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 1
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 2
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 3
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 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 for the period
Worked example. A wholesaler issues these credit memos in a month with gross invoiced sales of $2,400,000 (excluding tax), a figure that includes a $6,800 duplicate invoice:
- Memo 7841, return: 40 units invoiced at $85 ($3,400) returned in saleable condition, cost $52 each. 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.
- Memo 7842, shortage: 12 units short on an invoice at $30 each; credit $360 plus tax $36.
- Memo 7843, pricing error: invoiced at list ($4,200) instead of the contract price ($3,780); credit $420 plus tax $42.
- Memo 7844, damage: goods damaged in transit and kept at an agreed 40% allowance on a $2,500 invoice; credit $1,000 plus tax $100, with a $1,000 claim raised against the carrier.
- Memo 7845, error: cancellation of the $6,800 duplicate invoice plus tax $680.
- Memo 7846, "goodwill": $2,200 requested by a salesperson against a 120-day-old balance. Finance finds the customer disputes a late delivery, so the credit is approved as a late-delivery allowance and the reason code is changed from goodwill to service failure.
Credits other than the duplicate cancellation total $3,400 + $360 + $420 + $1,000 + $2,200 = $7,380. Corrected gross sales are $2,400,000 minus $6,800 = $2,393,200, so the credit memo rate is $7,380 / $2,393,200 = 0.31% and net revenue is $2,393,200 minus $7,380 = $2,385,820. By reason: returns 46%, service failure 30%, damage 14%, pricing 6% and shortage 5%.
Buyer's side: the customer that received memo 7843 debits payables $462, credits purchases $420 and credits input tax $42, then deducts $462 from its next payment run.
Control review: credits by salesperson show one person requesting three "goodwill" credits in three months for the same customer, whose payments have been irregular. Finance finds two receipts applied to the wrong account, so the pattern is a misapplication rather than a fraud, but only the monthly report by salesperson revealed it.Case study
Seen in the real world
This is a fictional, illustrative scenario. 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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