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

Prepayments and Accruals: Practical Examples for SaaS Startups

Your SaaS startup just had a fantastic month. The numbers look strong, morale is high, and your runway seems solid. Then, the invoice for your annual software subscription lands, and suddenly your profit and loss (P&L) statement shows a massive loss. Alternatively, you close the month feeling great, only to be hit with a surprisingly large cloud infrastructure bill two weeks later. These scenarios obscure the true financial health of your business. Understanding how to record prepayments and accruals in SaaS startups is the key to creating a predictable, professional financial operation that investors trust. It’s about creating a true picture of your monthly burn rate, not just a record of when cash leaves the bank.

How to Record Prepaid Expenses for Annual Subscriptions

Paying for software annually often comes with a discount, but it creates a significant accounting challenge. When you pay a large upfront bill, like an $18,000 annual Salesforce subscription, the common mistake is to record it as a one-time expense in the month you pay. This immediately distorts your financials, making one month look disastrously unprofitable and the next eleven artificially lean. This is a common pitfall in startup bookkeeping basics.

The correct approach under accrual accounting is to treat this payment not as an immediate expense, but as a prepaid asset. You have paid for a resource that you will benefit from over the next twelve months. In your accounting software like QuickBooks or Xero, this payment is initially recorded on your balance sheet under an account like Prepaid Expenses.

Each month, you then recognize a fraction of that cost as an expense. This process is called amortization. For a $12,000 annual HubSpot subscription, you would amortize it at $1,000 per month. Instead of one huge hit, your P&L shows a consistent, predictable $1,000 expense each month. This method of SaaS expense recognition provides a stable view of your operational costs. See QuickBooks guidance on recording prepaid expenses for platform-specific steps.

The impact is stark. With the incorrect cash-basis method, your P&L would show a -$12,000 software expense in January and $0 for the rest of the year. With the correct accrual-basis method, your P&L shows a manageable -$1,000 software expense every single month. This approach to managing deferred costs ensures your burn rate reflects reality.

Example Journal Entries for a Prepaid Expense

Let's walk through the journal entries for the $12,000 annual subscription paid in January. Journal entries use debits and credits to record financial transactions.

1. Initial Payment in January: When you pay the invoice, you are swapping one asset (cash) for another (the right to use software for a year). You are not yet recording an expense on your P&L.
   • Debit (increase) Prepaid Expenses: $12,000
   • Credit (decrease) Cash: $12,000
2. Monthly Amortization (End of January): At the end of the first month, you "use up" one month's worth of the software. You now recognize this portion as an expense and reduce your prepaid asset.
   • Debit (increase) Software Expense: $1,000
   • Credit (decrease) Prepaid Expenses: $1,000

You will repeat the second entry at the end of every month for the next eleven months. After twelve months, the Prepaid Expenses account for this subscription will be back to zero, and you will have correctly matched the expense to the period in which you received the benefit.

How to Handle Accrued Expenses for Usage-Based Costs

A scenario we repeatedly see is with usage-based services like cloud hosting. You use the service throughout the month, but the bill often does not arrive until 10-15 days into the next. If you only record expenses when you pay them, your financial reports for the usage month will be misleadingly positive, as they are missing a major cost. This creates a nasty surprise and makes cash flow forecasting unreliable.

This is where accrued expenses are essential. An accrued expense is a cost your business has incurred but has not yet been invoiced for or paid. A perfect example is your monthly AWS bill estimated at ~$5,000.

At the end of the month of usage, you record a $5,000 expense on your P&L and a corresponding $5,000 liability on your balance sheet, typically in an account called Accrued Liabilities. This gives an accurate picture of your profitability for that month. When the actual bill arrives, you clear the liability. Sometimes the estimate and actual bill differ. For example, your estimated AWS bill of $5,000 has an actual bill of $5,150. You simply book the $150 difference in the current month. This small adjustment is far better than being completely blind to a $5,000 cost.

Without this discipline, your January P&L would show a $0 cloud expense, making the month look better than it was. Then, in February, it would show a -$5,150 expense, making that month look worse. By accruing correctly, your January P&L shows the -$5,000 expense it actually incurred, and February simply shows a small -$150 adjustment. Using a month-end accruals checklist can make this routine.

Example Journal Entries for an Accrued Expense

Using the AWS example, here is how you would record the accrual and subsequent payment.

1. End-of-Month Accrual (End of January): Based on your AWS cost dashboard, you estimate $5,000 in usage for January. You record this expense now, even without a bill.
   • Debit (increase) Cloud Hosting Expense: $5,000
   • Credit (increase) Accrued Liabilities: $5,000
2. Bill Arrival and Payment (Mid-February): The actual bill arrives for $5,150. You now pay it and clear the liability you created, recognizing the small difference.
   • Debit (decrease) Accrued Liabilities: $5,000
   • Debit (increase) Cloud Hosting Expense: $150 (the variance)
   • Credit (decrease) Cash: $5,150

This two-step process ensures your costs are recognized in the correct period, giving you a timely and accurate view of your operational performance.

Why This Isn't Just "Accountant Stuff" for SaaS Founders

Misaligned expense recognition directly damages the credibility of your financial reporting for SaaS founders. When you seek investment, backers perform due diligence on your financials. A volatile P&L filled with spikes from improperly booked prepayments and accruals is a major red flag. It suggests a lack of financial control and makes it difficult to assess the underlying health of the business.

Clean, accrual-basis accounting directly impacts the SaaS metrics investors scrutinize:

• Gross Margin: If your AWS bill is part of your Cost of Goods Sold (COGS), failing to accrue for it makes your gross margin look artificially high one month and then crash the next. Investors need to see a consistent, true margin to believe in your unit economics.
• Customer Acquisition Cost (CAC): If your HubSpot or Salesforce subscriptions are part of your sales and marketing expenses, booking them as a lump sum will massively inflate your CAC for one month, making your go-to-market strategy appear inefficient and unsustainable.

Investors need to see a predictable burn rate and a clear, consistent relationship between costs and revenue. Handling advance payments and accrued costs correctly demonstrates operational maturity and gives them confidence that you understand the levers of your own business.

Practical Steps to Get Started

The goal is to match expenses to the period in which they generated value, not the period in which cash moved. This is the core "matching principle" of accrual accounting, which is standard under both US GAAP and UK standards like FRS 102. For an early-stage startup, consistency is more important than perfect precision.

The reality for most startups is more pragmatic: you do not need to accrue every small expense. What founders find actually works is focusing on the top three to five largest prepayments and accruals. This is often an 80/20 approach where a few key items provide most of the financial clarity. These typically include your annual software stack (Salesforce, HubSpot), cloud costs (AWS, Google Cloud), and perhaps large performance marketing campaigns.

You can even manage this in a simple spreadsheet before formalizing it in QuickBooks or Xero as your company grows. By the time you are preparing for a Series A, this should become a non-negotiable part of a formal monthly close process. Your bookkeeper or fractional CFO can help set up the necessary recurring journal entries to handle amortization and accruals correctly. This discipline gives everyone a clear view of financial performance to make better decisions. For more, see the Cash vs. Accruals topic.

Frequently Asked Questions

Q: What is the difference between a prepaid expense and an accrued expense?
A: The key difference is the timing of cash. A prepaid expense is when you pay cash upfront for a good or service you will receive later (like an annual software license). An accrued expense is when you receive a good or service first and pay for it later (like monthly cloud usage).

Q: Do I need to amortize a small, $200 annual subscription?
A: Generally, no. For immaterial amounts, the effort outweighs the benefit. Most startups apply a "materiality threshold," for example, only prepaying expenses over $1,000. Focus your energy on the large, recurring costs that significantly impact your monthly P&L.

Q: How do I accurately estimate an accrued expense like an AWS bill?
A: Most usage-based services provide a real-time or daily-updated cost dashboard. On the last day of the month, log in to your provider's portal (like AWS Cost Explorer or Google Cloud Billing) and use the month-to-date figure as your accrual estimate. It will be very close to the final invoice.

Q: Can I manage this in a spreadsheet instead of accounting software?
A: Yes, in the very early stages (pre-seed), a spreadsheet can work for tracking your top 3-5 prepayments and accruals. However, as your transaction volume grows, moving this process into software like QuickBooks or Xero is essential for accuracy, scalability, and creating investor-ready reports.