Running a business involves a set of minor and major tasks that one must take care of. This also includes the preparation of various credentials to keep a check on the payments disbursed and payments outstanding for a particular period. One such document is a credit memo, a contracted form for credit memorandum. It is a credential that reduces the amount that buyers owe to sellers, given the adjustments made with respect to the prior invoice.
What Is A Credit Memo?
As the name suggests, a credit memo is a note that jots down or records the future credit liabilities of a seller. A seller is one who offers goods and services to clients and customers in exchange for money. Also known as a credit note, this memorandum can be classified into two categories – external and internal.
An external note is one that is sent to buyers to inform them about the outstanding credit on their account. On the contrary, an internal credit memo is prepared by sellers to ensure accurate account management. In the latter case, the buyers remain unaware of this credit amount. The sellers make the required adjustments for the buyers. After adjusting the amount with respect to the payment made for the latest purchases and the expected price the buyers are likely to pay for future purchases, the sellers prepare the credit note or memo.
Recording a Credit Memo
Given the adjustments that sellers make to buyers’ accounts, a credit memo is considered an important financial document in the account management system. However, recording the details for the same is quite crucial. This is because the preparation of these notes includes the addition and deduction of many payments and dues. Thus, one must be very careful while recording a credit memo.
Credit notes are prepared in three situations:
- Reduce or reverse an Accounts Receivable (AR) item, thereby recording a decrease in the amount that buyers owe
- Reverse a sales transaction that has previously been entered
- Write off any AR item that remains uncollected.
The approach towards accounting for or recording the credit notes differ, depending on two scenarios, i.e., whether it is being maintained as a buyer or a seller.
Recording As A Buyer
When an individual or company purchases a product but does not find it up to the mark in terms of quality or some other factor, they immediately return it. In such a scenario, the liability of the buyer decreases as the credit gets reduced. In case, you – the buyers – have already paid for the purchase, the seller will provide you with the credit note, which you can utilize for adjustment in your future purchases.
As a buyer, a person’s journal entry will reflect a debit entry for the credit memo to the supplier’s account, indicating a reduction in liability. The purchase return account, on the other hand, has a credit entry for the note.
Recording As A Seller
As soon as you receive the returned product. The credit note needs to be prepared to help your business not miss out on any transactional information. For a brick-and-mortar store, it is a store credit and not a credit note. The journal entries for both are different. Here, the Accounts Payable takes it as a debit note and the Cash account accepts it as a credit entry. The store credit debits the Cash account while making it the credit entry for Accounts Payable when the businesses do not refund the amount to customers.
On the other hand, when it is business-to-business accounting, it’s a debit entry for a Sales Return account, initially. Next, the credit entry is reflected in the buyers’ account or the AR. As a business, however, you have to take a look at the journal entries at regular intervals to ensure the credit memo is prepared, keeping in mind the adjustments to keep the transactions accurate and flawless. This, in turn, makes brands more trustworthy in the eyes of the customers and clients.
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Issuing A Credit Memo
Businesses issue credit memos along with the original invoice. However, they also have a lot of other ways of issuing these notes to buyers. As soon as these reach buyers, they have two options to take care of them. Firstly, they might demand a cashback alternative for the items they have returned. Secondly, there is an option where they can forfeit the credit document. This is considered a crucial alternative when the buyers are not happy with the supplier and they want to switch to some other service provider.
Issuance of a credit memo is indicative of the health of the business. In case a business has to prepare multiple credit memos throughout the year. It reflects the loopholes in the accounts management system. Thus, taking control of the frequency of issuance of a credit memo is highly recommended to improve the accounts management functions.
Now that you know what is a credit memo and why it is important to record and issue it. It will be easier for you to understand how to take care of the situation if your business frequently has to prepare these notes. However, if it’s something that you do once in a while. It is quite obvious for a growing business like yours to go through such situations. Hence, a little bit of care would help avoid such credit memo creations. In case, you encounter such instances, proper recording and issuance will help you keep proper track. So, go for it and take control of your business finances.
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