Recording credit notes and refunds

A credit note reverses all or part of an invoice. In the books it is posted as the mirror image of the invoice, through the customer or supplier account, and then allocated against the invoice it relates to. If the invoice has already been paid, the credit note leaves a balance owed back, which is either set against the next invoice or settled by a refund recorded through the bank.

What is a credit note, and when is one issued?

A credit note is a document from a supplier to a customer that reduces the amount the customer owes. Typical reasons are returned or faulty goods, an agreed price reduction, a volume rebate, or an invoice raised in error. For VAT purposes, VAT Notice 700 paragraph 18.2.3 says a valid credit note must reflect a genuine mistake, overcharge or agreed reduction in the value of the supply, and must give value to the customer, meaning a genuine entitlement either to a refund or to an offset against future supplies.

The credit note does not delete the invoice. Both documents stay in the records, and the link between them is the allocation. Section 386 of the Companies Act 2006 requires records sufficient to show and explain the company’s transactions, and an invoice silently edited or deleted after issue fails that test. The VAT content of a credit note, including what it must show and how discounts work, is covered in our separate page on credit notes, discounts and VAT. This page concentrates on the bookkeeping.

How do you record a credit note issued to a customer?

It is entered in the sales ledger as a credit note, not as a journal, so that it appears on the customer’s account and in the sales day book. The double entry is the reverse of the sale:

• debit sales, or a sales returns account if the business tracks returns separately, with the net amount;
• debit output VAT with the VAT element;
• credit the customer account with the gross amount.

Posting through the customer account keeps the sales ledger in agreement with the debtors control account. A credit note posted as a journal directly to sales reduces turnover but leaves the customer still showing the original debt.

How is the credit note matched to the invoice?

Once posted, the credit note is allocated in the software against the invoice it relates to. If the credit is for part of the invoice, the invoice stays open for the balance. If the customer has not yet paid, the next payment is allocated against the reduced balance and the account clears to nil.

Where returned goods cannot be traced to a single invoice, the allocation is made to the oldest relevant invoice or left on account until the customer pays. Paragraph 18.2.3 still requires the credit note to give the number and date of the original VAT invoice where possible; if that cannot be done, the business must be able to satisfy HMRC by other means that VAT was accounted for on the original supply.

Unallocated credit notes are one of the main reasons an aged debtors report looks wrong: old invoices appear overdue while an unused credit sits further down the same account. Allocating promptly keeps credit control working from accurate figures.

What if the customer has already paid?

Then the credit note leaves the customer account in credit: the business owes the customer money. There are two ways to settle it.

• Offset. With the customer’s agreement, the credit is allocated against the next invoice. No cash moves.
• Refund. The business pays the customer. The refund is recorded as a payment from the bank with a debit to the customer account, which brings it back to nil, and the refund is allocated against the credit note. It is not posted to sales, because the credit note has already reduced sales.

A refund recorded straight to the sales account, with no credit note, reduces turnover but never clears the customer’s original receipt, and the bank and customer ledgers stop agreeing. Every refund needs a document behind it: a credit note, or for a refund of an overpayment, a record of what was overpaid. Overpayments are a different situation, covered in our page on unallocated receipts and overpayments.

How do you record a credit note received from a supplier?

The entries mirror the purchase invoice: debit the supplier account with the gross amount, credit the purchase or expense account with the net amount, and credit input VAT with the VAT. VAT Notice 700 paragraph 19.7 requires a record of all credits received from suppliers for taxable supplies, and says that where the credit adjusts deductible input tax, the business must adjust its records of supplies received and its input tax.

The credit is then allocated against the supplier invoice. The most common payment error is paying a supplier invoice in full while a credit note sits unallocated, which leaves the business owed money it may never chase. Reconciling the purchase ledger to the supplier’s statement catches this; see our page on reconciling supplier statements. A refund received from a supplier is posted as a receipt into the bank, credited to the supplier account and allocated to the credit note.

When does the VAT adjustment fall?

VAT Notice 700 paragraph 18.2.6 says that, where the adjustment is not correcting an error already declared on a VAT Return, the adjustment arising from a credit note is made in the VAT period in which the decrease in price occurs, which for decreases in price is the period in which the refunded amount is paid to the customer. Among the conditions for a valid credit note, paragraph 18.2.3 lists issuing it within 14 days of the refund payment being made. If the original VAT was wrong and has already been declared, paragraph 18.2.6 says the error correction rules in VAT Notice 700/45 apply instead.

Paragraph 18.2.1 allows supplier and customer to agree not to adjust VAT when the customer can reclaim all the VAT, in which case paragraph 18.2.3 says the document should state “This is not a credit note for VAT”, and both parties must still adjust their records of outputs and inputs.

What does a worked example look like?

Illustration only. A business invoices a customer £1,200, made up of £1,000 net and £200 VAT. The customer pays in full. A week later £250 of the goods are returned damaged and the business issues a credit note for £300, being £250 net and £50 VAT, then refunds the customer.

Step	Debit	Credit	Customer balance
Invoice	Customer £1,200	Sales £1,000, output VAT £200	£1,200 owed
Payment received	Bank £1,200	Customer £1,200	Nil
Credit note	Sales £250, output VAT £50	Customer £300	£300 in credit
Refund paid	Customer £300	Bank £300	Nil

Net sales are £750 and output VAT £150. The credit note is allocated against the invoice and the refund against the credit note, so the account shows a complete, matched trail.

What about expected returns at the year end?

Credit notes issued after the year end can relate to sales made before it. For periods beginning on or after 1 January 2026, revised Section 23 of FRS 102 requires a business selling with a right of return to recognise revenue only for products expected not to be returned, a refund liability for amounts expected to be refunded, and a refund asset in inventory for the goods expected back (paragraph 23.53). Paragraph 23.49 requires the refund liability to be updated at each reporting date. In a small business this usually means reviewing credit notes raised shortly after the year end and deciding whether they belong to the old year, as part of the cut off review.

What mistakes come up most often?

• Editing or deleting the original invoice instead of issuing a credit note.
• Posting credit notes or refunds by journal, so the customer or supplier account never clears.
• Leaving credits unallocated, which distorts the aged debtors and creditors reports.
• Netting customer credit balances against debtors in the accounts. FRS 102 paragraph 2.96 prohibits offsetting assets and liabilities unless the standard requires or permits it, and paragraph 8 of Schedule 1 to SI 2008/409 has the same rule, so material credit balances belong in creditors.
• Counting the same reduction twice by issuing a credit note and also posting the refund to sales.

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Related Accountapedia entries

• The VAT control account
• The aged creditors report
• The general ledger and subsidiary ledgers
• Sales and purchase day books explained
• Writing off a debt in the books
• VAT65A refunds for overseas businesses

Sources

• GOV.UK: Vat guide notice 700
• legislation.gov.uk: Act 2006 c. 46, section 386
• Financial Reporting Council: FRS 102 September 2024 tmKYWO6
• legislation.gov.uk: SI 2008/409, schedule 1

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 19 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.