Credit Note Definition
A credit note, also called a credit memo, is a commercial document that a seller sends to the buyer when credit is being applied against the buyer’s order. It’s used to show a reduction in the amount owed by the buyer to the seller.
During a B2B transaction, you can issue several commercial documents: purchase orders, invoices, receipts, and more. You’ve probably heard of the three documents previously mentioned but credit notes might be a new concept for you.
Also, credit notes can be a little tricky to understand. When you break them down, you’ll learn that credit notes are useful to your business’s accounting tasks and customer relations.
Credit notes are flexible documents that can often save the day when you run into problems during the invoice stage of the transaction.
If you’re ready to learn what a credit note is and how to use them in your own business, we’re sharing everything you need to know.
Let’s get started.
What Is a Credit Note?
Also called a credit memo, a credit note is a commercial document that a seller sends to the buyer when credit is being applied against the buyer’s order. It’s used to show a reduction in the amount owed by the buyer to the seller.
How Does a Credit Note Work?
A credit note could be applied against the buyer’s order for various reasons:
The Order Was Damaged During Transit
If you run an ecommerce business selling physical products, then you will need to ship your orders to the customer’s address. However, incidents like broken or missing items can occur between the order and delivery dates.
If this happens and the customer refuses a replacement, you can issue a credit note for the full or partial amount against the outstanding balance. This reduces the amount a buyer pays for the order.
The Buyer Accidentally Overpaid
You might be surprised to hear that some buyers accidentally pay more than the requested amount on the original invoice. If you need to manually enter the amount owed, the buyer can accidentally hit an extra key and overpay. You would need to issue a credit in order to balance out your accounting records. Once the credit note is made, you can refund the difference back to the buyer.
A Mistake Was Made on the Original Invoice
Similar to a buyer overpaying, a seller can mistakenly overcharge. For example, the seller accidentally charges $200 instead of $100. With your accounting records, you can’t simply edit or delete and reissue the original invoice. Instead, you need to issue a credit note in the amount of $100. This will correct the mistake to reflect the correct balance of $100.
The Buyer No Longer Wants the Order
If you already sent the invoice, but the buyer no longer wants the requested product or service, you can issue a credit note for the full amount. This will update the balance to show that nothing is owed by the buyer.
Partial Credit Needs to Be Issued
When issuing a credit note, you might not always want to credit the full amount. Rather, you want to issue partial credit against the outstanding balance.
For example, a buyer orders $1,000 worth of product from you. However, your manufacturer reports that $100 worth of product was damaged. In this scenario, the buyer would only be obligated to pay for $900 worth of product. You can issue a credit note in the amount of $100 against the outstanding balance.
You Need to Provide a Cash Refund
Since there won’t be an electronic receipt or a transaction ID for a cash payment, you issue a credit note to reflect the refund. When issuing a credit note in your system, you enter it as a negative balance, which will show an amount paid to the buyer in your records.
What Is Included on a Credit Note?
When creating a credit note, you want to thoroughly detail the involved parties, order details, and the amount. Here is a list of information you’ll find on a credit note:
- Seller’s contact information (business name and address)
- Buyer’s contact information (business name and address)
- Original invoice information (invoice number and date)
- Purchase order number
- Itemized list of products or services rendered
- A new line with credit note number and date
- The amount of credit being issued
- New payment terms (updated balance and new due date, if applicable)
- Shipping and taxes
You might notice that a credit note shares similar information with the original invoice. This helps keep the credit note easy to understand and easier to track the changes from the original invoice.
Here is an example of a credit note template:
Why Credit Notes Are Necessary
A common reason for issuing a credit note is to correct an error or update an invoice. For example, the buyer might want to reduce or increase the amount of product ordered. Depending on whether the original invoice has been paid, you can either edit it or issue a credit note.
If the Invoice Hasn’t Been Sent Yet
If the original invoice hasn’t been sent, you can get away with editing the invoice before sending it. There is no outstanding balance showing for the invoice in your accounting records until you send the invoice.
You don’t need to contact your customer about correcting the invoice. Rather, you can simply edit the invoice and then send it out after you confirm the information is correct.
If the Invoice Has Already Been Sent
If the invoice has already been sent, the process isn’t as simple as editing the invoice. Instead, you must keep the original invoice and issue a credit note. Here’s why:
Let’s say that you meant to charge $500, but accidentally charged $600. When the buyer receives the invoice for the increased amount, they will probably be alarmed. You should contact your customer as soon as you realize the mistake and inform them that they only need to pay the agreed-upon $500.
However, your accounting records show the outstanding balance is $600. When the buyer issues payment for $500, your records would still show an outstanding balance for $100.
To correct this, the seller issues a credit note for $100. This will correct the balance to zero in your accounting records.
The Difference Between Credit Notes and Refunds
When reading about credit notes, you might notice the similarities they share with refunds. However, there are key differences to be mindful of:
Before we describe the differences, let’s learn more about refunds.
You’re likely familiar with the refund process. When you want to return an item you ordered, you’ll request a refund. You may also request a refund if you were unhappy with the service received, like a car detailing or tailoring.
When the store clerk issues a refund, you can request to receive cash or have the funds returned to the credit or debit card used.
Now, let’s dive into two main differences between credit notes and refunds:
Invoice Payment Status
Credit notes are issued before an invoice is paid. Refunds are issued after an invoice has been paid.
When you issue a refund, there is an actual exchange of money. The refund amount is debited from the seller’s account and returned to the buyer.
However, when a credit note is issued, no funds are moved because payment has not been issued yet. Rather, it’s applied as a credit to correct the amount owed before it’s paid.
Recommended Credit Note Software
FreshBooks is an accounting software that offers various tools to improve your efficiency and productivity. With FreshBooks, you can create and customize branded invoices and credit notes. By doing all your accounting with one platform, you can streamline the process.
FreshBooks offers plans starting at $15 per month. With this basic plan, you gain all your standard accounting needs, including the ability to create unlimited invoices and send credit notes. With higher-level plans, you can also unlock more features like unlimited proposals and onboarding more clients. Sign up for FreshBooks’ free 30-day trial to determine whether this accounting software works for you.
Invoicera’s slogan is “Invoicing Simplified” and that’s exactly what they offer. Invoicera’s software optimizes your accounting operations, from online invoicing to time tracking.
An attractive feature from Invoicera is their completely free plan. You gain access to all their core features, including sending credit notes, scheduling invoices, and automating payment reminders. Their next plan is $15 per month and offers additional perks, like onboarding 100 clients and bringing on an additional staff member to access your account. With a free plan that serves your core accounting functions, Invoicera is an excellent consideration for bootstrapping businesses.
Invoicing is a critical stage of a transaction because it’s how you collect payment after a product has been shipped or a service has been scheduled or fulfilled. However, things don’t always go perfectly and sometimes you need to make adjustments. Whether an order needs to be canceled, or you’re only able to partially fulfill an order, or you accidentally overcharged, a credit note can fix that for you.
With credit notes, you can correctly update the amount owed depending on the circumstance. Or you can cancel an order entirely by issuing a credit in the same amount to zero out the balance. Credit notes are flexible in their functions and will serve you during any invoicing mishaps you run into so your accounting records stay updated and accurate.