How to Create a Credit Note in Xero

At Towerstone Accountants we provide specialist limited company accountancy services for directors and owner managed businesses across the UK. We created this webpage for business owners who want practical guidance on choosing and using accounting software, including day to day bookkeeping tasks, invoicing, bank feeds, and reporting. Our aim is to help you keep accurate records, reduce admin time, and stay compliant with HMRC and Companies House requirements.

Creating a credit note in Xero is something almost every business needs to do at some point. It might be because an invoice was raised incorrectly a customer returned goods a discount was agreed after invoicing or a service was cancelled. While the process itself is straightforward the accounting and VAT treatment behind it needs to be right or it can cause problems later with your reports VAT return and customer balances.

In this article I will explain clearly how to create a credit note in Xero step by step. I will also explain when you should use a credit note how it affects VAT and what happens after the credit note is created. I am writing this in the first person based on how I guide my own UK clients through Xero and everything here reflects UK accounting practice and HMRC expectations.

Xero is widely used in the UK and the steps below apply to the standard UK version.

What a credit note actually is

Before looking at the steps it helps to be clear on what a credit note does.

A credit note is a document that:

• Reduces or cancels an existing invoice

• Adjusts the amount a customer owes

• Corrects income and VAT previously recorded

• Creates a credit balance that can be refunded or applied to another invoice

A credit note is not just an internal adjustment. It is part of your sales records and in most cases should be sent to the customer.

When you should use a credit note

In practice I see credit notes used for a few common reasons.

These include:

• An invoice was raised for the wrong amount

• VAT was charged incorrectly

• Goods were returned

• A service was not fully delivered

• A goodwill discount was agreed after invoicing

• An invoice needs to be cancelled completely

If an invoice has already been approved or sent you should use a credit note rather than deleting or editing the invoice. This keeps your audit trail clean.

Why you should not delete invoices instead

Many people are tempted to delete invoices and start again. This is risky.

Deleting invoices can:

• Break the audit trail

• Cause discrepancies in reports

• Create issues if VAT has already been reported

• Raise questions in an HMRC enquiry

Using a credit note shows clearly what happened and why.

Step by step how to create a credit note in Xero

I will now walk through the process exactly as I explain it to clients.

Step one go to the Sales area

Log into Xero and from the main dashboard:

• Click Business

• Select Invoices

• Go to the Sales tab

This shows all your sales invoices including draft approved and paid invoices.

Step two open the invoice you want to credit

Find the invoice that needs to be corrected.

You can:

• Search by customer name

• Search by invoice number

• Filter by status or date

Click on the invoice to open it.

Step three choose Add Credit Note

Once the invoice is open look for the option that says:

• Add Credit Note

This is usually found near the top of the invoice screen.

Clicking this tells Xero you want to create a credit note linked directly to this invoice which is the safest approach.

Step four choose full or partial credit

Xero will ask whether you want to:

• Credit the entire invoice

• Credit part of the invoice

If the invoice is completely wrong choose a full credit.

If only part needs correcting choose a partial credit and adjust the quantities or amounts.

Step five review the credit note details

Xero will automatically create a draft credit note using the same details as the invoice.

At this stage check carefully:

• Line items

• Quantities

• Prices

• VAT rates

• Dates

• Description

This is where most mistakes happen especially with VAT. The VAT treatment on the credit note should usually match the original invoice.

Step six approve the credit note

Once you are happy:

• Click Approve

Approving the credit note posts it to your accounts and updates your reports.

Until it is approved it does not affect your figures.

Step seven decide what to do with the credit

After approving the credit note Xero will give you options.

You can:

• Allocate it to the original invoice

• Leave it as a credit on the customer account

• Apply it to another invoice

• Refund it to the customer

What you choose depends on the situation.

How to apply a credit note to an invoice

If the customer has not paid the original invoice:

• Apply the credit note to that invoice

• Xero will reduce or clear the balance automatically

If the customer has already paid:

• The credit will sit on their account

• You can either refund it or apply it to a future invoice

How to refund a credit note in Xero

If you owe the customer money back:

• Open the credit note

• Choose the Refund option

• Select the bank account

• Enter the refund date

• Confirm the transaction

This records the money leaving your bank and clears the credit properly.

How credit notes affect VAT

This is an area where accuracy matters.

If the original invoice included VAT:

• The credit note should usually include VAT

• The VAT amount will reduce your output VAT

• The adjustment will feed into your next VAT return

If you are on the cash accounting scheme:

• VAT is adjusted when the refund or allocation happens

If you are on the standard accrual scheme:

• VAT is adjusted when the credit note is approved

This timing difference is important and often misunderstood.

Credit notes and VAT returns already submitted

If the original invoice was included in a VAT return that has already been submitted:

• The credit note will appear in the next VAT return

• You do not normally amend the old return

• The adjustment is made going forward

Only in rare cases would a VAT return need to be amended.

Credit notes and your reports

Once approved a credit note affects several areas:

• Reduces sales income

• Reduces VAT payable

• Updates the customer balance

• Appears in aged receivables

• Appears in the audit trail

This is why credit notes are the correct method rather than manual journals for sales corrections.

Creating a standalone credit note

In some cases you may need to create a credit note without linking it to an existing invoice.

For example:

• A goodwill refund

• A pricing dispute resolved later

• A historic correction

To do this:

• Go to Business

• Select Invoices

• Click New Credit Note

• Choose the customer

• Enter the details

• Approve the credit note

Standalone credit notes should still be used carefully and documented clearly.

Common mistakes I see with credit notes in Xero

There are a few issues that come up regularly.

These include:

• Using the wrong VAT rate on the credit note

• Forgetting to approve the credit note

• Leaving credits unapplied for long periods

• Refunding without allocating the credit

• Using journals instead of credit notes

• Deleting invoices instead of crediting them

Most of these cause reporting or VAT problems later.

Credit notes and cash flow

Credit notes affect cash flow indirectly.

They can:

• Reduce future customer payments

• Create refunds that need to be paid

• Affect aged debt reports

It is worth reviewing credit notes regularly especially if margins are tight.

Credit notes and customer communication

In most cases you should send the credit note to the customer.

This helps:

• Keep records aligned

• Avoid disputes

• Show transparency

• Match customer statements

Xero allows you to email credit notes directly just like invoices.

Using credit notes in month end reviews

I often recommend reviewing credit notes as part of month end checks.

Look at:

• Why they were raised

• Whether they were avoidable

• Whether pricing or invoicing needs improvement

Frequent credit notes can signal wider issues in billing or service delivery.

How an accountant uses credit notes in Xero

From an accountant’s perspective credit notes are part of good housekeeping.

I use them to:

• Maintain a clean audit trail

• Ensure VAT is reported correctly

• Keep customer balances accurate

• Avoid manual adjustments that cause confusion

When used properly they make year end and VAT reviews far smoother.

What not to do instead of a credit note

Avoid:

• Editing approved invoices

• Posting manual journals to sales

• Ignoring small errors

• Refunding money without a credit note

These shortcuts almost always cause more work later.

Final thoughts

Creating a credit note in Xero is simple but it plays an important role in keeping your accounts accurate compliant and easy to understand. The key is to use credit notes whenever an approved invoice needs correcting and to make sure VAT and allocations are handled properly.

In my experience businesses that use credit notes correctly have far fewer issues with VAT returns customer balances and HMRC queries. Once you understand the logic behind them they become a routine and reliable part of day to day bookkeeping rather than something to worry about.

You may also find our guidance on how to add bank details to xero invoice and how to reconcile in xero helpful when exploring related accounting software tasks. For a broader overview of software options and setup guidance, you can visit our accounting software hub.