Credit notes: What are they, how do they work, and when do you use them?

Business transactions are not always perfect. Deals might have been sealed, invoices may have been sent, payments could have been made, only to later find out that the customer wants to cancel part of their order. In such cases, you cannot simply delete the invoice and create a new one, as it would create inaccuracies in your financial records. So, how can you offset the extra amount without altering or deleting the existing invoice? The answer is a credit note.

In this article you'll learn about what credit notes are, how they can help businesses stay compliant with tax laws, and when businesses can issue them.

What is a credit note?

A credit note, also known as a credit memo or credit invoice, is a legal document that a business sends to its customer to reduce part of the amount owed or correct the previously issued invoice. Credit notes are issued in specific cases like if an erroneous invoice is sent out or if a customer returned products and is seeking reimbursement. They acknowledge such reimbursements to keep your books accurate.

Depending on the customer's preference, the difference in the balance amount is either issued as credits (which can be later used for future purchases) or refunded immediately in cash. Let's take a look at how these credit notes work with an example.

A computer accessory store sells 10 monitors, priced at $100 each at 10% tax rate. It issues an invoice with a grand total of $1,100.

INV-0001 (Original Invoice issued by store)

Cost of 10 monitors = $1,000
Tax rate        = 10%
Total             = $1,100

However, upon receiving the products, the buyer finds two of the monitors damaged and seeks reimbursement. The store will have to raise a credit note.

CN-001 (Credit note for 2 monitors, referencing INV-001)

Cost of 2 monitors   = $200
Tax rate        = $20
Total             = $220

The $220 can be used by the buyer as credit or as a refund. Note that the credit note is simply proof of acknowledgement and any transaction that is made related to them is considered a separate action.

Credit note format

A typical credit note consists of the following fields:

• Organization details - The name of the organization, address, and contact details.
• Credit note number - A sequential number uniquely identifying the credit note.
• Product/service and other details - The credit note also records the details of the products reimbursed, the quantity that is billed, the reference number of the order, and the credit amount.
• Authorized signature and issue date - Although this is optional, credit notes may contain a signature authorizing the credit note and the date in which it was issued.

When can businesses issue a credit note?

Return of goods or cancelled services

According to a 2024 study conducted by NRF on consumer returns, retailers interpreted that about 16.9% of their annual sales in 2024 would be returned. The reason for such returns or cancellations can be anything. The customers could have received damaged products or simply wished to purchase another product or a service by canceling the purchased one. Under such circumstances, issuing a credit note not only helps you with accurate accounting but also improves your customer's trust.

Overcharges or billing errors

Mistakes are human nature. Sometimes you might invoice your customer with the wrong details or overcharge them for products or services they never purchased in the first place. No matter how grave your invoicing errors are, acknowledging them and sending them a credit note immediately can help you save your business from financial misstatements and strained customer relationships.

Invoice adjustments, claims, and others

Even after sending invoices, there might be situations where the details need to be corrected or changed, the customers may have received only part of their order, or an advance payment may have been made but the sale would not have gone through. In all these cases, a credit note is issued to maintain transparency and accuracy.

Benefits of issuing a credit note

Improved customer relationship

Imagine not hearing anything about the product you returned for days? Sounds scary, right? Customers want acknowledgement and clarity on how they'll be reimbursed when they return your products or cancel services. Sending credit notes immediately after a product return or to correct any error in previously issued invoices eliminates the need for any unnecessary fear and promotes transparency. This, in turn, increases customer satisfaction and loyalty, while strengthening your business' reputation.

Accurate accounting and audit trail

Not issuing credit notes for erroneous invoices or product returns can overstate your realized revenue, leading to audit disputes and poor business decisions. On the other hand, issuing credit notes can facilitate accurate bookkeeping. Since each credit note records the reason for its issuance and links the original invoice, auditors can follow a clear paper trail, strengthening your trust with the regulators.

Supports tax compliance

Under certain tax regulations, issuing credit notes is an absolute necessity. For example, in India, under GST, the government suggests businesses raise a credit note for the original invoice when a sale does not proceed as intended. Moreover, in regions like the EU and New Zealand, credit notes are mandatory under VAT and GST regime. Thus, issuing credit notes not only helps with record-keeping, but also aids in staying compliant with tax laws.

Conclusion

From keeping your customers happy to maintaining your books accurately, credit notes can help your business in several ways. The key is to calculate differences accurately and link the original invoice as a reference. For a business with numerous transactions, calculating these numbers for each product return or an invoicing error can be a time-consuming task. That's why using an online billing software like Zoho Billing can help.

Apart from creating credit notes for invoices, this robust billing platform also aids businesses with subscription management by deploying diverse pricing models and providing advanced features like dunning management, hosted payment pages, and more. Explore Zoho Billing pricing plans to find out what works best for you and transform the way you business.