Understanding What is Credit Memo & When to Use It
During financial transactions, you may need to grant credit to consumers to accommodate situations in which goods are returned, a pricing dispute exists, or the buyer is not obligated to pay the whole amount of the invoice. In such circumstances, a Credit Memo can be issued to store the credit balance and offset it against a transaction.
A credit memo is a legal document that shows the credit balance and can be used to balance current invoices or apply to future invoices.
In this article, we’ll discuss all the relevant information about credit memos, including why it is issued and what a credit memo involves. But, before we get started, let’s start from the basics.
What Is A Credit Memo?
A credit memo is an abbreviation for “credit memorandum,” which is a document provided by the seller of goods or services to the buyer that reduces the amount owed to the seller under the conditions of an earlier invoice. The credit memo normally includes information about why the amount listed on the memo was issued, which can later be used to aggregate information about credit memos to identify why the seller is issuing them.
The credit memo is recorded as a reduction in the seller’s accounts receivable balance, while it is recorded as a reduction in the buyer’s accounts payable balance.
If the buyer hasn’t paid the seller yet, the credit memo can be used to offset a portion of the invoice-based payment. If the buyer has already paid the full amount of the invoice, the buyer can use the credit memo to make a payment for future purchases to the seller or to demand a cash payment in exchange for the credit memo.
A credit memo can also be classified as an internal credit memo, in which case the buyer will not receive a copy. When a company is writing off an outstanding receivable balance, this method is commonly employed.
It is important to note that you may only generate a credit memo after you have billed your customer. Also, when issuing a credit memo against an invoice, make sure it is for the same amount or less than the total value of all the bills in the billing schedule for an asset.
When Is A Credit Memo Issued?
The seller may issue a credit memo to the buyer in a variety of circumstances, and some of the most common ones are listed below:
- For any reason, the buyer returned the items or rejected the services
- Delivered items are damaged or defective
- The pricing on the initial invoice had errors, the majority of which were clerical in nature
- The original invoice was overpaid by the customer
A Comprehensive Credit Memo Example
To help you get a better understanding of how credit memos work, we’ve provided an example between Mr Mehta and Clothing Manufacturers, LTD.
Mr Mehta bought a few clothes from Clothing Manufacturers, LTD., and the company has a 15-day return policy. As per their policy, any clothing returned will be compensated in store credit only, and cash refunds are not permitted.
After Mr Mehta purchased the clothes, he found that one of the items that he bought had a couple of stains on it. He went to the store to return it. The Store Manager addressed the situation and assured Mr Mehta that he will accept the return.
A credit memorandum should be issued in this circumstance since the company needs to lower a previously issued invoice to pay the client for the damaged items. Mr. Mehta’s account at Clothing Manufacturers, LTD will be credited with the total amount paid for the returned goods after the memo is sent, and he can use that positive credit to purchase another piece of clothing or swap his existing one for another of the same model.
The concept of crediting an account can be confusing because a credit normally implies a reduction in an asset account while the consumer receives an increase. However, this works because the store is crediting its receivable and providing the customer with a voucher to shop there. If you’re facing some challenges with understanding when and how to issue a credit memo, you could consider using professional book-keeping and accounting services.
Understanding How To Settle Credit Memorandums
If a buyer has paid the entire invoice amount, they have two options for resolving a dispute in their favour. One possibility is to utilise a credit memorandum to offset any future payments to the seller. In addition, the buyer may request a monetary payment based on what the seller owes the buyer.
If the buyer has not yet paid the seller, the credit memo can only be used as a partial offset to the invoice. They must still pay what is owed after the reduction mentioned in the memo.
In the case of a credit memorandum, the buyer records the memo as a reduction in its accounts payable balance. The seller must then record the note as a reduction as well, but it is a reduction of its accounts receivable (money coming in).
What Components Are Mentioned In A Credit Memo
The supplier should include the products, quantities, and product or service prices that both parties agreed upon. The credit note usually refers to the original invoice and explains why the credit note was issued. The credit can be given to the consumer in the form of cash or it can be applied to future transactions.
Rather than providing a cash refund, most businesses prefer to apply it to future purchases. Additionally, it’s also a good idea to include some information for good book-keeping and administrative purposes.
It’s also a good idea to include the following for administrative and record-keeping purposes for both parties:
- The date when the credit memo is issued
- The number of the credit memo, which can also be linked to the invoice number (This is important as it can then be easily found in your accounting system.)
- The reference number of the customer
- The terms of the payment
- Contact details for the company, including but not limited to the company number, VAT or EIN number and billing or shipping address
However, not all businesses include all of this information on their credit memos. Some do not give payment terms or contact information. If the original invoice included VAT, you must write a matching VAT credit note that includes the invoice details as well as the amount before VAT.
Make it clear at the beginning of the paper that it is a credit memo, not an invoice. This is done to avoid any potential misunderstanding on the part of the consumer. To reduce the invoice amount, issue the credit memo within one month of the agreement between the customer and the vendor.
If you need some support or guidance with understanding when and how to issue a credit memo, you could consider contacting our experts at CharterCPA. We offer a comprehensive suite of outsourced accounting and bookkeeping services, including financial statement preparation and accounting system maintenance.