What is a credit note? How to issue one for your small business

Published Wednesday 26 November 2025

Table of contents

• What is a credit note?
• How to create and process a credit note
• Integrating credit notes with accounting software
• Best practices for managing credit notes
• Streamline credit note management with Xero
• FAQs on credit notes

Key takeaways

• Issue credit notes within 48 hours of identifying invoice errors, product returns, or service cancellations to maintain accurate cash flow and preserve customer relationships.

• Include all required legal information on credit notes such as business addresses, unique identification numbers, original invoice references, credited amounts, and VAT details to ensure HMRC compliance.

• Utilize accounting software to create credit notes directly from original invoices, which automatically copies relevant information, calculates VAT, and updates your financial records to reduce errors and save time.

• Store all credit notes for six years and reconcile them regularly in your financial reports to meet legal requirements and maintain accurate audit trails for tax purposes.

What is a credit note?

A credit note is a legal document that reduces or cancels the amount you owe on an original invoice. You issue it to show you owe money back to your customer.

Credit notes serve three main purposes:

• Correct invoice errors like wrong amounts or pricing
• Process returns when customers send products back
• Handle cancellations when services aren't delivered

This keeps your records accurate and helps you build strong customer relationships.

Key reasons for issuing credit notes

Common reasons for issuing credit notes

• refund for returned products
• cancel payment after purchase cancellation
• correct pricing errors
• apply early payment discounts

Purchase cancellations: Customer cancels after you've sent the invoice. The credit note cancels the outstanding payment.

Pricing errors: You charged too much on the original invoice. The credit note shows the overpayment amount.

Early payment discounts: Customer pays early and qualifies for a discount. The credit note reduces their balance accordingly.

When you manage your finances and cash flow, you need to know exactly how much is coming in and out of your business each day.

If your customer has not paid the invoice, the credit note cancels the amount owed. If they have already paid, the credit note shows a refund or can be used to offset a future purchase.

Credit notes versus debit notes: How are they different?

• Credit notes: You issue these to reduce what your customer owes.
• Debit notes: Your customer issues these to request a refund or dispute charges.

When buyers use debit notes:

• Received wrong or damaged products
• Disputing invoice amounts
• Requesting refunds for returned items

You must include the same essential information on both documents as you do on invoices.

Legal requirements for credit notes in the UK

You cannot delete an invoice. Instead, use a credit note to cancel the invoice or show a refund is owed. Your credit note must include:

1. Your business name and address
2. The buyer's name and address
3. The credit note issue date
4. A unique identification number (see below)
5. The original invoice number
6. The original invoice date
7. The amount being credited
8. The VAT amount and VAT number (if relevant)
9. The reason the credit note was issued, e.g., a refund or cancellation

Key compliance requirements

• use your invoice sequence (INV-001, INV-002) or a separate sequence for credit notes (CN-001, CN-002)
• adjust VAT amounts to match the credit note value
• store all credit notes for six years to meet HM Revenue and Customs (HMRC) requirements

VAT calculations: Always adjust VAT amounts to match the credit note value.

Record keeping: Store all credit notes for six years to meet HMRC requirements.

How to create and process a credit note

How to create and process a credit note

1. Identify the need – Spot invoice errors, process returns, or handle cancellations as soon as possible
2. Calculate the amount – For a £200 invoice cancellation, your credit note shows -£200
3. Issue promptly – Quick action prevents cash flow confusion and maintains customer relationships

Manual vs automated approach: Traditional methods require creating documents from scratch. Modern accounting software copies invoice details automatically, reducing errors and saving time.

You can reduce admin and errors by using digital credit notes and bookkeeping. Xero accounting software helps you do this efficiently.

Using templates and software

Accounting software such as Xero reduces errors. You can create credit notes directly from invoices, copying the relevant information. If you have an invoice awaiting payment, Xero applies the credit note automatically.

Features like automatic VAT calculation and ledger integration save you time. Your financial documents stay compliant and ready for audits.

Integrating credit notes with accounting software

Most businesses need accounting software to keep accurate records and work efficiently. Here are the benefits of using Xero accounting software for credit notes.

Benefits of using Xero credit notes

Key Xero credit note benefits:

• Automated record updates: Your accounts update instantly when you create credit notes, keeping balances accurate.
• Clear audit trails: Track every credit note change with complete transparency for accounting reviews.
• Secure data storage: Bank-level security protects your financial information and customer details.
• Customer credit management: Store credit balances that automatically apply to future invoices, improving cash flow.

Best practices for managing credit notes

Good financial habits help you run a healthy business. Here are practical tips for managing credit notes.

Make sure you're timely

Issue credit notes within 48 hours. Delays can confuse your cash flow and frustrate your customers.

Why timing matters

• keep your cash flow accurate
• build trust with quick responses
• prevent errors by processing credit notes promptly

Best practice: review outstanding credit notes at the start of each month to catch any delays

Keep accurate records

Set up a system to keep your credit note records. Use unique numbers, correct dates, and business information for each credit note.

When you use Xero, your credit notes appear in sales and purchase reports. You can easily allocate each credit note to the right invoice.

Reconcile credit notes in financial reports

Reconcile all credit notes to keep your financial reports accurate and transparent. This makes audits and tax returns easier.

Software like Xero automates much of this work for you.

Streamline credit note management with Xero

Credit notes help you handle invoice corrections quickly and keep your customer relationships strong.

Xero helps you create credit notes quickly and updates your accounts automatically. This reduces errors and saves you time.

Try Xero for free and make managing your invoicing easier.

FAQs on credit notes

Issuing and managing credit notes can bring up a few questions. Here are answers to some common ones.

Does a credit note mean a refund?

Not always. A credit note shows the amount you owe your customer. You can refund this amount or apply it to a future invoice.

What is the difference between a credit note and an invoice?

An invoice requests payment from your customer. A credit note shows you owe money back to your customer, cancelling all or part of the original invoice.

Can I delete an invoice instead of issuing a credit note?

Do not delete an invoice after you issue it, especially for VAT. Instead, issue a credit note to create a clear audit trail and keep your records accurate.

How long do I have to issue a credit note?

There is no strict legal deadline, but issue a credit note as soon as you know you need one. This keeps your records accurate and your customers informed.

Do credit notes affect my VAT returns?

Yes. If you are VAT-registered, a credit note reduces the VAT you declared on the original invoice. This lowers your total sales and the VAT you owe to HM Revenue and Customs (HMRC).