What is a Credit Memo?
Small, medium, and large business owners sell their products to a wide variety of customers and clients. Sometimes orders become damaged, incomplete, or the wrong product is shipped.
When this happens, the customer will want to be compensated for the damaged or returned items.
This is where the credit memos come in. These instruments are an important and integral part of the accounting structure.
They allow for tracking of returns, damages, or write-offs. Additionally, they allow a business to maintain clean accounting records on the sales transaction.
No matter what a company sells, at some point they will be faced with issuing a credit.
In this post we’ll define exactly what is a credit memo, show how it is used in business today, and provide internal control tips when dealing with memos.
Table of Contents
What is a credit memo?
A credit memorandum (memo) is issued by a seller of goods or services to the buyer. The memo reduces the amount that the buyer owes to the seller. The credit issued can be for part or all the respective invoiced amount and is posted against the buyers outstanding balance.
Why is a credit memo important?
While having a product returned due to a defect, wrong item, or incomplete order is not what a business owner wants, the process can help develop good insights into their customers.
From the accounting standpoint, the credit should be treated as an adjustment to revenues and receivables.
Assume Company A sold $1,250 of products to a customer on January 15, 2020. The customer realizes part of the products are damaged and unsaleable. They return $700 of the product back to Company A on February 17, 2020. The journal entry for the original transaction and for the credit memo would look like this:
This entry leaves the ‘audit trial’ of the original revenue entry. This trail is key because a company needs to maintain historical sales transaction data to be able to forecast future sales expectations. The net effect of the entry is to reduce the respective receivable and the corresponding revenue.
Both the balance sheet and the revenue accounts are netted to show actual effect. It should be noted the entry assumes the inventory returned is not saleable any longer and therefore not put back into inventory.
Additionally, a credit adjustment can be issued for a customer whose account balance is deemed uncollectible. This is usually done through an adjustment in the allowance for bad debt.
However, it can be done through a memo. The key part is that the adjustment needs to have approval from executive management.
The financial aspect of a credit memo is that it will usually affect the bottom line. If the merchandise is damaged, there will be no restoring of the product.
The cost into the inventory is lost, so when a credit memo is posted it has a direct effect on net income.
Non-Financial Importance of a Credit Memorandum
Another important aspect for the business owner is to look past the financial accounting of the transaction.
Why did the customer return the product? Was there damage due to shipping? Was it a faulty product run?
These are the questions that need to be answered. Receiving the product back may not be ideal from a net income standpoint, but management also needs to understand the causes.
This will then allow for an examination of all processes to see if there is a problem in the product.
In regard to marketing and advertising, the company must ask if the customer returned the product because it didn’t perform as expected. Is any part of the advertising and product packaging misleading?
Internal Controls Related to a Credit Memorandum
An important aspect on that tends to get missed is the concept of internal controls. Businesses fear an employee committing fraud.
An easy way for an employee to commit fraud or embezzlement is through credit memos. The memos in can reduce an accounts receivable without having to record cash.
If a customer sends in payment on their account, and the accountant wants to steal the payment, the easiest way is to record a memo. The payment goes in their pocket and the receivable gets reduced without anyone noticing.
Therefore, all memos must be reviewed and approved by management.
If possible, the adjustment should be recorded by an individual who does not have accounts receivable duties. The controls over credit memos should have the same heighten level as the controls over the cash of the company.
Tips and Reminders
- Credit memos allow for maintaining the audit trail for the original transaction(s).
- Understand that an adjustment for a credit memo is a direct hit to the bottom line.
- Learn from the transaction. Why was the merchandise returned? Was it damaged? Are other products in the same run defective? Was marketing misleading?
- Maintain proper internal controls over the recording of the credit memo.
While no business likes to see their product returned, learning the underlining cause will make a business more profitable and increase its long term value.