What is a Proforma Invoice? How and Why to Use It?
In business, documents can provide information, request payments, establish relationships and can be legally binding. A proforma invoice is unlike other invoices used in business with few distinct differences.
Table of Contents
- What is a proforma invoice
- When should a proforma invoice be sent
- Benefits of a pro forma invoice
- Is a proforma invoice legally binding
- Difference between proforma invoice and other types of invoices
- Proforma invoices and taxes
- How to create a proforma invoice
What is a proforma invoice
A pro forma invoice acts as an agreement of “good faith” between seller and buyer. The terms stated such as price, quantity, etc. are negotiable. It is visibly labeled “proforma invoice” and has no invoice number, which means it is not useful for accounts payable, unlike sales invoices. However, some choose to follow AP best practices and use a pro forma invoice number. The invoice should contain all the information a final sales invoice would typically have, thus giving the buyer all the information needed to arrange the purchase from the seller.
Furthermore, it serves as an understanding between the buyer and seller, that each side is committed to the sale/purchase of the required goods or services without any payment at this point. Sellers can be reassured that the buyer will complete the order and pay once the final sales invoice is issued. And buyers are protected from any sudden surcharges/overcharging that might be made by the seller.
A fashion boutique can use the prices quoted on a proforma invoice for the required fabric to confirm the order with the supplier. Once the fashion boutique receives the required fabric, payment can be made as per the sales invoice, which will closely reflect the previously issued proforma invoice, with minute differences, if any, such as taxes.
It is also used when exporting and importing goods internationally, as it contains all the information needed for customs clearance.
When should a proforma invoice be sent
As mentioned earlier, a pro forma invoice is not the official final sales invoice. It is sent when the buyer is committed to purchasing from the seller, but an agreement on the purchase is yet to be reached. So, it serves as a document of commitment between buyers and sellers, with respect to the final details, such as cost, quantity & specifications. It is also used to seek internal approval for the purchase of goods/services by buyers.
Sellers shipping goods internationally also use them extensively. Customs laws at ports worldwide, require details of the goods being shipped to be easily accessible and visible. Therefore, to ensure a speedy customs clearance, proforma invoices come in handy to share details such as weight, value, taxes, shipping costs, delivery fees, etc.
Benefits of a pro forma invoice
- Streamlines the sales process between the buyer and seller prior to confirming the purchase.
- Creates transparency by outlining all the agreed upon terms such as date of delivery, price, quantity, etc.
- It can serve as a purchase order or quotation. Buyers might need this for internal approval of the purchase.
- Since the invoice is not legally binding, both buyer and seller can use the invoice for negotiating better terms and making any changes to the order.
- Helps build better and longer client relationships since proforma invoices act as “good faith” agreements. It ensures that both the seller and buyer are committed to the sale/purchase of the goods/services
Is a proforma invoice legally binding
A pro forma invoice is not the same as a final sales invoice, and is not used for accounting purposes. The information stated in the invoice can be negotiated and changed, unlike a sales invoice which is final and binding. It is more like a quotation and is not recorded in accounts payable processes. Hence, it is not legally binding.
Can a proforma invoice be cancelled
The answer is it doesn’t need to be. The reason being it is not an invoice. It is the same as a quotation or estimate of what the buyer can expect from the seller for the purchase of the required goods/services. If the sale does not happen then no action is needed.
Difference between proforma and other types of invoices
Now that we know what a proforma invoice is and why it is used, how does it differ from other types of invoices used by businesses?
This invoice is issued after the goods have been delivered or shipped. Whereas, a pro forma invoice is sent before the sale of the goods and the details such as quantity have not been confirmed. Commercial invoices are primarily used for international shipments and reflect the exact quantity shipped. It helps sellers ship the goods to the buyer with ease and efficiency. A commercial invoice serves as a shipping document that is used by customs at every port. The invoice helps customs agencies levy the appropriate duties, import fees and taxes. The details on the commercial invoice also ensures to customs officials that export compliance requirements have been met.
A sales invoice is issued, with an invoice number, when the goods/services have been delivered and payment is due. It is a legally binding agreement and is recorded in accounts payable. Whereas the proforma invoice is like a quotation, is not legally binding and is sent before the sale and details have been confirmed. A sales invoice can also serve as a tax invoice, since it includes VAT/GST and other taxes. The final sales invoice can be used to reclaim VAT/GST.
When the goods received are damaged or some error has been made in the purchase, a seller can issue a credit memo to the buyer. A credit memo issues a refund for the original value or part of, that can be used for orders in the future. The difference is that a pro forma invoice is sent before goods have been ordered and a credit memo is issued post delivery of damaged goods.
A purchase order (PO) is a commercial document confirming the purchase of goods. It is sent to the seller through the buyer’s purchasing department. A purchase order is legally binding, as the terms are final and cannot be negotiated. Although a purchase order and a proforma invoice are both sent before the goods have been delivered, the key difference is that a pro forma invoice is a quotation that is sent from the seller to the buyer, whereas the PO process is a confirmation of the order sent from the buyer to the seller.
Proforma invoices and taxes
Since proforma invoices are not final sales invoices, they cannot be used for tax purposes or treated as VAT/GST invoices. This is because it doesn’t fit the “tax point”, which is the time of supply. The final sales invoice, with the date of the transaction, is the actual time of supply and therefore the tax point for claiming VAT/GST.
Additionally, proforma invoices should mention all applicable taxes (VAT, GST etc.), especially if the business is VAT/GST registered. When applicable, the VAT/GST registration number of buyer and supplier should be clearly visible on the invoice. If the supplier is not VAT/GST registered then there is no need to mention tax details. Additionally, if the goods are VAT/GST exempt, then there is no need to include taxes.
How to create a proforma invoice
A proforma invoice is quite similar to the final sales invoice and contains all the same details. They can be easily created using accounting or word processing software.
What to include on a proforma invoice?
The invoice should contain all the information the buyer needs to confirm or seek approval for placing the order. The details to include are:
- Date of Issue
- Seller and Buyer Details (Address, contact, etc)
- Details of goods/services
- Price of Goods
- Validity of offered price
- Payment Terms/method
- Applicable taxes if any
- Shipping costs if any
- Proforma invoice number if applicable
- Labeled Proforma Invoice
- Labeled Not a Tax Invoice
A proforma invoice is an important document because it ensures seamless business transactions while purchasing goods/services. It aids in creating transparency between buyers and sellers. Furthermore, it is not only a useful negotiating tool and essential for shipping globally, it also helps build stronger relationships between buyers and sellers.