Prepayments and Accruals for Deeptech Startups: Practical Examples and Journal Entries

Prepayments and Accruals: Practical Examples for Deeptech Startups

A large annual software bill hits your bank account, and suddenly your profit and loss statement shows a massive spike in your monthly burn. You know you have not suddenly become less efficient, but your key financial report suggests otherwise. This distortion makes it difficult to answer a fundamental question: how much are you really spending each month? For deeptech startups navigating long R&D cycles and managing investor expectations, this lack of clarity is more than an inconvenience; it can obscure your true financial runway.

Incorrectly classifying large upfront costs for lab space, intellectual property fees, or essential software licenses hides the real cost of operations. This creates a volatile and misleading picture of your startup’s financial health. The solution lies in adopting two core accounting practices: managing prepayments and recording accruals. These are not complex theories but practical tools for creating accurate, predictable financial reports that reflect your true performance.

The Core Principle: Matching Expenses to Performance

The idea behind both prepayments and accruals is the matching principle, a fundamental concept of accrual accounting. This principle states that you should recognize expenses in the same period as the revenue or benefit they help generate, regardless of when cash actually moves. This is the critical distinction between cash and accrual accounting. Cash accounting simply tracks money in and money out, which can create a lumpy, inaccurate view of your monthly performance.

Accrual accounting, in contrast, provides a true picture of your operational costs for a given period. It answers the question, “What did it cost us to operate this month?” even if the bills have not arrived or you paid for something a year in advance. For a deeptech startup, this means R&D costs are recognized as the work happens, not just when a contractor finally sends an invoice. Getting this right is the first step toward building financial statements that investors can trust and that you can use to make informed decisions about your runway and resource allocation.

How to Record Prepayments: Taming Large Upfront Costs

Prepayments, or prepaid expenses, are costs you pay upfront for goods or services that will be used over a future period. Instead of expensing the entire cash payment in the month you make it, you record it as an asset on your balance sheet. You then gradually expense it over the period you receive the benefit. This prevents a single large payment from drastically distorting one month's financial results and provides a clearer view of your ongoing operational costs.

Practical Example: Annual Software License

Consider a common deeptech scenario where you pay for a specialized annual software license essential for your research team. The fact is, a $24,000 payment for a 12-month software license should be expensed at $2,000 per month. Treating the entire $24,000 as a January expense would incorrectly inflate your burn for that month and understate it for the next eleven.

Here is how the correct accounting treatment unfolds over the first few months:

• January: Your company pays $24,000 in cash. On your Profit & Loss (P&L) statement, you only recognize $2,000 as a software expense. The remaining $22,000 is recorded on your Balance Sheet as a "Prepaid Software" asset.
• February: No additional cash is paid. You again recognize $2,000 as a monthly expense on the P&L, and the prepaid asset on your Balance Sheet reduces to $20,000.
• March: The pattern continues. Another $2,000 is expensed on the P&L, and the asset value decreases to $18,000. This process repeats until the asset is fully expensed.

The Journal Entries for Prepaid Expenses

To implement this in your accounting system, you first record the initial cash payment, which creates the asset. Then, you set up a recurring monthly journal entry to systematically expense that asset over its useful life. The monthly entry is simple.

Simplified Monthly Journal Entry:

Debit: Software Expense $2,000
Credit: Prepaid Software $2,000

This entry effectively moves $2,000 from your balance sheet (the asset) to your Profit & Loss statement (the expense). The debit increases your monthly expenses, while the credit reduces the value of your prepaid asset. Setting this up as a recurring transaction in QuickBooks or Xero automates the process.

A Special Case for Deeptech: Capitalizing and Amortizing IP Costs

A scenario we repeatedly see involves intellectual property. For deeptech startups, IP is a critical asset, and the costs associated with it, like patent filings, are not just one-time expenses. For instance, a $15,000 patent filing cost can be capitalized as an intangible asset and amortized over several years, typically 5-10.

This process, called amortization, is conceptually similar to expensing a prepaid item, but it occurs over a much longer period, reflecting the long-term value the patent provides. Instead of a large one-time hit to your P&L, you recognize a small, predictable expense each month, which better aligns the cost with the long-term competitive advantage the IP generates.

How to Record Accruals: Capturing Unbilled Expenses

While prepayments deal with cash paid out early, accruals handle the opposite: costs you have incurred but have not yet been invoiced for or paid. Overlooking accrued expenses is a common pitfall that leads to artificially low burn rates followed by surprise cash demands when invoices finally land. This can wreck your cash flow forecasts and create financial instability.

Practical Example: Specialist Contractor Costs

Deeptech startups often rely on specialized contractors or vendors for critical R&D, and their billing cycles can be slow or unpredictable. These experts are typically focused on the work, not on invoicing promptly. A typical situation is that a specialist consultant works 40 hours at $200/hour, resulting in an $8,000 cost to be accrued. Even without an invoice, that $8,000 is a real cost of doing business for that month and must be reflected in your financials to show an accurate burn rate.

The Journal Entries for Accrued Expenses

To record this, you create an accrual journal entry at the end of the month. This recognizes the expense in the period the work was performed and creates a liability acknowledging the obligation to pay.

Simplified Journal Entry (To Record Accrual):

Debit: Contractor Expense $8,000
Credit: Accrued Liabilities $8,000

This entry recognizes the $8,000 expense on your P&L and creates a corresponding liability on your balance sheet, acknowledging that you owe the money. When the invoice finally arrives and you pay it, you make another entry to clear the liability and record the cash outflow. This ensures the expense impacts your P&L in the correct month, not the month of payment.

The Financial Impact of Missing an Accrual

The impact on your monthly burn is significant. Imagine your lab received custom parts for a prototype in March, but the vendor invoice did not arrive until April. Let's say a vendor invoice for custom prototype components is for $50,000. Failing to accrue for this cost in March would dramatically understate your R&D expenses and mislead anyone reading your financial statements.

Let's compare the March P&L with and without accruals for both the $8,000 contractor and the $50,000 in materials:

• Without Accruals: Your total operating expense might appear to be only $30,000, showing a net operating loss of ($30,000). This looks manageable but is dangerously misleading.
• With Accruals: By correctly recording the incurred costs, your total operating expense jumps to $88,000, and your net operating loss is ($88,000). This is a starkly different, and far more accurate, picture of your startup's financial position.

Without the accrual, the monthly burn is understated by $58,000, creating a false sense of security about your financial runway.

The Strategic Payoff: Why This Matters for Funding and R&D Tax Credits

Maintaining this financial discipline is not just an accounting exercise. The payoff is twofold: it strengthens investor confidence and maximizes your eligibility for critical R&D tax credits. Accurate accounting is fundamental to building a scalable and fundable deeptech company.

Building Investor Confidence with Predictable Financials

Investors parsing your financial statements look for predictability and an understanding of unit economics. A P&L with wild, unexplained swings in burn rate signals a lack of financial control or a poor grasp of the underlying business drivers. A smooth, predictable expense line, achieved through the proper handling of prepayments and accruals, demonstrates that you have a firm grasp on your operations, burn rate, and financial runway. This builds trust and makes your financial projections more credible during due diligence.

Maximizing R&D Tax Credits in the US and UK

This accuracy is even more important when claiming tax credits. For US and UK deeptech startups, R&D tax credits are a vital source of non-dilutive funding. However, tax authorities require that claimed costs correspond to the period in which the R&D activity took place. As stated, tax authorities in the UK (HMRC) and US (IRS) focus on the timing of R&D activity for tax credit claims.

If you accrue for a US-based R&D contractor’s work in December, that cost is eligible for the tax year under the US R&D Tax Credit, which is governed by IRC § 41. Similarly, in the UK, if R&D work is completed before your fiscal year-end, you must accrue for it to include it in your claim to the UK R&D Tax Credit scheme, overseen by HMRC. Failing to accrue for work done in one fiscal year because the invoice arrived in the next means you could lose out on a significant portion of your claim for that period. Accurate, timely accounting is directly tied to your ability to secure these valuable funds.

Building a Reliable Month-End Process

Adopting accrual accounting practices is about creating clarity and control over your startup's finances. It replaces a chaotic, cash-based view with a predictable, operational perspective that is essential for managing runway and reporting to investors. The mechanics are straightforward and can be managed within your existing accounting software.

What founders find actually works is to build a simple, repeatable process. In practice, prepayments and accruals are managed via recurring journal entries in accounting software. UK teams can follow Xero setup guidance. For prepayments, you set up a recurring entry to expense a portion of the asset each month. For accruals, you identify recurring costs that are billed late and create a standard monthly journal entry that you can adjust as needed.

To ensure nothing slips through the cracks, discipline is key. A simple but effective method is to set a calendar reminder. As a recommended best practice, set a calendar reminder for the 28th of each month to review and record accruals and prepayments. During this monthly review, use a month-end checklist and ask yourself:

• Did we sign any new annual contracts for software, insurance, or rent?
• Did we incur any legal fees for IP or corporate matters that have not been billed?
• Which contractors or consultants performed work this month whose invoices we have not yet received?
• Did we receive any significant materials or components from suppliers ahead of an invoice?

By systematically addressing these questions each month, you transform your accounting from a reactive, historical record into a proactive tool for financial management. This discipline builds the foundation for scalable finance operations, ensuring you have the accurate data needed to navigate your startup’s growth. See the broader Cash vs. Accruals topic for the full framework.

Frequently Asked Questions

Q: What is a materiality threshold for prepayments and accruals?

A: A materiality threshold is an internal policy that dictates the minimum cost an item must have to be treated as a prepayment or accrual. For example, you might decide to immediately expense any item under $1,000 to save administrative time. This practical step focuses your efforts on the large costs that significantly impact your financials.

Q: How often should a startup record accruals and prepayments?

A: These adjustments should be made every month as part of your month-end close process. Monthly updates ensure your financial reports, including your P&L and balance sheet, are consistently accurate. This allows for reliable tracking of your burn rate and financial runway, which is critical for early-stage companies.

Q: What is the main difference between an accrued expense and accounts payable?

A: Both are liabilities, but the key difference is the invoice. Accounts payable represents money you owe for which you have already received an invoice from a vendor. An accrued expense is an expense you have incurred and owe, but for which you have not yet received an invoice.