How to Calculate Bad Debt Provisions for SaaS and Professional Services Companies

What is a Bad Debt Provision and Why Does It Matter for Startups?

That first unpaid invoice from a new customer is an annoyance. The second is a concern. When several invoices age past 90 days, the revenue you celebrated on your Profit and Loss (P&L) statement starts to feel disconnected from the cash in your bank account. For an early-stage startup, this gap isn't just an accounting problem; it's a direct threat to your runway. Discovering too late that this startup accounts receivable risk has distorted your financial projections can create serious issues for cash management and fundraising conversations.

Proactively accounting for this risk is not just good financial hygiene; it’s a necessary discipline for building a resilient business. The formal process for this is creating a bad debt provision, a crucial step in understanding how to handle bad debts in startup accounting. This process ensures your financial statements reflect reality. For a complete overview of related workflows, see the Invoicing and Collections Process hub.

A bad debt provision, often called an allowance for doubtful accounts (ADA), is an estimate of the revenue you have earned but do not realistically expect to collect. It’s a formal admission that, unfortunately, not every customer will pay their bills. This concept is central to accrual accounting, which is governed by a simple but powerful rule known as the matching principle. According to accounting standards, "The 'matching principle' of accrual accounting requires that expenses be recognized in the same period as the related revenues." (Source: GAAP). This means you must recognize the potential expense of non-payment in the same period you recognize the revenue, not months later when you finally give up collecting.

This provision is recorded in a contra-asset account on your balance sheet. It sits directly opposite your gross Accounts Receivable (AR), reducing its total value. The resulting figure, Net AR, gives a more realistic picture of the cash you actually expect to receive. It's critical to understand that creating this provision is a non-cash transaction. You are not physically moving money into a separate savings account. Instead, you are making an accounting entry to ensure your financial statements are accurate and not overly optimistic about future cash flow.

How to Handle Bad Debts in Startup Accounting: Three Estimation Methods

For a new founder, the biggest challenge is struggling to calculate a realistic allowance for doubtful accounts with little to no payment history. Without years of data, how can you make an educated guess? The good news is there are established, straightforward methods that investors and auditors recognize, even for early-stage companies. To be effective, your chosen method should be paired with basic credit control processes to minimize the number of overdue client payments in the first place.

1. The 'Get Started' Approach: Percentage of Revenue

This is the simplest method and is perfectly acceptable for pre-seed and seed-stage startups. You simply apply a flat percentage to your total revenue on credit for a given period, such as a month or quarter, to calculate your bad debt expense. The key is choosing a reasonable percentage based on your industry and business model. While your own data will eventually become the best guide, industry benchmarks provide a sound starting point for your startup bad debt reserve.

For instance, a common starting bad debt provision range for B2B SaaS startups is 1-3% of revenue. This range reflects the typically recurring nature of the revenue and standardized contracts. Professional services firms might use a higher percentage, as projects can be large, bespoke, and more prone to disputes. Here are some typical starting points:

• B2B SaaS: 1% to 3%
• Professional Services: 2% to 5%
• D2C / E-commerce: 0.5% to 2%

To use this method, if your SaaS company generated $100,000 in revenue this month, you would create a bad debt expense of $2,000 (using a 2% provision). This approach is valued for its simplicity and is a great way to build the financial discipline early on.

2. The 'Getting Serious' Approach: AR Aging Analysis

As your business grows, especially around the Series A stage, you will need a more granular method for managing customer nonpayment. The AR Aging method groups your outstanding invoices by how long they have been past due and applies a progressively higher reserve percentage to older invoices. The logic is simple: the older an invoice gets, the less likely it is to be paid. This approach gives a more dynamic and accurate estimate of your financial risk.

Most accounting software, like QuickBooks and Xero, can generate an AR Aging report automatically, which is your starting point. You then apply a reserve percentage to the total AR in each aging bucket. For example, a set of "Example AR Aging reserve percentages: Current (1%), 31-60 days (5%), 61-90 days (20%), 91+ days (50%)." Let’s walk through a calculation based on this methodology:

• Current Invoices: $80,000 in AR x 1% reserve = $800 provision
• 1-30 Days Past Due: $25,000 in AR x 3% reserve = $750 provision
• 31-60 Days Past Due: $10,000 in AR x 10% reserve = $1,000 provision
• 61-90 Days Past Due: $5,000 in AR x 25% reserve = $1,250 provision
• 91+ Days Past Due: $2,000 in AR x 50% reserve = $1,000 provision

In this scenario, your total required allowance for doubtful accounts is the sum of these calculations: $4,800. This figure would then be compared to your existing allowance, and you would book an adjusting journal entry to match this new, more accurate total.

3. The 'Founder Insight' Layer: Specific Customer Adjustments

No formula can replace your specific knowledge about your customers. The reality for most Series A startups is that a quantitative method should be paired with qualitative judgment. This overlay allows you to adjust the formula-based provision based on information you have about specific clients. A scenario we repeatedly see is a founder knowing a key customer is in financial trouble long before it is reflected in their payment patterns.

Consider a professional services firm that used the AR Aging method and calculated a $10,000 provision. They know one of their largest clients, with a $20,000 invoice sitting in the '31-60 days' bucket, just had a major funding round fall through. The formula suggests only a 10% provision ($2,000) for that invoice, but the founder knows the collection risk is much higher. They can apply a qualitative overlay to specifically reserve 80% ($16,000) of that single invoice, adjusting the total provision upwards to reflect this specific, known risk.

Implementing Your Policy: Journal Entries and Documentation

An estimate is only useful if it is applied consistently and documented properly. A clear policy is how you avoid investor or audit pushback during diligence. For systematic follow-up on overdue invoices, see our Collections Process Automation guide.

Create a Formal Bad Debt Policy

Your first step is to create a simple, one-page internal policy document. It doesn't need to be complex, but it should clearly state the following to ensure a consistent uncollectible invoice process:

• Methodology: State which method you use (e.g., AR Aging analysis).
• Assumptions: List the percentages you apply to each aging bucket and the rationale, if available (e.g., "based on initial industry benchmarks, to be updated with company data").
• Review Cadence: Specify how often you review and update the provision. Monthly is best practice.
• Write-Off Criteria: Define the specific trigger for giving up on an invoice and writing it off completely. A solid benchmark is that "A common policy criterion for a full write-off is when an invoice is 180 days past due and multiple collection attempts have failed."

Booking the Journal Entries Correctly

Once you have calculated the required provision, you must record it in your accounting system. This involves understanding the difference between recognizing the initial expense and performing the eventual write-off. The provision entry recognizes the expense on your P&L, while the write-off entry removes the specific uncollectible invoice from your AR but does not impact your P&L again, because the expense was already accounted for.

Here are the typical journal entries you would make in accounting software like QuickBooks (US) or Xero (UK):

To Establish or Increase the Provision: You make an entry that increases the bad debt expense and the allowance account.

• Debit: Bad Debt Expense (This increases expenses on your P&L).
• Credit: Allowance for Doubtful Accounts (This increases the contra-asset account on your Balance Sheet, reducing your Net AR).

To Write Off a Specific Unpaid Invoice: When you officially give up on collecting a specific invoice, you remove it from your books.

• Debit: Allowance for Doubtful Accounts (This reduces the allowance balance).
• Credit: Accounts Receivable (This reduces the specific customer's AR balance to zero).

Getting this two-step process right is key to managing customer nonpayment and maintaining accurate financials that reflect the true health of your business.

Evolving Your Bad Debt Strategy as Your Startup Grows

Knowing the theory is one thing; implementing it is another. Your approach to handling overdue client payments and accounting for bad debts should evolve with your startup's stage to meet increasing expectations for financial rigor.

Pre-Seed & Seed Stage

Your priority here is simplicity and speed. Use the Percentage of Revenue method. Pick a conservative percentage based on industry benchmarks (e.g., 1-2% for B2B SaaS) and apply it to your monthly credit revenue. Document this choice in a simple memo. Both QuickBooks and Xero can handle the journal entries easily. The goal is to build the habit and demonstrate basic financial controls to early investors.

Series A Stage

At this stage, financial diligence from investors and potential acquirers increases significantly. It’s time to graduate to the AR Aging method. Your investors and auditors will expect this level of sophistication. Use the AR Aging report in your accounting software to perform the calculation monthly. Formalize your accounting policy, including your reserve percentages and the specific trigger for writing off unpaid invoices. This is also when the qualitative overlay becomes important. Your conversations with customers provide valuable data that should inform your provision.

Series B Stage & Beyond

By now, you have enough historical data to refine your process. Analyze your past write-offs to see if your AR Aging percentages are accurate. For example, if you have historically collected only 30% of invoices that are over 90 days old, your provision for that bucket should be 70%, not a generic 50%. Your process should become a well-oiled machine, combining historical data, systematic analysis, and qualitative insights from your sales and finance teams. At this scale, you might also consider options like collections outsourcing for persistent non-payers.

Whether you are a US or UK-based company, these principles are universal. In the UK, these practices align with FRS 102 standards for financial reporting. For US companies, they are a core requirement of US GAAP. The objective in both jurisdictions is the same: to present a 'true and fair' view of your company's financial position. This isn't just a compliance exercise. It's about maintaining a clear, realistic view of your financial health to protect your most critical asset: the cash runway that fuels your growth. Continue exploring best practices at the Invoicing and Collections Process hub.

Frequently Asked Questions

Q: What is the difference between a bad debt provision and a write-off?
A: A bad debt provision (or allowance for doubtful accounts) is an estimate of future uncollectible invoices, recorded as an expense when revenue is earned. A write-off is the final step of removing a specific, confirmed uncollectible invoice from your accounts receivable. The provision is the proactive estimate; the write-off is the reactive removal.

Q: How often should I update my allowance for doubtful accounts?
A: Best practice is to review and update your allowance for doubtful accounts monthly as part of your month-end close process. This ensures your financial statements remain accurate and reflect the current risk in your accounts receivable. A monthly cadence allows you to spot negative payment trends early and take corrective action.

Q: Can I claim tax relief on bad debts in the UK or US?
A: Generally, yes, but the rules differ. In the US, you can typically deduct bad debts in the year they become worthless under the "direct write-off" method for tax purposes. In the UK, tax relief (for VAT and Corporation Tax) is usually available for specific, written-off bad debts, subject to certain conditions like the debt being over six months old for VAT. Always consult a tax advisor for specifics.

Q: What if I have one very large invoice that I think won't be paid?
A: This is where the "Founder Insight" or qualitative overlay is crucial. If a single large invoice has a high risk of non-payment due to specific circumstances (e.g., you know the client is in financial distress), you should specifically provide for it at a higher percentage, or even 100%, regardless of what the standard AR aging formula suggests.