What Is a Credit Note: Meaning, Examples, and Tips

No matter whether you run a large or small business, chances are that throughout your experience you’ve come across credit notes.

But what does this term mean, how does it influence your accounting, and what else should you know about it?

In the following sections, we explain everything you need to know on the topic of what is a credit note.

Credit Note Definition

Before we can explain the reason behind having credit notes in the first place, it’s essential to explore what is a credit note.

In essence, also referred to as a credit memo or a credit memorandum, a credit note represents a financial document issued by businesses (the seller of products or services) to buyers informing them that credit is being applied to their account. 

Credit memos are issued as a substitute for a cash refund and can be considered a negative invoice.

In short, a credit note acts as a notification that the customer doesn’t have to pay the total amount of an initial invoice. 

The Purpose of Credit Notes

A credit note often plays an important role in the invoicing process for both large and small business owners. 

Its main purpose is to offset a previous invoice that has already been paid. Sellers can issue credit notes whenever they need to cancel an invoice, both partially and the full amount. 

How Credit Notes Work

Once it has been identified that there’s a need to issue a credit note, the seller compiles all necessary information to create the document. 

The credit note usually goes through an approval process internally within the seller’s company. Once authorised, it is sent to the buyer. The seller must then make all necessary changes to their accounting records and reduce the accounts receivable. 

On the other hand, the buyer makes a record of the credit note and reduces accounts payable. 

When it comes to how to issue a credit note, all you have to do is gather and record all of the must-have components. 

Key Elements of a Credit Note

Every credit note will be different but typically, this document consists of the following key elements:

• Credit note number;
• Date;
• Company address;
• Original invoice reference;
• Seller details;
• Buyer details;
• Adjustment description;
• Amount;
• Signatures.

Making sure that you have all of this information available before preparing your credit notes can help you enjoy a quicker and easier process, alongside faster approval times.

Common Reasons for Issuing Credit Notes

Usually, credit notes are necessary in circumstances where there is a need to make changes to a previously issued invoice. 

For example, a popular reason to issue a credit note is when a customer returns goods as a result of defects, damages, or other problems. 

Another example could be a service being cancelled, a pricing error causing an overcharge, or perhaps products being delivered in lower quantities than agreed on. 

Credit notes can even be used to apply discounts that were promised but not included in the original invoices.

Examples of Credit Notes

To create a more detailed picture of credit notes, let’s look at a credit note example from real life.

A sports company X purchases materials for their shoe production from a supplier company Z. The materials cost £1,000. 

Once company X receives an invoice (with invoice number 1000000032) for their purchase, they realise that there is an error and inform company Z.

As a result, company Z issues a credit note against invoice number 1000000032 and sends it to company X. This means that the invoice is cancelled and £1,000 is recorded as positive under accounts payable. 

In case company X has completed the payment to company Z before the changed credit note invoice, they can use the £1,000 for future payments or request a full refund. 

Credit Note vs. Debit Note

In some cases, credit notes can be confused with debit notes. However, the two terms differ by definition and purpose.

Unlike credit notes, debit notes are used to request payment for goods that have already been returned or services that have already been provided. In essence, they inform customers about current debt obligations.

While the credit note informs that a buyer’s account has been credited, a debit note informs that the seller’s account has been debited.

In other words, by issuing a credit note, the provider of the goods or services takes responsibility to pay back the reduced amount or adjust it in the following transaction. Once the credit memo is issued by the seller, the buyer will also issue an instrument referred to as a debit note. 

Legal Requirements for Credit Notes

As an official document, a credit note must comply with a number of legal requirements. 

These are mostly related to the fundamental elements that must be included in a credit note to make it legitimate. 

For example, all credit notes must contain a unique identification number, a date of issue, and a reference to the original invoice. We looked into the key components of a credit note in a previous section. 

Apart from these fields, a credit note must also outline terms and conditions related to its issuance. 

By complying with all legal requirements associated with credit notes, you can make sure that you are fully tax compliant, work with financial accuracy, and avoid legal conflicts.  

Impact of Credit Notes on Accounting

Credit notes can have a significant impact on accounting as they directly influence revenue from the made sales. 

As a result of a sales credit note, reductions are made to the accounts receivable balance. This ensures that the business remains aware of what customers still have to pay and ensures balance sheet accuracy.

When a credit note refund is issued for returned goods, in most cases, changes should also be made to inventory records. This can have an impact on how accurate your Cost Of Goods Sold (COGS) analysis is. 

Moreover, credit notes can have an influence on tax liabilities, especially when it comes to Value-Added Tax (VAT). The tax that is initially accumulated from the sale must be changed to reflect the return on allowance. 

Tips for Managing Credit Notes

To ensure that you’re managing credit notes effectively, make sure that you have clear policies and procedures when issuing them. 

Make sure your team is aware of the situations when credit notes can and should be issued, the authorisation process, must-have documentation, and others. Where possible, rely on sophisticated accounting software to help you automate credit note issuance and keep track of your credit notes. 

Don’t forget to regularly review issued credit notes to detect any discrepancies or gaps that could be filled. 

Most importantly, make sure you remain tax-compliant. Remember that the tax amount collected on the sale should be adjusted to note the return. 

Frequently Asked Questions

Is a credit note the same as a refund?

No, credit notes and refunds are not the same. Refunds suggest immediate cash back, while a credit note simply notifies about the amount due to the buyer. The buyer can reduce their payment via a credit note or request a cash amount.

When are credit notes issued?

Credit notes are issued on several occasions. These include when goods are returned, when an invoice error is corrected, or when a discount or rebate is applied. They can also be issued for service cancellations or adjustments.

Are credit notes subject to VAT?

Yes, one of the most important things to understand about credit notes is that they’re subject to VAT and must reflect any adjustments to the VAT amount.