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What does a credit memo mean in simple terms?
What are the essential elements you should know!
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What Is A Credit Memo
A credit memo, short for credit memorandum, is when a seller of goods or services issues a document to a buyer reducing the amount owed by the buyer further to the issuance of a past invoice.
In other words, when a buyer is issued a credit memo, it means that it will owe less money to the vendor.
In some cases, a buyer’s prior invoice is partially reduced and in other cases an entire invoice is credited.
Typically, the credit memo will provide the buyer or client information as to the reason why the credit memo has been issued and to which invoice it relates to.
This way, the buyer will have the ability to make the proper credit memo journal entry from an accounting perspective, document the transaction, and ultimately pay the right amount.
When a credit memo is issued, the seller’s accounts receivable and the buyer’s accounts payable are reduced.
Why Credit Memos Are Issued
In business, there are many reasons why a company may issue a credit memo to another.
Here are some common reasons why a company will issue a credit memo reducing the amount owed by the client:
- There was a mistake in the issuance of the invoice
- The buyer returned some goods back to the seller as they were defective or not consistent with the order
- The buyer has the right to ask for a partial refund if not satisfied
- There was a mistake in the price charged
- The buyer does not agree with the seller’s invoice
- The seller offers credit to the client to maintain good relations
What Information Is on A Credit Memo
Every credit memo will have some information providing details relating to the credit being issued.
Some companies will offer more information than others.
In general, you can expect to find the following information on credit memos:
- Credit memo date
- Client’s name and address
- Reference to a purchase order number
- Reference to prior outstanding invoices
- Specific items, goods, or services credited
- A short note as to why the credit is issued
With this information, the client or buyer receiving the credit memorandum will know which seller invoice to offset, why the credit was issued, and keep proper track of its accounts payable.
Why Credit Memo Is Important
Companies should keep track of how much credit they are issued by their vendors and suppliers so they can accurately determine how much they owe.
Not only it’s important to know how much you should pay your vendors but keeping track of your accounts payable will also help improve your cash flow.
For example, if your company is issued invoices from its suppliers during a given period for $50,000 and where there are credit memos issued totaling $5,000, you’ll actually need to pay $45,000 (instead of $50,000).
If you don’t keep track of how much credit has been issued, you will inadvertently pay $50,000 thereby losing $5,000 to spend in other areas of your business and also your suppliers may take a long time before realizing the mistake and reimbursing you the funds.
In essence, you can use your credit memos to offset the total amount payable by your organization.
In the event that you have already paid the total amount of the invoice without offsetting your credit memo, you can either ask for a refund or use that credit against future invoices.
Credit Memo Definition
How do you define credit memo?
In accounting, a credit memo can be defined as follows:
A credit memo is a document issued by a company reducing the amount owed by a client following the issuance of an invoice
In other words, a credit memo is characterized as follows:
- It is issued by a company to whom money is owed by a client
- It is generally issued after the issuance of an invoice
- It offsets the amount owed by the client under a previous invoice
Credit Memo Example
Let’s look at an example of how a company may use a credit memo in practice.
Imagine that a client orders 50 units of a product from a seller at a price of $100 per unit.
The seller delivers the 50 units to the client and issues an invoice for $5,000 so the client can pay for the purchase.
However, the buyer realizes that there were 10 units that were defective and returns them.
Following the return of the goods, the seller issues a credit note of $1,000 reflecting the 10 items returned.
In this case, the client will have received an invoice of $5,000 and a credit note of $1,000.
If the client has not yet made any payment, it can simply pay the difference between the invoice and the credit note ($4,000).
However, if the client has already paid the $5,000, it will have a credit of $1,000 with the seller.
The client can either ask for a refund of the $1,000 or use the $1,000 to offset future invoices.
Credit Memo FAQs
Let’s look at a few commonly asked questions related to credit memos.
What Is The Difference Between Credit Memo vs Invoice
A credit memo serves a different function than an invoice.
An invoice is a document issued by a seller of goods or services indicating to a buyer the amount of money it owes for the goods and services purchased.
For the seller, the invoice increases its accounts receivable and for the client it increases its accounts payable.
On the other hand, a credit memo is a document issued by a seller reducing the amount owed by a client under a previously issued invoice.
The credit memo offsets the balance owed by the client.
What Is The Difference Between Credit Memo vs Credit Refund
A credit memo and credit refund are not the same things.
A credit memo is when a seller reduces the amount owed by a buyer under a previously issued invoice.
On the other hand, a credit refund is when a seller actually reimburses the credit to the buyer in cash.
What Is An Internal Credit Memo
In some situations, a company’s finance department may post an internal credit memo.
When this happens, the client or buyer will not receive a copy of the memo credit (making it an “internal” transaction).
This is usually done when a company is writing off an accounts receivable balance and will use a credit memo posting to reduce the account.
Credit Memo Meaning Takeaways
So there you have it folks!
What Is Credit Memo In Accounting
A credit memo is a document sent to a buyer from a seller reducing the amount owed by the buyer to the seller.
In essence, this document is generally sent following the issuance of an invoice to the buyer.
There are many reasons why credit memos are issued by sellers to buyers.
The most common reason is when a buyer returns goods or there’s a dispute on the invoice.
Now that you know what credit memos mean, why they are important, and how they work, good luck with your transaction and accounting!
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