A credit memo, also known as a credit memorandum, is a document used by a seller to adjust or reduce the amount owed by a buyer for goods or services purchased. Credit memos provide a way for businesses to correct billing mistakes or account for returns after an invoice has already been issued. Unlike debit memo, which increases the amount owed, credit memo decreases the amount owed.
What is a Credit Memo in Accounting?
In accounting terms, a credit memo is a source document that decreases accounts receivable for the seller and reduces accounts payable for the buyer. It allows both parties to properly record the transaction in their books.
Key details on a credit memo normally include:
- The original invoice number
- Credit memo number
- Date issued
- Company and customer information
- Reason for the credit
- Description of credited items
- Amount of the adjustment
Unlike a refund which reverses a sale, a credit memo is issued after the original invoice and reduces the existing balance due. It does not cancel the entire sale.
When are Credit Memos Used?
There are several common situations where businesses issue credit memos:
Returned Merchandise: When a customer returns goods that were previously purchased, the seller can send a credit memo to offset the value of the returned items. This properly accounts for inventory and revenue reductions from the return.
Pricing Errors: If an invoice contains incorrect pricing that overcharges a customer, the seller can send a credit memo to rectify the mistake and reduce the amount owed to the proper pricing.
Damaged Goods: When a customer receives damaged, defective, or unsatisfactory products, the seller may issue a credit to account for the diminished value and compensate the buyer.
Overpayments: If a customer accidentally overpays an invoice, the seller can process a credit memo for the amount overpaid rather than issuing a cash refund.
Discounts or Allowances: Sellers may use credit memos to apply discounts, rebates, or other negotiated pricing allowances to reduce the total amount due from a customer.
Cancellations: For cancelled orders or services, a credit memo can properly account for the reversal of the sale in the books.
How are Credit Memos Applied?
For open invoices where payment has not yet been made, the credit memo reduces the total amount owed by the customer. The customer then pays the net amount after deducting the credit.
If a payment on the original invoice has already been made in full, the customer has two options:
- Apply the credit memo amount to future purchases
- Request a cash refund of the credit memo value
The application of a credit memo should be agreed upon by both the buyer and seller. Proper documentation and approvals are key when issuing credit memos to avoid disputes.
Credit Memo vs. Debit Memo
While they sound similar, credit and debit memos are distinctly different:
- Credit memos decrease the amount owed.
- Debit memos increase the amount owed.
Think “credit reduces the balance, debit adds to it”.
Examples of Credit Memos
- A retailer issues a credit memo for $100 to a customer who returned a defective product. This properly accounts for the return in their books.
- A wholesaler provides a $500 credit memo to a retailer who was incorrectly overcharged on a previous invoice. This corrects the billing error.
- A customer receives a $250 credit memo after overpaying their last invoice from a supplier.
- A seller credits a buyer $1000 for promotional discounts that were promised but not applied on the original invoices.
Credit Memos for Bank Transactions
Banks also use credit memos but in a different manner than trade transactions. Bank credit memos increase the available balance for a customer rather than reducing the amount owed.
For example, banks may issue credit memos for:
- Interest earned on deposit account balances
- Loan principal payments credited to the account
- Refunds of fees previously charged
- Correction of errors that negatively impacted the account
In summary, credit memos are important documents for properly adjusting buyer accounts after invoices have been issued. They allow sellers to account for returns, corrections, overpayments, and other situations requiring balances to be decreased in the books. Both buyers and sellers should retain credit memos as evidence supporting reductions applied.
Frequently Asked Questions
What are the key details included in a credit memo?
Credit memos normally include the original invoice number, credit memo number, date, company and customer information, reason for the credit, description of credited items, and amount of the adjustment.
When do you have to issue a credit memo?
Common situations where credit memos are required include returned merchandise, pricing errors, damaged goods, overpayments by customers, negotiated discounts or allowances, and cancelled orders.
What is the difference between a credit memo and a refund?
A refund reverses an entire sale while a credit memo adjusts the amount owed on an existing invoice. Refunds require issuance of payment, while credit memos reduce balances owed.
How do you account for a credit memo?
The seller records a credit memo as a reduction to accounts receivable. The buyer records it as a decrease in accounts payable. It is applied against the original invoiced amount.
Can a customer request a cash refund for a credit memo?
If the original invoice has already been paid in full, the customer can choose to receive the value of the credit memo as a cash refund rather than applying it to a future purchase.
What is the difference between a credit memo and a debit memo?
A credit memo reduces the amount a customer owes, while a debit memo increases the amount owed. Think “credit reduces, debit adds”.
When do banks issue credit memos?
Banks use credit memos to increase account balances for transactions like interest earned, loan payments received, refunds provided, and error corrections.
How long should credit memos be retained?
Credit memos should be kept for the same period of time as the original invoices and sales documents – generally for a minimum of 4 to 7 years.
Do credit memos require authorization?
It’s a best practice for sellers to obtain proper approval and maintain documentation before issuing any credit memos to buyers. This prevents unauthorized adjustments or fraud.