Reversing Accruals: When to Reverse and How to Stop Entries That Distort Key Metrics

Reversing Accruals: When and How

Your startup’s January books are closed, and profitability looks strong. Then, in mid-February, a legal bill for $10,000 arrives for work completed in January. If you book it in February, you have a problem. January’s profit was artificially high, and February’s is now artificially low. This single invoice **distorts key metrics** like gross margin and runway for two consecutive months, confusing budget owners and making it harder to manage cash. This common scenario highlights a critical need for a disciplined approach to **monthly closing adjustments**. The solution isn’t an ad-hoc fix; it’s a systematic process for booking expenses in the period they occur, known as accruals, and then correctly undoing those estimates with reversing journal entries. This guide explains **how to reverse accruals in startup accounting** to ensure your financial statements are consistently reliable.

Why Reversing Accruals is Fundamental to Startup Accounting

At its core, accounting for a growing startup is about accuracy and timing. The matching principle, a key concept in both US GAAP and IFRS, dictates that expenses should be recognized in the same period as the revenue they helped generate. An accrual is the primary tool to achieve this alignment.

Accrual: A journal entry made to record an expense that has been incurred but not yet invoiced or paid.

However, booking the accrual is only half the process. A reversing entry is the mirror image of the accrual, posted on the first day of the next accounting period. It is **the mechanism to undo the accrual** so that when the actual invoice arrives, it can be booked normally without double-counting the expense. This two-part system, the accrual and its reversal, ensures that the estimated expense impacts the correct month while the cash outflow is correctly tracked when the payment is made later. Getting this right is not just about clean books. A proper **accrual reversal process** must follow GAAP/IFRS timing principles to avoid audit adjustments, a critical step for maintaining investor confidence and navigating due diligence. This system of **undoing accrual entries** is fundamental to producing trustworthy, period-over-period financial reports.

A Step-by-Step Guide to the Accrual Reversal Process

A robust **accrual reversal process** moves your financials from inconsistent guesswork to a reliable system. This isn't about achieving perfect GAAP compliance from day one, but about building the discipline for **directionally correct financials** that accurately reflect business performance. For startups using tools like QuickBooks or Xero, this can be managed effectively with a three-step approach.

Step 1: Identify and Estimate Accruable Expenses

The first step is to identify significant expenses incurred in a month for which you haven’t received an invoice by the time you close the books. The key here is materiality. You don’t need to accrue every small expense. Instead, you should establish a formal materiality threshold.

Materiality Threshold: The dollar amount above which an expense is considered significant enough to require an accrual.

The reality for most pre-seed to Series B startups is pragmatic. Pick a number and stick with it. For a Pre-Seed or Seed company, this can be around $1,000 to $2,500. As you grow, this will change. A materiality threshold for a Series A company is often higher, around $5,000 or more. Work with department heads to estimate the value of these expenses based on contracts, statements of work, or past invoices.

Step 2: Record the Accrual and Schedule the Automated Reversal

Once you have your list of estimated expenses, you record them with a journal entry. Crucially, you should also schedule the reversal at the same time. Modern accounting software makes this straightforward. In QuickBooks, you can tick a “Reversing” box when creating a journal entry, which automatically creates the corresponding reversal for the date you specify. In Xero, you can use the “Post and Reverse” feature. This automation **removes human memory from the equation**.

Let’s walk through a numerical example. A SaaS startup used a marketing contractor in January and estimates the work to be worth $5,000.

• January 31 (Accrual Entry): You create a journal entry to record the estimated expense. This ensures January’s Profit & Loss statement reflects the $5,000 marketing cost and the Balance Sheet shows a corresponding liability.
  • Debit (increase) Marketing Expense: $5,000
  • Credit (increase) Accrued Liabilities: $5,000
• February 1 (Reversing Entry): The reversal automatically posts on the first day of the next month. Reversal entries should be dated for the first day of the following month, which is **standard practice expected by auditors**.
  • Debit (decrease) Accrued Liabilities: $5,000
  • Credit (decrease) Marketing Expense: $5,000

This entry zeros out the accrual from the balance sheet and temporarily puts a negative $5,000 in February’s marketing expense account, ready to be offset by the actual invoice.

Step 3: Book the Actual Invoice and Reconcile

On February 15, the actual invoice arrives for $5,250. You enter this into your accounting system as a standard bill. This entry creates the payable to the vendor.

• February 15 (Actual Invoice Entry):
  • Debit (increase) Marketing Expense: $5,250
  • Credit (increase) Accounts Payable: $5,250

The net impact on February’s P&L is now correct. The $5,250 debit from the invoice and the $5,000 credit from the reversal result in a net expense of just $250 for February, which is the variance between your estimate and the actual cost. January correctly shows a $5,000 expense. This systemization is critical. According to a 2022 survey by the Controller's Council, manual journal entries are **a leading source of financial closing errors**. Using your accounting software’s features for **automated accrual reversals** dramatically reduces this risk.

Common Mistakes in Undoing Accrual Entries (And How to Fix Them)

Even with a clear process, certain issues commonly arise in a fast-paced startup environment. Understanding these sticking points is the first step toward **correcting accrual mistakes** and ensuring your **accruals in financial statements** are sound.

1. Forgetting to Reverse a Manual Accrual

A scenario we repeatedly see is** when a manual accrual is booked at month-end, but the corresponding reversal is forgotten. When the actual invoice is then booked in the following month, the expense is counted twice: once as the accrual and once as the bill. This error understates profit and can cause significant confusion for budget owners who see costs they cannot explain.

Prevention: The easiest fix is prevention. Always use the built-in reversing journal entry functions in your accounting software. For any manual entries that are absolutely necessary, a comprehensive month-end close checklist is your best defense.

2. Incorrect Timing of Reversing Journal Entries

The **timing of reversing journal entries** is not flexible. A common mistake is dating the reversal entry incorrectly, for instance, on the last day of the next month instead of the first. This pushes the reversal’s impact into the wrong period, defeating the purpose of the accrual. It can lead to a negative balance in an expense account for an entire month, which is **a red flag for investors and auditors**.

The Rule: Reversals are always dated for the first day of the following period. This ensures the reversal nets against the actual invoice within the same month, keeping your period-over-period reporting clean. Be aware that jurisdiction-specific regulations, such as UK VAT timing rules, can also affect how accruals are managed.

3. Inconsistent Application of Materiality

As a startup scales, what was once a material expense can become noise. If your finance process relies on one person’s ad-hoc judgment of what to accrue each month, your financial data will become inconsistent. An expense accrued one month might be ignored the next, making trend analysis unreliable.

Solution: Formally document your materiality threshold and share it with anyone involved in the closing process. Schedule a review of this threshold every six to twelve months, or after a significant funding round, to ensure it still makes sense for the company’s new scale.

How a Disciplined Accrual Process Impacts Your Startup

Moving from ad-hoc financial fixes to a reliable month-end close process is achievable for any startup. A disciplined accrual reversal process is a foundational element that provides clarity and builds trust with stakeholders. Its implementation and importance can vary slightly depending on your business model and stage.

For Founders and CEOs: A Clear View of Financial Health

The primary benefit is **an accurate view of runway and burn rate**. When expenses are matched to the correct period, your financial model becomes a more reliable tool for strategic decisions. It provides investors with confidence that you have a firm grasp on the company’s financial health, which is invaluable during due diligence.

For SaaS and E-commerce: Protecting Key Metrics

For these businesses, accuracy in **monthly closing adjustments** directly impacts key performance indicators. The cost of goods sold for an e-commerce business or the cloud hosting costs for a SaaS platform must be accrued correctly to calculate an accurate gross margin. This, in turn, affects the calculation of metrics like Customer Acquisition Cost (CAC) and Lifetime Value (LTV), which are closely scrutinized by investors.

For Biotech and Deeptech: Ensuring Compliance and Maximizing Credits

In these sectors, the stakes are even higher. R&D expenses must be meticulously tracked for grant reporting and for claiming tax credits. A proper accrual process for large, un-invoiced R&D expenditures, like work from a contract research organization (CRO), ensures that these crucial costs are recognized in the correct period, strengthening compliance and maximizing potential tax benefits.

Scaling Your Process from Seed to Series A

As your company scales, the **accrual reversal process** itself doesn’t change, but its importance grows. The materiality threshold will increase, and the tolerance for error will shrink. What begins as a method for generating **directionally correct financials** evolves into a required discipline for producing fully compliant financial statements. By implementing a systematic approach early and leveraging **automated accrual reversals** in your accounting software, you build **a scalable financial foundation** that supports your startup’s growth. For broader guidance, read the complete hub on Cash vs Accruals.

Frequently Asked Questions

Q: What is the difference between an accrual and accounts payable?

A: An accrual is an estimate for an expense you've incurred but have not yet received an invoice for. Accounts Payable (AP) is the liability recorded when you receive the official invoice from a vendor. The accrual acts as a placeholder in the correct financial period until the actual bill creates the AP entry.

Q: Can I reverse an accrual in the middle of the month?

A: No, the correct accounting practice is to post the reversing journal entry on the first day of the following month. This ensures the reversal and the eventual invoice net out within the same reporting period, preventing distortion of your monthly financial statements and keeping your books clean for auditors.

Q: What happens if the actual invoice is very different from my accrued estimate?

A: The entire difference will be reflected in the month the invoice is booked. For example, if you accrued $5,000 and the final invoice is $7,000, the extra $2,000 expense hits the P&L in the current month. If variances are consistently large, you should work to refine your estimation process.

Q: Why can't I just wait for the invoice to arrive and book it then?

A: Waiting for the invoice violates the matching principle of accrual accounting. It distorts your monthly performance by pushing expenses into later periods, making your profit seem higher than it was. This provides a misleading view of your burn rate, runway, and overall financial health to investors and your team.