When to issue a credit memo
A credit memo (credit memorandum) is issued by a seller of services or goods to a buyer when the buyer has paid more than they should to settle an invoice.
The seller issues credit to the buyer that reflects the amount overpaid.
Sellers often issue a credit memo in cases of rejected goods or services (damaged or unsatisfactory product), incorrect price of an original invoice (discounts) or when a buyer has overpaid on the original invoice.
Keep in mind that a credit memo isn’t the same as a refund.
A refund reverses the original purchase, placing funds back in the buyer’s hands.
A credit memo is a separate transaction that reduces the amount of the original invoice, with the balance (the overpaid amount) credited to the buyer to apply toward future purchases.
Reasons why credit memos are issued
Correction of an invoice error
On the seller’s side, in case an incorrect invoice has already been posted as “paid” in accounting, a credit note will be issued to the buyer’s account to turn the payment made by that customer into credit.
Subsequently, the seller will then generate a new invoice with a new invoice number, and the correct amount will be deducted from the buyer’s account with the remaining balance available for future invoices.
Goods damaged or lost during transit
Here credit memos are used when the seller has already sent a product that either was damaged or lost during the shipping process.
Warranty
In this instance, a credit memo is requested alongside replacing defective or broken parts with new ones once they are available in stock.
The manufacturer issues a credit memo to the dealer for an amount equivalent to the cost of spare parts (replacements of defective parts).
Price change
You can issue a credit memo when the deal has already been completed but the price of the product or service changed for some reason.
This could be post-sale discounts or when the seller changes the price due to defects found in the product.
Buyer overpaid on the original invoice amount
This often happens when a buyer doesn’t factor in discounts available to them or the invoice has an incorrect amount of goods.
When this occurs, a credit note is issued to return the price difference to the buyer’s account.
Buyer makes a change to an order after the invoice was issued
Credit memos are issued when a part of the order is modified.
For instance, if a buyer amends their order from five items to four items, a seller should then issue a credit memo recording the new changes.
Buyer cancels a purchase
A seller can also issue a credit memo when a buyer cancels a purchase because the delivery was late and the goods no longer meet their needs.
In that case, a credit memo will work as proof of return of goods.
Example of a credit memo use case
A Seller Company A — we’ll call them SCA — sells products to a Buyer Company B, which we’ll name BCB.
These companies have worked together for some time, and both pride themselves on keeping excellent accounting records.
After closing one deal between companies, the sales team at SCA gets a new price sheet for all its buyers: material costs have decreased and they are passing the savings along to those buying their products.
As a result, BCB has now overpaid on their latest invoice.
SCA issues a credit memo to Buyer Company B, informing BCB that they have overpaid, and they (BCB) now have a credit on the books to apply toward future purchases.
Both companies update their accounting records to reflect the change.
How credit memos are settled when issued
In case a buyer has already paid the full amount of the invoice, they have two choices to resolve the discrepancy:
Use a credit memo to establish credit toward paying any future invoices
In this case, a buyer will use a credit memo issued by a seller as “purchasing power,” applicable for any upcoming payments the buyer may make.
Ask for a refund that matches the amount of the credit memo
The buyer has the right to ask for a cash payment transferred to them that equals the value of the credit memo.
In case the buyer has partially paid the invoice or hasn’t yet paid the seller, they then have this option:
Use a credit memo as a partial offset to the original invoice
The buyer will still be required to pay the amount that is owed after the reduction of the amount specified in the issued credit memo.
The buyer records a credit memo in accounts payable as a reduction.
The seller should record the credit memo as a reduction as well, noted in the accounts receivable ledger (money coming in).
Create, sign and manage accounting documents with PandaDoc
Sellers have different reasons to issue credit memos, but the bottom line is that credit memos help buyers and sellers maintain strong and trusting relationships with one another.
Credit notes also work as legal documents that acknowledge receipt of services or products.
Creating and managing credit memos can be done by using accounting software like PandaDoc.
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