Here's just a few example scenarios of when you might want to credit your customers and how you should go about doing so.
An unpaid invoice you've issued has an incorrect amount
Let's say that you've issued a sales invoice to one of your clients for a net figure of £1000. However, before you have received a payment you realise that the invoice was only meant to be for a net value of £100. This is where you should use a credit note instead of a refund, because you cannot issue a refund of money that you never initially received.
Instead you can raise and issue a credit note for £900, and your client will receive the credit note now documenting the error and that they should now pay £100.
A customer has paid a proportion of the invoice but wants to pay less than the total
Imagine that you have performed a service for a client for which you have charged a total of £1000 + VAT, but the customer believes that they should pay no more than £800 + VAT. If you agree and wish to lower the total of the invoice to £800 + VAT you should use a credit note. You will simply have to raise a credit note for the difference of the original amount (£1000) and the new amount (£800). So a £200 credit note will need to be issued for this invoice.
A customer has fully paid an invoice but wants their money back
For this example, let's imagine that you have issued a sales invoice of £500 + VAT and your customer has paid you the full amount for the invoice. However, after reviewing your service they decide that they want their money back, and for this example, let's say that you agree. This is where you should use a refund. To create a refund you will first need to raise a credit note for the amount you wish to refund, and then to record how the money left your account you will need to create a refund and allocate it to the credit note.
In bank reconciliation you will then have to reconcile the initial client payment with when the money entered your account and then reconcile the refund with when the money went back out again.
Combinations of credit notes and refunds
You can record combinations of credit notes and refunds to accurately reflect reality. For example, you may issue an incorrect invoice for £1000, credit note it to its initial value of £100 and then receive a £100 payment for it. A client could then demand a 50% cut in the price because of poor service and you would then have to issue a refund for £50.