What it means
Invoices are not always right and deliveries are not always accepted. When a customer returns goods, receives less than was billed, is charged the wrong price, or negotiates an allowance after the sale, the seller must reduce what the customer owes.
A credit memo does that formally: it is a document with its own number, dated, referencing the invoice it adjusts, stating the reason, showing the amount and the tax, and sent to the customer so that both parties' records agree. The seller's accounting depends on the reason.
A return of goods reverses the sale: revenue is reduced (or a sales returns account is debited), the receivable is reduced, and the goods, if resaleable, are returned to inventory at cost with cost of sales reduced. A pricing error or allowance reduces revenue and the receivable, with no inventory effect.
A credit for a service not performed reduces revenue. A credit for damage that is the seller's responsibility may be charged to a quality or warranty expense rather than to revenue, depending on policy.
A credit to cancel an erroneous invoice reverses it entirely. Sales tax is reversed in proportion, and the credit memo is the document that supports the tax adjustment.
The buyer's accounting mirrors it: the payable to the supplier is reduced, and the purchase (inventory or expense) is reduced, with input tax adjusted. The buyer matches the credit memo to its own return or claim record and deducts it from the next payment, or requests a refund if the account is otherwise clear.
Credit memos matter for control in three ways. First, they are the easiest way to write off a receivable without calling it a write-off: a credit memo for "goodwill" against an old balance is a bad debt by another name, and should be treated as one.
Second, they can conceal misappropriation: a person who takes a customer's payment and issues a credit memo for the same amount leaves the customer's account clean and the theft invisible; separating the authority to issue credits from the handling and application of cash, and reviewing credits by customer and by issuer, is the defence. Third, they can manipulate revenue: credits issued after a period end for sales recognised before it, or withheld until after a period end to protect the period's revenue, distort the timing, and auditors examine credit memos issued after the year end for sales that should not have been recognised.
Good practice therefore includes: a numbered sequence; a stated reason code on every credit memo (return, shortage, pricing, damage, allowance, error, goodwill); authorisation levels by amount, with larger credits approved by a manager independent of sales; a requirement for supporting evidence (a goods returned note, a claim, a pricing agreement); a monthly report of credits by reason, customer, salesperson and issuer, reviewed for patterns; and treatment of "goodwill" and "unspecified" credits as write-offs requiring finance approval. Credit memo volumes also feed process improvement: a high rate of pricing credits indicates a price file problem, a high rate of shortage credits a picking problem, a high rate of returns a quality or specification problem, and each has a cost beyond the credit itself.
In practice
Real-world examples.
Example
A retailer issues a credit memo to a customer's store account for a returned appliance and a separate one for a price-match adjustment on another purchase.
Example
A software company issues a credit memo cancelling three months of subscription fees after a service outage, charged to a service credits expense rather than to revenue under its accounting policy.
Example
A manufacturer issues a year-end volume rebate to a distributor as a credit memo against the distributor's account, having accrued the rebate through the year.
Think of it
“A credit memo reduces what a customer owes-issued for returns, corrections, or adjustments.
Formula
Calculation
Seller's entry (return of goods): Debit Sales returns (or Revenue) and Debit Sales tax payable; Credit Accounts receivable. Debit Inventory; Credit Cost of sales (at cost, if resaleable)
Seller's entry (price adjustment or allowance): Debit Revenue and Sales tax payable; Credit Accounts receivable
Buyer's entry: Debit Accounts payable; Credit Purchases or Inventory and Input tax
Credit memo rate = Value of credit memos / Gross invoiced sales x 100%, tracked by reason
Net revenue = Gross invoiced sales minus Credit memos (returns, allowances, pricing) for the period
Worked example. A wholesaler of electrical products issues credit memos during a month against gross invoiced sales of $2,400,000 (excluding tax).
- Credit memo 7841: customer returned 40 units invoiced at $85 each ($3,400) as unsuitable; goods received back in saleable condition; cost $52 each. Entry: debit sales returns $3,400, debit sales tax payable $340 (at 10%), credit receivables $3,740; debit inventory $2,080, credit cost of sales $2,080. Reason code: return, customer choice; a 15% restocking charge applies under the terms, so a separate invoice for $510 plus tax is raised.
- Credit memo 7842: short delivery of 12 units on an invoice for 100 at $30; credit $360 plus tax $36. Reason: shortage; picking error confirmed by the warehouse.
- Credit memo 7843: invoice priced at list ($4,200) instead of the customer's contract price ($3,780); credit $420 plus tax $42. Reason: pricing error; the customer's contract price was not loaded in the system.
- Credit memo 7844: goods damaged in transit, customer kept them at an agreed 40% allowance: invoice $2,500, credit $1,000 plus tax $100. Reason: damage; a claim is raised against the carrier for $1,000.
- Credit memo 7845: cancellation of a duplicate invoice for $6,800 plus tax $680. Reason: error; the original invoice stands.
- Credit memo 7846: "goodwill" credit of $2,200 plus tax requested by a salesperson against a customer's balance that is 120 days old. Held for finance director approval; investigation finds the customer disputes the underlying invoice for late delivery and the salesperson had promised a credit six months ago without recording it. Approved as a late-delivery allowance with a note to the salesperson about recording commitments; reason code changed from goodwill to service failure.
Month totals: credits excluding the duplicate cancellation: $7,380 on $2,400,000 of gross sales, a credit memo rate of 0.31%; by reason: returns 46%, service failure 30%, damage 14%, pricing 6%, shortage 5%. Net revenue for the month: $2,392,620 (the $6,800 duplicate never having been revenue, its cancellation does not reduce net revenue but corrects gross invoicing to $2,393,200).
Control review: credits by issuer show one credit controller issuing 60% of all credits by number; investigation finds she handles the largest customers, which is consistent. Credits by salesperson show one issuing three "goodwill" credits in three months, all to the same customer, whose payments have been irregular; finance reviews the customer's cash application and finds two receipts applied to a different account. The pattern is a misapplication, not a fraud, but the review that found it exists because credits are reported by salesperson.
Buyer's side: the customer who received credit memo 7843 records: debit payables $462, credit purchases $420, credit input tax $42; it deducts $462 from its next payment run and matches the credit to its own price query log.
Year-end cut-off: the auditors review credit memos issued in the first month after year end totalling $18,000 and trace each to its invoice date; $11,000 relates to invoices dated before the year end for goods returned after it. The returns are for goods the customers had a right to return, and the company's returns provision at year end is tested against them.Case study
Seen in the real world.
A distributor's credit controller had authority to issue credit memos up to $5,000 without approval and also applied customer payments. Over three years she took $140,000 of customer cheques, banked them to an account in a similar name, and issued credit memos to the customers' accounts for the same amounts, coded as "pricing adjustment" or "goodwill", so that no customer was chased and no balance looked wrong. The credits totalled 0.4% of sales, within the range nobody questioned.
A new finance manager introduced a monthly credit memo report by issuer and reason, and the pattern appeared immediately: one issuer, two reason codes, always round amounts, always to customers who paid by cheque, never supported by a claim or return note. The distributor recovered $30,000 from its insurer and nothing from the controller.
Its new procedure separated credit issue from cash application entirely, required supporting evidence for every credit (a returns note, a claim, a pricing document, a signed customer complaint), removed "goodwill" and "unspecified" as reason codes (such credits are now write-offs approved by the finance director), and reviews credits monthly by customer, salesperson, issuer and reason. The finance manager's report observed that credit memos had been the one document in the business that reduced what customers owed without anybody asking why.
Watch out
Common mistakes.
- Allowing the person who issues credit memos also to apply customer cash, which makes credits the instrument of choice for concealing diverted payments.
- Accepting "goodwill" or "unspecified" as a reason, which turns credit memos into unrecorded write-offs and unreviewed favours.
- Ignoring credit memo patterns, which reveal pricing file errors, picking problems, quality failures and salesperson behaviour that each cost more than the credits themselves.
Questions
People also ask.
What is the difference between a credit memo and a refund?
A credit memo reduces what the customer owes (or creates a credit on the account for future purchases). A refund returns cash. A credit memo may be settled by a refund if the customer's account is otherwise clear.
Does a credit memo reduce revenue?
Usually, if it relates to returns, pricing or allowances against sales. Credits for the seller's service failures may be charged to expense under the seller's policy. Cancellation of an erroneous invoice corrects revenue rather than reducing genuine sales.
Who should approve credit memos?
Someone independent of the sales team and of cash handling, with authority levels by amount, on the basis of documented reasons and supporting evidence. Small routine credits (returns with a goods received note) can be approved within credit control; larger or unusual ones by finance management.
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