A Practical Framework for Bad Debt and Expected Credit Loss Policies

Why a Bad Debt Policy is Crucial for Handling Startup Receivables

For a growing startup, a rising accounts receivable balance often feels like a key indicator of success. But revenue on paper and cash in the bank are two very different things. Without a clear process for managing customer payment defaults, you risk overstating your financial health, creating surprise cash gaps, and presenting misleading reports to investors. A formal bad debt policy is not just for large corporations or audit preparation; it is a fundamental tool for managing runway and maintaining financial discipline.

Establishing a framework for expected credit loss is one of the first steps in building a resilient finance function. It ensures the revenue you report is the revenue you can realistically collect. This process provides a systematic way to handle uncollectible accounts, improving the accuracy of your financial statements and demonstrating sound credit risk management to stakeholders. For broader documentation guidance, see the accounting policy hub.

Understanding the Core Concept: The Allowance for Doubtful Accounts

At its core, a bad debt policy is about proactively recognizing that not all of your invoices will be paid. Instead of waiting for an invoice to become definitively uncollectible, accounting principles require you to estimate and reserve for future losses. This is achieved by creating a contra-asset account that offsets your accounts receivable balance.

The terminology for this reserve account differs by location. According to US GAAP, the "US Terminology for the reserve account is 'Allowance for Doubtful Accounts'." In the United Kingdom, you will more often see the "UK Terminology for the reserve account is 'Provision for Bad Debts'." Both terms describe the same concept: a pool of funds set aside to cover expected future write-offs.

This has a dual impact on your financial statements. First, you record an expense on your income statement called 'Bad Debt Expense', which reduces your reported profit for the period. Second, you credit the 'Allowance for Doubtful Accounts' on your balance sheet. This account is paired with Accounts Receivable, reducing its net value. The result is a more accurate picture of the true, collectible value of your receivables, often called the Net Realizable Value.

How to Estimate Credit Loss When Handling Startup Receivables

This is the most common challenge for early-stage companies: determining a defendable expected credit loss rate without years of historical payment data. The reality for most pre-seed to Series B startups is more pragmatic. You do not need a complex statistical model to get started. A provision matrix based on an accounts receivable aging report is a practical and defendable method for managing overdue invoices.

An A/R aging report, a standard feature in accounting software like QuickBooks and Xero, categorizes all outstanding invoices by how long they are past due. The provision matrix applies a progressively higher loss percentage to older invoices, reflecting the increased credit risk over time. You can start with a baseline and adjust it based on your specific experience. A common starting point for these percentages is:

• Current: 0.5% to 1%
• 1-30 Days Past Due: 3% to 5%
• 31-60 Days Past Due: 10% to 20%
• 61-90 Days Past Due: 25% to 50%
• 90+ Days Past Due: 50% to 75%

The key to making this method work is to tailor it to your business model and document your reasoning. For example, your approach to receivables impairment might vary significantly by industry.

• SaaS Businesses: You might find that B2B enterprise clients on annual contracts have a near-zero default rate, justifying a very low provision percentage. In contrast, smaller monthly customers on self-serve plans may pose a higher risk due to churn or payment failures, requiring a higher percentage. You could apply different matrices to these distinct customer segments.
• E-commerce Businesses: Companies using platforms like Shopify or Stripe for direct-to-consumer sales often have very low credit risk, as payment is collected upfront via credit card. However, if you also have invoiced wholesale accounts, those receivables carry a higher risk of customer payment defaults and should be assessed with a more conservative provision matrix.
• Professional Services Firms: Your risk can be tied to project milestones and client satisfaction. A dispute over a deliverable can delay payment indefinitely. Your provision matrix might be influenced by the age of an invoice and any known disputes with the client.

To defend these percentages to an investor or auditor, start with a baseline and document your logic for any adjustments. The rhythm of documenting, applying, and reviewing this policy quarterly builds a defendable history of your credit risk management. Remember to document your logic, apply it consistently, and review it periodically.

A Step-by-Step Guide to Implementing Your Bad Debt Policy

Putting this policy into practice involves a straightforward, repeatable process at the end of each reporting period, typically monthly or quarterly. This ensures your allowance for doubtful accounts remains accurate and reflects your current receivables.

1. Run Your Accounts Receivable Aging Report
   This report is your foundation. In QuickBooks, you can find it under Reports > Who owes you > Accounts receivable aging summary. In Xero, it is located under Accounting > Reports > Aged Receivables Summary. This report provides a detailed breakdown of all outstanding invoices grouped by their due date status.
2. Apply Your Provision Matrix to Calculate the Required Allowance
   Export the aging report to a spreadsheet. Apply your defined percentages to the total balance in each aging bucket to calculate the required allowance for that category. Sum these amounts to determine the total required balance for your 'Allowance for Doubtful Accounts'. For example, consider a firm with a total A/R balance of $210,000. Applying the matrix might look like this: the 'Current' bucket of $150,000 at 1% requires $1,500; the '1-30 Days' bucket of $40,000 at 5% requires $2,000; the '31-60 Days' bucket of $15,000 at 20% requires $3,000; and the '61-90 Days' bucket of $5,000 at 50% requires $2,500. The total required allowance would be $9,000.
3. Record the Adjusting Journal Entry
   Compare the newly calculated required allowance ($9,000 in our example) to the existing balance in your 'Allowance for Doubtful Accounts' account. If your current allowance is, for example, $7,000, you need to increase it by $2,000. The standard accounting "Journal entry to increase the allowance: Debit 'Bad Debt Expense', Credit 'Allowance for Doubtful Accounts'." This $2,000 entry adjusts the books. This is a non-cash expense that correctly matches the potential loss to the period in which the revenue was earned. Our expense recognition policy offers more guidance on matching and cut-off.
4. Implement Write-Off Procedures for Specific Uncollectible Accounts
   Writing off a specific invoice is a separate action from the periodic allowance adjustment. This occurs when you have exhausted all collection efforts and deem a specific invoice uncollectible. A "typical write-off trigger for a specific invoice is when it is deemed uncollectible, e.g., after 180 days past due." The journal entry for this is a debit to the 'Allowance for Doubtful Accounts' and a credit to 'Accounts Receivable'. This action removes the specific invoice from your books. Note that this entry does not impact your income statement; the expense was already recognized when you funded the allowance in a previous period.

Navigating Accounting Standards: IFRS 9 vs. ASC 326

While deep compliance with accounting standards can seem overwhelming for a startup, the underlying principle is straightforward. The Key international accounting standard is IFRS 9, which uses an 'expected loss' model. For US companies, the Key US accounting standard for credit losses is ASC 326, which introduced the Current Expected Credit Loss (CECL) model.

Both standards are built on a 'forward-looking' principle. They require companies to reserve for losses they *expect* to incur, not just those that are already past due. This is a significant shift away from older models that were more reactive. For a startup, this means you cannot simply wait for an invoice to be 90 days late before considering it a risk.

You are not expected to build sophisticated statistical models like a public company. However, using a provision matrix based on A/R aging is a simplified, practical way to adhere to the core 'expected loss' principle. It systematically accounts for future risk based on current data. As your company grows and prepares for a formal audit, especially around a Series A or B fundraise, having a documented policy based on this principle becomes critical. It demonstrates financial maturity and robust credit risk management to potential investors and auditors. UK startups can find related guidance in the UK accounting policy manual.

How to Document Your Policy for Bad Debt and Startup Receivables

A bad debt and expected credit loss policy is more than an accounting formality; it is a critical tool for cash management and accurate financial reporting. It ensures your income statement and balance sheet are not inflated by revenue you will never collect. Integrating this process helps prevent overstated revenue and the surprise cash gaps that can cripple a growing business.

For most startups, a simple, one-page policy document is sufficient. It serves as an internal guide for your finance team and a clear explanation for investors or auditors. This document should be clear, concise, and easy to follow.

Your policy should include the following sections:

• Purpose: A brief statement explaining the policy's goal. This is typically to accurately state the net realizable value of accounts receivable and to recognize bad debt expense in the same period the related revenue is earned.
• Methodology: Describe the use of the A/R aging report and a provision matrix to estimate the allowance for doubtful accounts. State that this method aligns with the 'expected loss' principle.
• Provision Matrix: List the specific percentage rates applied to each aging bucket. This provides clear, objective criteria for the calculation.
• Review Cadence: State that the finance lead or founder will review the adequacy of the allowance and the matrix percentages on a quarterly basis to ensure they reflect current business conditions and collection experience.
• Write-Off Trigger: Define the specific criteria for writing off an individual invoice. This could be a set time, such as 180 days past due, or an event like the confirmation of a customer's bankruptcy.

Start simple, document your logic, and apply the process consistently. For related guidance on timing, see the accruals and prepayments guide. You can find more templates at the accounting policy hub.

Frequently Asked Questions

Q: At what stage should a startup implement a formal bad debt policy?
A: A startup should implement a bad debt policy as soon as it begins generating significant revenue through invoices (accounts receivable). It is best practice to establish this policy early, typically around the seed stage, to instill financial discipline before receivables become difficult to manage or an audit is required.

Q: Can I use different provision percentages for different types of customers?
A: Yes, this is a recommended practice. Segmenting your customers and applying different provision rates is a great way to refine the accuracy of your allowance for doubtful accounts. For example, you might apply a lower rate for stable enterprise clients on annual contracts and a higher rate for smaller, monthly customers.

Q: What is the difference between bad debt expense and writing off an account?
A: Bad debt expense is the estimated, non-cash expense recorded on the income statement each period to fund the allowance. A write-off is the operational act of removing a specific, confirmed uncollectible invoice from your accounts receivable balance. The write-off itself does not hit the income statement because the expense was already recognized.

Q: How does this policy affect my company's valuation?
A: A clear bad debt policy positively impacts valuation by demonstrating financial maturity and accurate reporting. It provides investors with confidence that your reported revenue and assets are realistic. Overstated receivables can be a red flag during due diligence, potentially leading to valuation adjustments or a loss of trust.