Set up accrual accounting in Xero to build a reliable financial engine

For many early-stage startups, financial reporting is a chore, a scramble to produce numbers for a board meeting or tax filing. If your Profit & Loss statement seems disconnected from your actual business performance, showing huge profits one month and deep losses the next, you are not alone. This volatility often happens when your accounting reflects cash movements, not true operational health. Properly implementing an accrual-based system is the solution. This guide provides a practical walkthrough of how to set up accrual accounting in Xero, helping you move from confusing cash-based reports to a reliable financial engine that supports strategic growth.

Understanding Accrual vs. Cash Basis Reporting in Xero

Before diving into Xero settings, it’s important to clarify the objective. The ultimate goal is not to simply check a box labeled “accrual accounting.” It is to produce a Profit & Loss (P&L) statement that accurately reflects your company's performance in a given period. This is achieved by adhering to the Matching Principle, a core accounting concept stating that revenue and the expenses incurred to generate that revenue should be recognized in the same period.

This marks the fundamental difference between Xero accrual vs cash basis reporting. The cash basis records transactions only when money changes hands, which can significantly distort your monthly performance. For example, UK guidance on VAT cash accounting highlights how timing can differ for tax purposes. In contrast, the accrual basis records revenue when it is earned and expenses when they are incurred, regardless of cash flow.

For a SaaS, Biotech, or Deeptech startup, this distinction is vital. Investors and leadership need to see consistent performance metrics and stable unit economics. A P&L that swings wildly based on when an annual contract is paid or a large supplier bill is settled obscures the true health of the business and undermines confidence.

How to Set Up Your Financial Scaffolding in Xero

Getting accrual accounting right begins with a one-time setup of your financial structure. A common pitfall that leads to distorted financial statements is misconfiguring your Chart of Accounts and Tracking Categories. These two Xero features serve distinct but complementary purposes in a robust Xero financial reporting setup.

Chart of Accounts (CoA): The Backbone of Your Reporting

Your Chart of Accounts (CoA) is the backbone of your financial reporting. It is a complete list of every account in your general ledger, organized into categories like Assets, Liabilities, Equity, Revenue, and Expenses. For accrual accounting, your CoA must include specific balance sheet accounts that do not exist in a cash-only setup. These accounts are essential for holding prepaid expenses, deferred revenue, and accrued liabilities.

While a complex CoA can be overwhelming, the reality for most pre-seed startups is more pragmatic: start with a simple, scalable structure. If you are still deciding whether to convert, see our guide on when to switch from cash to accrual accounting.

Consider this startup-focused CoA structure for your accrual accounts:

• Current Assets
  • Prepaid Expenses (Parent Account)
    • 1401 - Prepaid Software Subscriptions
    • 1402 - Prepaid Insurance
    • 1403 - Prepaid Event Sponsorships
• Current Liabilities
  • Deferred Revenue (Parent Account)
    • 2201 - Deferred Subscription Revenue
  • Accrued Expenses (Parent Account)
    • 2301 - Accrued Legal & Professional Fees
    • 2302 - Accrued Contractor Invoices
    • 2303 - Accrued Software Costs

Tracking Categories: An Operational Lens on Your Data

Tracking Categories are Xero’s way of providing an operational lens on your financial data. While the CoA tells you what you spent money on (e.g., software), Tracking Categories tell you why or who spent it (e.g., the R&D department). This is essential for calculating departmental budgets, analyzing profitability by project, and understanding key performance indicators.

A standard setup for a tech startup involves creating a ‘Department’ tracking category. This allows you to tag every revenue and expense transaction to a specific team.

Example ‘Department’ Tracking Category Setup:

• Sales & Marketing
• Research & Development (R&D)
• General & Administrative (G&A)

When properly implemented, your well-structured CoA combined with insightful Tracking Categories gives you a complete, multi-dimensional picture of your business performance.

Managing Deferred Revenue for Accurate Performance

One of the most common challenges for SaaS and professional services firms is accounting for upfront payments on long-term contracts. If a customer pays for a year of service in advance, how much revenue did you actually earn this month? Under accrual accounting, you only recognize revenue as you deliver the service.

This is where the Deferred Revenue account comes into play. Deferred Revenue is a liability on your balance sheet that represents cash you have received for a service you have not yet delivered. For instance, a $12,000 annual subscription paid in January is recognized as $1,000 of revenue each month for 12 months. This method prevents a single month from looking extraordinarily profitable while the following eleven months show no revenue from that customer, which would erode investor confidence.

Here is how to manage this process using journal entries in Xero:

1. Initial Invoice Reconciliation (January): When the customer pays the $12,000 annual invoice, reconcile the payment against your default P&L Revenue account as usual.
2. Month-End Adjusting Journal (Jan 31): Create a manual journal to move the unearned portion of the revenue off the P&L and onto the balance sheet.
   • Debit: Revenue ($11,000)
   • Credit: Deferred Subscription Revenue ($11,000)
   • Description: To defer 11 months of annual subscription fee.
3. Repeating Monthly Journal (for Feb - Dec): Set up a repeating journal to post on the last day of each month for the next 11 months. This journal systematically recognizes one month's worth of revenue.
   • Debit: Deferred Subscription Revenue ($1,000)
   • Credit: Revenue ($1,000)
   • Description: To recognize one month of subscription revenue.

In the early stages, manual tracking of deferred revenue in a spreadsheet is manageable for the first 10-20 annual contracts. As your business scales, you can consider automating accruals in Xero with integrated tools that manage these schedules and post journals for you.

Matching Expenses with Prepayments and Accruals

Just as revenue must be matched to the period it is earned, expenses must be matched to the period in which they are incurred. This principle avoids distortions, like paying for an annual software license in March and making that month appear deeply unprofitable. The process involves two key concepts: Prepaid Expenses and Accrued Expenses.

Prepaid Expenses: Smoothing Out Upfront Costs

Prepaid Expenses are assets on your balance sheet representing payments made for goods or services you have not yet used. Common examples include annual software subscriptions, insurance premiums, or fees for a conference months away. For instance, a $6,000 annual software bill paid in January should be recognized as a $500 expense each month for 12 months. This smooths out your P&L, providing a more accurate view of monthly profitability. In practice, treat material prepayments as described in our prepayments and accruals guide for SaaS startups.

Example Prepaid Expense Journal in Xero:

1. Initial Bill Coding: When the $6,000 bill arrives, code the entire amount to your ‘Prepaid Software Subscriptions’ asset account, not an expense account.
2. Repeating Monthly Journal: Create a repeating journal that posts on the last day of the month for the next 12 months to amortize the expense.
   • Debit: Software Expense ($500)
   • Credit: Prepaid Software Subscriptions ($500)
   • Description: To recognize one month of annual software expense.

Accrued Expenses: Accounting for Unbilled Costs

Accrued Expenses are the opposite of prepayments. They are liabilities on your balance sheet for expenses you have incurred but have not yet been invoiced for. A classic example for a biotech or deeptech startup is recognizing costs for R&D contractor work completed in January, even if the invoice will not arrive until February. Accruing for this expense ensures your January P&L reflects the true cost of operations for that period. You can see more practical examples for biotech startups in our dedicated guide.

Example Accrued Expense Journal in Xero:

1. Month-End Accrual Journal (e.g., Jan 31): Post a manual journal for the estimated cost of the work completed.
   • Debit: Legal & Professional Fees ($2,500)
   • Credit: Accrued Expenses ($2,500)
   • Description: To accrue for unbilled legal fees for January.
2. Auto-Reversing Journal: When creating the journal, set it to automatically reverse on the first day of the next month (Feb 1). This zeros out the accrual. When the actual invoice arrives in February, you will code it to the Legal & Professional Fees expense account as normal. The reversal prevents the expense from being counted twice (once as an accrual and once as a bill).

Building a Repeatable 5-Day Month-End Close Process

Transitioning from cash to accrual in Xero requires more than just setup; it demands a disciplined, repeatable process. This is the month-end close, a checklist of activities performed each month to ensure your books are accurate, complete, and finalized promptly. The goal for a lean startup is to produce reliable financials by the fifth business day of the following month. A structured close process eliminates last-minute manual fixes that delay board reporting and tax compliance.

This process turns the concepts from the three pillars into a routine. It is where you post your journals for deferred revenue, prepaid expenses, and accrued expenses. A key principle to apply here is materiality. Do not waste hours accruing a $50 monthly software bill; focus on the significant items that materially impact your financial statements.

An effective 5-day close structure often looks like this:

• Day 1: Cash & Transactions: Reconcile all bank accounts, credit cards, and payment processors like Stripe. Ensure all transactions from the period are categorized correctly.
• Day 2: Revenue Recognition: Update your deferred revenue schedule with any new annual or multi-period contracts. Post the monthly journal entry to recognize the portion of revenue earned in the period.
• Day 3: Expense Management: Update your prepaid expense schedule and post the monthly amortization journal. Identify and post journals for any significant accrued expenses, consulting with department heads for estimates if needed.
• Day 4: Review & Analysis: Perform a preliminary review of the P&L and Balance Sheet. Compare actual results to your budget or forecast and investigate any significant variances to understand business drivers.
• Day 5: Finalize & Report: Make any final adjustments based on your review. Lock the period in Xero to prevent further changes. Distribute the final financial package to stakeholders.

Make the month-end close repeatable by using templates and a documented checklist. You can start with the checklist in our month-end accruals checklist for startups.

Key Steps to Implement Accrual Method Bookkeeping in Xero

Implementing the accrual method bookkeeping in Xero is a foundational step in building a scalable finance function. It moves your financial reporting from a simple historical record of cash movements to a strategic tool for managing your business and communicating with investors.

To get started, focus on the pillars in order. First, review your Chart of Accounts to ensure it includes the necessary asset and liability accounts for prepayments, deferrals, and accruals. Next, implement Tracking Categories to gain operational insight. Then, tackle your first revenue deferral by tracking annual contracts in a spreadsheet and creating the corresponding repeating journal in Xero. Do the same for your largest prepaid expense. Finally, adopt a simplified 5-day close checklist to make this process routine.

By following these Xero accounting best practices, you build a reliable financial engine that produces trustworthy reports, fosters investor confidence, and provides the clarity needed to make critical decisions about runway, hiring, and growth. See our hub on cash vs accruals for more.

Frequently Asked Questions

Q: What is the difference between accrued expenses and accounts payable in Xero?
A: Accounts Payable (or Bills) in Xero is for specific invoices you have received from suppliers but have not yet paid. Accrued Expenses is a liability account used to record expenses that have been incurred but for which you have not yet received an invoice. It is an estimate made at month-end.

Q: Do I need to make accrual adjustments for every small expense?
A: No, you should apply the principle of materiality. Focus on adjustments for significant items that would otherwise distort your financial reports. Accruing a $30 monthly bill is not a good use of time, but failing to accrue a $10,000 contractor invoice would meaningfully misrepresent your monthly profit.

Q: Can I run both cash and accrual reports in Xero?
A: Yes, Xero allows you to toggle between cash and accrual basis reports for key statements like the Profit & Loss and Balance Sheet. Once you have set up your accrual journals correctly, you can run an accrual basis report for management and investors, and a cash basis report for cash flow analysis or certain tax filings.