Creating an organized invoicing system is essential when you’re running a small business. As a freelancer or contractor, you may not have the support from a finance department to help ensure this.

This is why we recommend setting up a system in advance to help make the process seamless. For example, adopting an electronic invoicing system to help manage all of your clients and bills.

Having a numbering system is also critical to ensuring your invoices are properly organized.

But what happens when you need to cancel out an invoice that was either partially paid or unpaid altogether? This is where credit notes come in handy.

There are rules and regulations regarding the cancellation of invoices. You can’t create an invoice and then delete it from existence.

It’s essential to keep it on record but have a credit note attached detailing that it’s either been partially or completely canceled.

Adding this to your sales process is key. So let’s take a closer look at what a credit note is and why (and when) you should use them.

Credit Note vs Invoice

It’s important not to confuse credit notes with invoices. An invoice is a document you create to bill your customers for products or services provided.

It contains an itemized list of the goods or services, along with a break down of the rates, due date, and total amount owed. The invoice serves the purpose of providing customers with a detailed break down of what they must pay.

When done correctly, it can help to avoid disputes and non-payments.

A credit note or credit memo, on the other hand, is a document you attach to invoices. These are typically used when a customer returns items to the vendor.

As the vendor, you create a credit note and attach it to the original invoice to nullify it or to subtract the items returned. Or if you accidentally send duplicate items or the wrong items, credit notes can be used as well.

And the same can be done for services.

If a customer is dissatisfied with the services you provided – you can use a credit note to either cancel it out or to deduct an amount from the total price.

The customer returning the items can issue the credit memo to notify the vendor of the discrepancy.

In a nutshell, a credit note is used in conjunction with an invoice to update the amount owed to the vendor.

When to Use a Credit Note

As we discussed, there are several ways to use a credit note in your business. And due to certain laws in different countries, it’s essential to become accustomed to using them.

Not doing so could land you in trouble if you decide to cancel out an invoice improperly. It may look like you’re hiding money from your tax authority, which will likely lead to an audit and fines.

The legal way to cancel out some or all of an invoice is with a credit note. This clearly details what’s being canceled, why it’s being canceled, and how much is being canceled.

So when you’re looking to make changes to an order (either by the request of you or the client), then you’ll also have to edit the invoice and reissue it.

This will, in turn, organize your finances and help you track down what happened in the past when invoices were changed or canceled.

What Should a Credit Note Include?

When creating a credit note, there are key details you should include. There’s an outline you can use to ensure this.

Like a quote or invoice, credit notes must include specific information to be valid. Here’s a quick look at what should be included in your credit note.

First, you want to make a heading that’s clearly titled as a “Credit Note.” This way, the customer, finance department, company, and any other entities going over your invoices will know what it is.

The note should also dictate the amount that’s being reduced from the invoice. Also, the credit note must be issued within one month of the agreement between the customer and vendor to reduce the invoice amount.

Like with invoices, your credit memo should have an identification number so it’s recorded and easily searchable in your database. The issue date is also needed, along with your business’s name, address, and VAT number.

Then be sure to include the name and address of the customer that’s being credited. Or if you’re the customer, then you’ll need to add the vendor or supplier’s name and address.

Once you have all of this out of the way, you’ll need to detail why the credit is being issued. For instance, the customer was billed the wrong amount or was given items they didn’t order.

Afterward, write in the total amount of the credit being sought. This should exclude VAT. Then put in the rate for VAT, if applicable, along with the credit being given under VAT.

Don’t forget to include the gross amount of the credit with applicable VAT.

Creating and Issuing Credit Notes

As long as you’re including everything that’s required within your credit note, you’re good to go. But going about creating one may be time-consuming.

This is especially true if you’re not using tools and software to make the process easier. There are some accounting software you can use that will generate a credit note for you to attach to your existing invoice.

This is connected to the invoice for you. All of the information provided in the invoice is transferred to the credit note template.

You can edit the credit note to have a partial credit or you can eliminate specific lines and adjust amounts. The credit note is given a unique number within your invoicing sequence.

This will make it easier to manage your financial records. Remember, it’s not a good idea to have a gap in your invoicing sequence.

If you do, then this will be a red flag to your country’s tax authority.

As for distributing it, you can email it to your customers. If you’re using an invoicing tool, this is done for you through the platform.

Otherwise, you’ll have to create the invoice and credit note and attach it to an email to send to your customers. Or if you’re old school, you can always print it out and mail it via snail mail, which increases the risk of it being lost.

Managing Credit Notes in Your Bookkeeping

It’s not difficult managing credit notes in your financial records. One thing you’ll have to organize is your double-entry bookkeeping method.

This all comes down to when the credit note is issued. For example, was it issued before or after the invoice was paid? If the invoice hasn’t already been paid for, then you’ll have to debit the credited amount under “Revenue” and then credited under “Accounts Receivable.”

This is done for the specific customer’s account so its adequately applied to future orders.

Yet, if the invoice was already paid for (the goods returned and the refund issued), then the credit note will have to be recorded under “Revenue” and “Accounts Receivable.” This will adjust the amount of revenue your company received from that account.

This is another great thing about using online invoicing software. Since the bookkeeping is already built in, the credits and debits are automatically applied and linked to the invoice with the updated total.

Quick Tips for Using Credit Notes

There are some freelancers and small business owners who may feel credit notes aren’t necessary. These individuals normally using an Excel or Google Spreadsheet for their invoicing.

So instead of creating a credit memo, they delete the line, calling it canceled. However, if complications arise in the future, then this will make things more hectic.

For instance, if you’re VAT registered, and you don’t properly cancel out the invoice or the portion of it that’s refunded, then you could end up paying the VAT on a full sale.

This means more money out of your bank account for sales that are inaccurate.

When deducting from the total VAT, you’ll need to deduct the credits provided during that sales cycle. For example, if you sell £500 and credited £25, then the total Output Vat to report is £475.

In the event you’re using an invoicing software, you’ll find that you can’t edit an invoice that’s already been issued. In this case, you’ll need a credit note to show the changes.

But either way, you want to use a credit memo to manage your finances legally.

Now, if you run into a client that doesn’t pay your invoice on time, you don’t use a credit note. Instead, you label the invoice as “Bad Debt.” You write bad debts off as business expenses.

As for the VAT you pay on the original invoice, you can reclaim it by including it in the VAT reclaimed in your purchases.

Implementing Credit Notes in the Invoicing Process

Using credit notes is just another way of legally representing the revenue of your business. This way, you don’t pay more taxes or VAT than you need to.

Hopefully, this guide sheds light on the process so you can ensure your invoices and finances are in order.

Let us know in the comments what platform or systems you plan to use for creating invoices and credit notes!