.g., management decisions) or external ones (e.g., the buyer’s customer’s decisions), a buyer may change or cancel an order already paid for or placed. 

Customer dissatisfaction 

Customers’ expectations might not match what they receive. Perhaps a product was incorrectly listed or described by seller, or it didn’t meet quality expectations. 

An example scenario of issuing a credit note 

Construction Co. has just ordered three large flatbed trucks from their regular supplier, Truck Ltd. An automated invoice for the amount of $150,000 was issued by Truck Ltd and sent to Construction Co. 

Unfortunately, the invoice amount did not list the 10% discount promised by Truck Ltd.’s sales staff. 

Before anyone had detected the error, the payment is successfully made by Construction Co.’s accounting team (who were unaware of the discount issue). Truck Ltd. realise their mistake shortly after and issue a credit note for the amount Construction Co overpaid ($15,000). 

The credit note is also recorded by both parties internally so that their accounts are balanced. The next time Construction Co makes a purchase from Truck Ltd., the credit note is redeemed with the invoice – $15,000 is subtracted from the credit total. 

How do you issue a credit note? 

Credit notes are issued by and to accounting departments – i.e., along the same channels regular invoices are issued. 

They are usually directly associated with a specific invoice, so it is best to keep them in the same email chains as those (if your accounting software enables this). 

Sometimes they can be linked to a future invoice (as in the example above). The latter scenario plays out when it’s more convenient because multiple transactions between the parties regularly take place. 

Credit notes in accounting 

How exactly you enter credit notes into your accounts depends on which bookkeeping system you use. 

In single-entry bookkeeping, the credit note’s value should simply be entered on a customer’s account. In double-entry bookkeeping, it is entered both as credit under account receivables and debit under revenue. 

What information should you include on a credit note? 

The information on a credit note should be similar to that listed an invoice. This includes: 

  • Contact details 
  • Date details 
  • Related invoice number 
  • Payment terms & conditions 

Can a credit note have an expiry date? 

Credit notes do have expiry dates. This will be listed in their payment terms. The receiver usually has 12 months to use up the credit balance. 

Conclusion 

A credit note is an essential tool for keeping your company’s bookkeeping process clear. 

Without it, an original invoice would have to deleted and another invoice issued in its place when issues arise. This would create confusion in the accounting and auditing processes. 

Credit notes are issued for a number of reasons. These range from a mistake on the amount of the invoice listed to customers dissatisfaction with their purchase. 

They are evidence that financial conduct authorities often require (including in the United Kingdom). They also represent an important assurance that the buyer’s funds will be recovered. 

As documents, they are not unlike invoices. One difference is that they can be issued before or after a payment has been processed. 

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