Credit Memo (Credit Memorandum)

Updated on April 11, 2024
Article byAnugraha G
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Credit Memo?

A credit memorandum or credit memo is a document issued by the seller to the buyer, which acts as the source document for the sales journal that informs the buyers that the seller will decrease or credit the amount the buyer owes the seller in the trade receivables in the seller’s account.

Credit Memo (Credit Memorandum)

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It is an important document used during refund or return of goods sold, offering incentives or rectifying billing errors. It indicates a reduction in the owed amount and facilitates business communication in a transparent manner. It includes the sales details and so the seller should periodically review all open memos to settle them.

Credit Memo Explained

A credit memo is a document that a seller gives to the buyer after sending the invoice for the sales made. It contains various types of information like the number or code indicating the purchase order, item type, quantity, its price, the billing and terms of payment. All the above data are very important for the transaction, because it helps the seller track what and how much has been sold and what is the current inventory status.

The seller may raise a credit memo due to various matters like sales return or incentives and discounts. Sales return happens when the products sold are not up to the mark or satisfactory enough for the buyer. The product may not meet the standards or may have some defect. Sometimes the buyer may change their mind after buying the products and return it, resulting in raising of a credit memo from the seller. In such cases, the seller settles the transaction through the document as per credit memo accounting by returning the difference in price paid by the buyer and the current market price of the product.

It makes the business transactionBusiness TransactionA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements.read more between buyer and seller more smooth. It might incur some charges but compared to the advantages it has when compared to the invoice receipt, a credit note is handy. It can be credit or debit, depending on the price fluctuation from the actual price. The price volatility of products over time will decide the frequency between the two parties. Overall, it can be concluded that a credit memo, when used, makes the backtracking of a particular product’s discount history easy for the seller. The seller will increase or decrease his receivables, depending on the total amount.

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Components

It is similar to a sales invoice and contains the following components, usually in a product-oriented industry. The detailing and particulars in the credit memo make it significant, hence the usage of the same universal and globally accepted across all sectors and industries.

  1. Purchase Order number (PO)
  2. Terms of payment and bill
  3. Shipping address of a list of items
  4. Price of each item
  5. Quantity of each item.
  6. Date of purchase
  7. The total value of the transaction
  8. Total discounted amount in terms of each product;
Credit-Memo

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Template

Below is a picture of a typical credit memo format. We can see the parameters mentioned above in the particular format.

Credit Memo Format

In the above template we can see a standard format of the document which a seller typically issues to the buyer before credit memo accounting. It contains all the details regarding the sales of the product. Apart from that it will also contain the reason of raising the document, which can vary according to the situation.

Significance

When sellers want to discount the buyer’s price, they can only do so at the invoice level. It created confusion in the seller’s books of account when he was required to track back the particular product, which was discounted. Also, it is difficult to break down discounted products when calculating sales taxCalculating Sales TaxThe government levies sales tax on the consumption of various goods and services as the percentage added to the product and services from which the government earns revenue and does the company's welfare. In the United States, 38 different states have different taxes, from Alaska (1.76%) to Tennessee (9.45%).read more revenue summary. To avoid such a fuzzy business credit memo is issued. Sellers use this memo instead of using a discount to save money.

The reduction of price in the credit memo form will be specified at a product level and is easy for the transaction. The seller can also easily track back the discounted product in the case of the credit memo.

Example

Let us understand the concept of credit memo form with the help of a suitable example.

Company A is a manufacturing company that provides goods to company B. These two companies have a track record and have been doing business for some time now. A has dispatched a certain quantity of goods to the B. The sales team of A has received a new price list of products. The new prices are lower than the past prices. It may be due to a decrease in raw material cost, a decrease in overheads, and so on.

The company would have charged as per past prices to B, and B would have cleared the account or not. In both scenarios, company A will send a Credit Memo to company B stating that B should reduce the amount they owe A, the price of products should be the amount mentioned, and company A will reduce the same amount in their amount receivables. The memo will be the opposite if the prices of products shipped to Company B have increased.

It is a document prepared to adjust the errors made in the sales invoice, which has already been processed and sent to the customer. Usually, it comes into the picture if the client has paid more or less than the actual price of the goods or services taken. The seller will inform the buyer how much extra he has paid in the document, and he can keep the count during the next transaction.

Why Will A Seller Use A Credit Memo?

  • The buyer might return a few or all purchased items to the seller.
  • Items delivered might be defective, wrong size, or color; in other words, the delivery doesn’t meet the buyer’s expectations.
  • The buyer has a new requirement for the same shipment from the same seller.
  • Change is the price of items shipped to the buyer.
  • When an invoice amount is overstated a credit memo request can be used.
  • The discount is not applied properly to the products.
  • When the delivered goods or products get spoiled or damaged before their expiry tenure;

The above-said reasons make credit memo request important for conducting the business transaction of buy and sell. In other words, a credit memo is the opposite of the invoice, which is generated and given to the buyer by the seller of the product or provider of service. Unless invoices, credit notesCredit NotesA credit note is a financial document that sellers provide to buyers as a token of confirmation against registered returns. It acknowledges the cancellation and lets the sellers make a credit entry to the buyers’ account for the required amount. read more cannot be pledged to liquidate it.

Advantages

Here are some advantages of the concept. Let us study them in details.

  • The sales credit memo is created with a single click and is easy to document rather than manual entries, which will require more time and HR.
  • No Need to manually create negative revenue for the projects to create a credit note;
  • The single entry containing all particulars of the business transaction and thus easy to track in the book of accounts;
  • In the case of tracking back for discounted products, it is easy when a credit note is used instead of just an invoice.
  • It is nothing but the invoice receipt of sale but in the exact opposite direction in terms of the book of accounts.
  • It decreased the number of journal entries in the account, making it easy to track and report.

Limitations

Some limitations of the process of raising a sales credit memo are given below.

  • When applying for credit, the total number of invoices should be less than or equal to 1000.
  • When revoking the credit memo, the number of invoices should also be less than 1000.
  • Its issuance will incur an overage smoothening rollover charge.
  • The transaction also considers the ethical trust between the two parties in the business.
  • The buyer might wrongly argue about the delivered goods with the sole purpose of availing of a credit memo facility.

Thus, it is important to understand the pros and cons of the concept so as to implement it in a suitable manner and appropriate situations. This will help maintain transparency and efficiency in accounting process in order to facilitate running of business operations smoothly and efficiently.

Credit Memo Vs Debit Memo

Both the above are two kinds of financial documents that are normally used for business transactions. But their objective and details are quite different from each other. Let us study the differences:

  • The main purpose of the former is to inform the party that they will get a return of the amount they paid for a transaction, whereas the purpose of the latter is inform the party that they should pay back an amount related to a transaction.
  • The latter indicates a decrease in the accounts payable in increase in accounts receivable, whereas the former indicates a fall in receivables and rise in payables.
  • The former is issued when the product sold is returned by buyer due to which a refund will be given, in which case the document will reduce the outstanding balance of the customer. But the latter is issued in case the buyer has paid less and the balance amount has to be collected.
  • In the account statement, the former will increase payable or decrease receivable depending on the transaction, whereas the latter will increase receivables or decrease payables depending on the transaction.

Thus, we see from the above points that the main difference lies in the purpose for which they are used. Depending on that, the accounting treatment is made in the books.  

This has been a guide to what is Credit Memo (Credit Memorandum). We explain the differences with debit memo, template, examples, components, significance. You can learn more from the following articles –