What is a credit note?

Confused by a “credit note” in your inbox? A credit note is a business document that grants you a refund or a future discount in the event of discrepancies with an existing invoice.

Sellers use credit notes to document a reduction in the amount a buyer owes them, in response to returned products, a reduced price (perhaps after a dispute), accounting errors, order changes or cancellations, and so on. Unlike debit notes, which a buyer issues to a seller, stating the reasons for a product’s return, credit notes are issued by the seller upon accepting the return or the conditions of the return.

In this article, we’ll explain what a credit note is, when to issue one, the information to include in one, and how a credit note compares with other business documents.

Let’s begin!

Definition of a credit note

A credit note is a business document that reduces a buyer's outstanding balance in specific circumstances — such as returns, invoicing errors, and discounts.

For example, if your supplier sells you some material for €100, they’ll issue an invoice to keep track of the sale. If you discover that 5% of that material is defective and ask for a €5 refund, the supplier will issue a €5 credit note to maintain a document trail. The credit note will reduce your outstanding balance or, if you’ve paid already, grant a refund or a future discount.

Since credit notes are closely linked to invoices, they are crucial for tax and accounting compliance. Depending on the country you’re doing business in, credit notes have different formal requirements specified in the local VAT law.

For example, some countries require that suppliers use a “corrective invoice” or “reverse invoice” instead of a credit note in certain scenarios. We’ll discuss the differences between corrective invoices, credit notes, and other business documents later in this article.

For now, we hope it’s clear that you should always check local regulations or consult an advisor when dealing with credit notes.

When to issue a credit note

A supplier will generate a credit note to adjust the amount owed by a customer. This can happen in several situations:

Invoice mistakes

Occasionally, a seller will accidentally overcharge a customer on an invoice, and they’ll have to use a credit note to amend the error. When this happens, the seller has two options:

• Option A: Issuing a credit note for the difference.
• Option B: Canceling the first invoice by issuing a credit note for its total amount and then issuing a new invoice for the correct amount.

Order returns

Imagine you discover a tear in the fabric of your new pair of sneakers. You request a return, and the online store emails you a credit note to reduce your outstanding balance or initiate a refund.

Order changes

Buyers may change the quantity or value of an order after the initial invoice has been issued. In such a case, a credit note is handy.

Suppose you make a full pre-payment on a six-month lease of equipment, and your contract allows you to return that equipment early for a partial refund. Although the seller initially issued an invoice for the full six months, when you turn in your leased items early, they’ll issue a credit note to document the refund.

Discounts

Sellers often incentivize early payments by offering discounts. In such a case, they will issue a credit note to offset the buyer's initial payment.

Suppose you buy a TV for €500, but the store offers a €50 discount if you pay within a week — and you pay within that time. The seller will issue a credit note for €50 to document the discount applied to your invoice.

What information should a credit note include?

Credit notes usually include the same kind of information as invoices. At a minimum, they should contain enough information to identify the supplier and the buyer and explain the amount adjusted and the reason for the adjustment.

Since credit notes can have tax implications, some governments do have regulations about the information that’s required, especially in countries with mandatory e-invoicing.

Credit note example

Let’s look at a credit note in action. In our example, the London-based “Big Law Firm Ltd.” is billing “Cool Startup S.L.” for ten hours of legal services at £150 per hour, by issuing an invoice.

After a brief discussion with its client, Big Law Firm agrees to adjust the number of billable hours to seven, and it issues a credit note for the three-hour difference. The example document below shows that an amount of £450 has been credited to the buyer, reducing the payable amount to £1,050.

Reverse or corrective invoices and credit notes

Before we dive into this section, a quick caveat: While credit and debit notes are somewhat standardized globally, there’s no universal definition of a corrective invoice, so this article provides Invopop’s view and our attempt to identify patterns.

Some countries with stricter invoicing requirements, such as Germany and Spain, don’t allow the use of credit notes in certain situations. Instead, they require that suppliers replace the previous invoice with a corrective invoice.

A corrective invoice — also called a reverse invoice — serves the same purpose as a credit note: to adjust the money a buyer owes a seller. The difference between corrective invoices and credit notes is subtle.

• Credit notes adjust the balance but don’t formally modify the original invoice.
• Corrective invoices actually replace the original invoice.

Returning to the previous example, Big Law now has two standing documents: a £1,500 invoice and a £450 credit note, making its accounts receivable amount £1,050. In other countries, Big Law Firm may have been required to issue a £1,050 corrective invoice, which would void the first invoice. As you can see, the net effect is the same: Cool Startup owes Big Law Firm £1,050.

Credit notes in accounting

For a buyer, a credit note is a refund, so it reduces costs that have been recorded as expenses in the P&L and decreases the accounts payable in the balance sheet.

For a seller, a credit note is a reduction in sales, so it reduces the revenue booked as sales in the P&L and decreases the account receivables amount in a balance sheet.