How Startups Should Record Prepayments and Accruals to Stabilize Burn Rate

Why Your Burn Rate Is So Volatile (And How to Fix It)

Your monthly burn rate report is a rollercoaster. One month, it looks incredibly low, giving you a false sense of security about your runway. The next, it skyrockets after you pay an annual software subscription, triggering panic. This volatility makes it impossible to have a meaningful conversation with your board about performance or to accurately forecast when you’ll run out of cash.

This isn’t a sign of a failing business; it's a symptom of looking at your finances through the wrong lens. The solution is learning how to record prepayments and accruals. Mastering this aspect of startup accounting moves you from simply tracking cash to understanding your company’s true financial health, month by month. It’s the key to making your financial reports a reliable tool for decision-making, not a source of confusion.

The Matching Principle: Accrual Accounting Basics

At the heart of solid startup accounting is a single idea: the matching principle. This principle states that you should recognize expenses in the same period as the revenue they helped generate. It's the core difference between cash and accrual accounting. Cash accounting is simple: you record transactions when money leaves your bank account. While easy, it gives a distorted view of your operational performance.

A huge annual payment makes one month look disastrously unprofitable, while the next eleven look artificially lean. Accrual accounting basics solve this by matching expenses to when you actually use the service or receive its value. This gives you a true picture of your monthly expenses, regardless of when you pay the bill. Your Profit & Loss (P&L) statement reflects this operational performance, showing your profitability over a period. Your Balance Sheet provides a snapshot of what you own (assets) and what you owe (liabilities) at a specific point in time. Understanding how to record prepayments and accruals is the practical application of this principle, addressing two common timing problems: the Pay-Now, Use-Later problem (Prepayments) and the Use-Now, Pay-Later problem (Accruals).

How to Record Prepayments to Tame Your Burn Rate

A prepayment is an expense you’ve paid for in advance but haven’t fully used yet. Think of annual software subscriptions, insurance premiums, or event sponsorships. Instead of expensing the entire amount on your P&L when you pay, you record it as a "Prepaid Expense" on your Balance Sheet. This is an asset because it represents a future economic benefit you've already secured. You then release a portion of that asset to the P&L as an expense each month over the service period. This process is called amortization.

A Practical Example: The Annual Software Subscription

Let’s walk through a classic SaaS startup example: the $12,000 annual subscription for a critical software tool, paid on January 1st.

Under cash accounting, your January P&L would show a massive $12,000 expense, making the month look terrible. Under accrual accounting, the process smooths this out:

1. Initial Payment (January 1st): In your accounting software (QuickBooks or Xero), you create a journal entry. You debit "Prepaid Expenses" (an asset on the Balance Sheet) for $12,000 and credit "Cash" for $12,000. Your January P&L is not affected at all. Your burn rate remains stable.
2. Monthly Amortization (January 31st): At the end of the first month, you record an adjusting entry to recognize one month's worth of the expense. You debit "Software Expense" (on your P&L) for $1,000 and credit "Prepaid Expenses" for $1,000.

You repeat this second entry every month for the entire year. The result is a smooth, predictable $1,000 software expense on your P&L each month. This reflects the reality of your operations and provides a consistent view of your startup expense timing. You don't need to do this for every small charge. In practice, the materiality threshold for prepayments at a seed-stage company can start at anything over $1,000-$2,000.

How to Record Accruals to Capture Hidden Costs

Accruals handle the opposite problem: services you've consumed but haven't been invoiced or paid for yet. An accrued expense, or accrued liability, is a way to recognize a cost in the period it was incurred. This ensures your financial statements are not missing significant, predictable expenses just because a bill is late. It answers the question, "My month-end reports look good, but I know a huge bill is coming. How do I account for that now?"

A Practical Example: The Unbilled Legal Fees

Consider a common scenario: you engaged a law firm for your seed round, and they did $10,000 worth of work in March. You know the invoice is coming, but it will not arrive until mid-April.

Without an accrual, your March P&L would be missing a $10,000 expense, making your burn look artificially low. Your April P&L would then take the full hit, skewing that month's results. Here’s how to handle it correctly:

1. Accrual Entry (March 31st): At the end of March, you create a journal entry to "accrue" for the expense. You debit "Legal & Professional Fees" (on your P&L) for $10,000 and credit "Accrued Liabilities" (a liability on the Balance Sheet) for $10,000. This correctly places the expense in March, matching it to the period the work was done.
2. Payment (April): When the invoice arrives and you pay it, you record the cash outflow and clear the liability. You would debit "Accrued Liabilities" for $10,000 and credit "Cash" for $10,000. Notice the P&L is not touched in April; the expense was already recognized.

This is vital for biotech or deeptech startups using expensive lab supplies or contract research organizations where invoicing can lag by weeks or months. It ensures your financials reflect reality, not just your vendor's billing cycle.

When This Moves From "Good Practice" to "Must-Do"

Okay, you get the theory. But when do you really need to get serious about this? The answer depends on your startup's stage and circumstances. How you record prepayments and accruals in startup accounting evolves from a helpful internal discipline into a critical external requirement.

For Internal Strategy and Early Investors

For pre-seed and seed-stage companies, disciplined prepayment and accrual accounting is a sign of operational maturity. It gives you, your co-founders, and your early investors a reliable view of your burn rate and runway. It prevents unpleasant surprises and builds confidence by showing you have a firm grip on the company's financial health. It’s a powerful internal tool for managing cash.

For Formal Audits, Fundraising, and Compliance

As you scale toward a Series A or B, or as you approach specific compliance milestones, it becomes a non-negotiable requirement. This is when the process shifts from "good practice" to "must-do."

The triggers are typically external. Formal audits require accrual accounting under standards like US GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). If you are preparing for a significant fundraise, an acquisition, or just implementing strong governance, your investors will expect financials prepared on an accrual basis.

The geographic focus of your business also introduces specific mandates. For UK companies, R&D tax credit claims require expenses to be recognized in the correct accounting period. If you mis-time your R&D costs, you risk losing out on this critical source of non-dilutive funding. In the US, the rules are just as strict. For example, SaaS companies under audit must adhere to ASC 606 for revenue recognition, which requires recognizing revenue when it is earned, not when cash is received. This is the revenue-side equivalent of expense accruals, handling deferred revenue for startups and advance payments from customers. Misclassifying these can lead to costly rework and audit exposure.

Your Implementation Roadmap: A Step-by-Step Guide

Moving from theory to practice does not require a CFO or enterprise software. You can start today in QuickBooks or Xero with a simple, repeatable process.

Step 1: Set Your Materiality Threshold

You do not need to prepay a $100 software bill. The reality for most pre-seed startups is more pragmatic. Start with the guideline that the materiality threshold for prepayments at a seed-stage company can start at anything over $1,000-$2,000. This prevents you from getting bogged down in tiny transactions while still capturing the large payments that skew your burn rate.

Step 2: Update Your Chart of Accounts

In QuickBooks or Xero, ensure you have two key accounts set up. This is the foundational structure for tracking these items correctly.

• Prepaid Expenses: Under Assets > Current Assets.
• Accrued Liabilities: Under Liabilities > Current Liabilities.

Use our chart of accounts template for SaaS to ensure you have a robust setup.

Step 3: Create a Disciplined Month-End Close Process

This is where consistency pays off. At the end of each month, build a routine to identify these items. Refer to our Month-End Bookkeeping Checklist for Startups.

• Identify Prepayments: Scan your bank transactions for large, one-off payments for annual or quarterly services. For each, ask: "Does this cover more than one month?" If yes, book it to Prepaid Expenses and create a simple spreadsheet to track its monthly amortization.
• Identify Accruals: Ask yourself and your team: "What significant services did we use this month that we haven't been invoiced for?" Common culprits are legal fees, contractors, accounting services, and for biotech firms, CRO or lab services. Estimate the cost and record the accrual.

Step 4: Record the Journal Entries

In QuickBooks (via the "+" New button) or Xero (under Accounting > Manual Journals), enter the debit and credit entries detailed in the examples above. The core rule is that your total debits must always equal your total credits. Follow our journal entry best practices for clear documentation.

Common Pitfalls to Avoid

Forgetting to Reverse Accruals: When you pay a bill you previously accrued, you must debit the Accrued Liability account, not the expense account again. Double-counting is a frequent mistake.

Ignoring the Balance Sheet: Prepayments and accruals live on the Balance Sheet. If you only look at your P&L, you will miss the full picture of your company's financial position.

Setting an Unrealistic Threshold: A threshold that is too low creates unnecessary work. One that is too high can still lead to lumpy financials. Adjust your threshold as you grow and payment sizes increase.

Return to the Bookkeeping Fundamentals hub for related guides.

Frequently Asked Questions

Q: What is the main difference between a prepayment and an accrual?
A: A prepayment is an asset on your Balance Sheet representing cash you paid for a service you have not yet fully used (Pay-Now, Use-Later). An accrual is a liability on your Balance Sheet representing a service you have used but not yet paid for (Use-Now, Pay-Later).

Q: As an early-stage startup, can I ignore this and just use cash accounting?
A: While you can start with cash accounting for simplicity, switching to accrual methods early builds good habits and prevents costly financial clean-up later. Most investors will require accrual-based financials for due diligence starting at the seed or Series A stage, so it is best to be prepared.

Q: How does deferred revenue relate to prepayments and accruals?
A: Deferred revenue is the mirror image of a prepayment, but for income. It is cash you have received from a customer for a service you have not delivered yet, like an annual software subscription. It is a liability that you recognize as revenue over time, following the same matching principle.

Q: Do I need a full-time accountant to manage this?
A: Not necessarily at the pre-seed stage. You can manage this with good accounting software like QuickBooks or Xero and a clear month-end process. However, as your transaction volume and complexity grow, a part-time bookkeeper or fractional CFO becomes essential for accuracy and compliance.