How to account for UK government grants under IFRS: practical guide for startups

Understanding Grant Accounting: The Core IFRS Principle for UK Startups

Securing a grant from an organisation like Innovate UK is a major milestone for any deeptech or biotech startup. It validates your research and provides crucial non-dilutive funding. But after the celebration, a practical challenge emerges: how do you account for this cash correctly? Misclassifying funds can distort your financial health, create mistrust with investors, and even risk clawbacks. For a founder or part-time finance lead using Xero, navigating the complexities of IFRS compliance for startups can feel daunting. This guide provides a clear, step-by-step process for UK startups to manage Innovate UK grant reporting, ensuring your accounting is both compliant and useful for making key business decisions about your runway.

Before diving into Xero, it is essential to grasp the one principle that governs all grant accounting. The primary accounting standard governing government grants under IFRS is IAS 20, Accounting for Government Grants and Disclosure of Government Assistance. This standard is built upon a core concept you may already know: the 'matching principle'. In this context, the rule is simple but non-negotiable: grant income is recognised in the Profit & Loss (P&L) statement in the same periods as the expenses it is intended to compensate.

What does this mean in practice? You cannot recognise the entire grant as revenue the day the cash lands in your bank account. Doing so would show a huge, misleading profit in one month, followed by months of seemingly high R&D costs with no corresponding income. This incorrect approach creates a volatile P&L that makes performance impossible to track and alarms investors. Instead, you must match the income bit-by-bit to the specific, eligible project costs as you incur them, whether that’s a scientist's salary, a specific software subscription, or lab consumables. This approach provides a true and fair view of your project's financial performance over time, which is the entire goal of IAS 20 explained simply.

Step 1: Classify Your Grant Type for Correct IFRS Treatment

To begin accounting for government funding, you first need to answer a simple question: was this grant given to you for day-to-day project costs, or to buy a large piece of equipment? This distinction separates grants into two primary categories under IAS 20, each with different accounting treatments.

Revenue Grants

These grants are intended to cover operating expenditures, such as salaries, contractor fees, materials, and other day-to-day project costs. For the vast majority of UK startups in biotech, deeptech, and SaaS receiving Innovate UK funding, this is the type of grant you have. The income from a revenue grant is recognised on the P&L as the related expenses are incurred. This direct matching ensures your financial statements accurately reflect the subsidised nature of your project activities period by period.

Capital Grants

These grants are provided specifically for the purchase of a long-term asset, like a specialised piece of lab equipment, manufacturing machinery, or a server. The accounting for capital grants is different because the economic benefit of the asset is realised over its entire useful life. Consequently, the grant income is typically recognised on the P&L over the same period, matching the annual depreciation expense of the asset. This prevents a large, one-off income entry when the asset is bought. For the remainder of this guide, we will focus exclusively on Revenue Grants, as they represent the most common scenario for early-stage, R&D-heavy companies.

Step 2: How to Account for Innovate UK Grants Under IFRS: The Core Mechanics

This is where we translate the matching principle into debits and credits within your accounting software like Xero. The process involves two key events: the cash arriving and the monthly recognition of revenue. Critically, these events separate the cash hitting your balance sheet from the revenue hitting your P&L, which is the foundation of compliant IFRS accounting for government funding.

Event 1: Receiving the Grant Cash

When the grant payment arrives from Innovate UK, it is not yet revenue. It's a liability because it's not yet earned; you have an obligation to the government to perform the work and incur the eligible costs you promised. This cash is initially recorded on the balance sheet as a liability, commonly named 'Deferred Grant Income'.

To implement this in Xero, you should create a new account in your Chart of Accounts. Navigate to Accounting > Chart of Accounts, click 'Add Account', and set the 'Account Type' to 'Current Liability'. Name it 'Deferred Grant Income'. When you reconcile the cash receipt in your bank feed, you will code it directly to this new liability account. This correctly reflects that you hold the cash but have not yet earned the right to call it income.

Event 2: Recognising Earned Income Monthly

At the end of each month, you must calculate the total eligible project expenses incurred during that period. This requires carefully tracking staff time, contractor invoices, and material purchases related to the grant project. For example, you might have £15,000 in salaries for two R&D engineers and £5,000 in specific project materials. The total, £20,000, is the amount of grant income you have 'earned' this month. The trigger for recognition is simple: spending.

You will then post a manual journal entry to move this earned amount from the balance sheet liability to P&L revenue. In Xero, go to Accounting > Reports > Journal Report and click 'Add New Journal'. The entry will debit the liability account (reducing the amount you owe) and credit a revenue account (recognising the income).

Here is what that monthly journal entry looks like:


| Account | Debit | Credit |
|-------------------------------|---------|---------|
| Deferred Grant Income (Liability) | £20,000 | |
| Grant Income (Revenue) | | £20,000 |


This journal perfectly reduces the liability on your balance sheet and simultaneously recognises the income on your P&L, perfectly matching it against the £20,000 of expenses you incurred in the same month. This monthly discipline is central to achieving IFRS compliance for startups.

Step 3: Building Your Evidence Locker to Prevent Grant Clawbacks

Innovate UK and other grant-awarding bodies have a right to audit your project expenditure to ensure funds were used correctly. According to Innovate UK's guidance, there are specific conditions on the award that must be met. Lacking a reliable process to track and evidence eligible costs is the single biggest risk for grant recipients, potentially leading to a clawback where you have to repay funds. Your accounting entries are only as strong as the proof that backs them up.

A scenario we repeatedly see is founders scrambling to find old invoices and timesheets months or years after the fact, often during a stressful audit. The solution is to build a meticulous, real-time evidence locker from day one. This should be a digital folder system that is organised, consistent, and easy to navigate for a third-party auditor. Every single cost you claim against the grant and recognise as income must have a clear, verifiable paper trail.

This audit trail typically includes:

• Staff Costs: Signed and dated timesheets detailing the hours each employee worked on the specific grant project. These must be linked to payroll records showing their gross pay to calculate the eligible cost. Use the time tracking for grant compliance guide for practical methods.
• Contractor Costs: Invoices with clear descriptions of the work performed, the dates of the work, and evidence of the corresponding bank payment. The invoice description should clearly tie back to the project's objectives.
• Materials & Consumables: Purchase orders, supplier invoices, and bank statements showing the payment was made. Ensure the items purchased are eligible under your grant agreement.

This is your defence against a clawback. A well-organised digital folder structure for your Innovate UK grant reporting might look like this:

InnovateUK_Project_12345/
└── Claims/
└── Q1_2024/
├── Staff_Costs/
│ ├── Timesheet_Employee_A_Mar24.pdf
│ └── Payroll_Summary_Mar24.pdf
├── Contractor_Invoices/
│ └── Invoice_XYZ_Consulting.pdf
├── Material_Invoices/
│ └── Invoice_Lab_Supplies.pdf
├── Bank_Statements/
│ └── March_2024_Statement.pdf
└── Month_End_Journal_Mar24.pdf

Step 4: Aligning IFRS Reporting with Your Management KPIs

Following IFRS rules for recognizing grant income creates a compliant P&L that will satisfy auditors. However, it also creates a common point of confusion for founders, boards, and investors. By design, the grant income on your P&L perfectly offsets the corresponding R&D expenses. This makes your net loss (or 'burn') appear much smaller than the actual amount of cash leaving your bank account each month. For a business focused on runway, this mismatch can distort critical conversations about financial health.

The practical consequence tends to be a disconnect between your formal financial statements and your internal management reporting. To solve this, you must distinguish between two different perspectives: the 'IFRS View' for formal reporting and the 'Management/Cash View' for internal decision-making.

The IFRS View vs. the Management/Cash View

The IFRS View is your official P&L, which includes grant income as a revenue line item (or as a reduction in expenses). It is correct for statutory accounts and is essential for deeptech financial reporting compliance.

The Management/Cash View, however, focuses on operational cash flow. It calculates your net cash burn by looking at total cash spent (including all salaries and project costs) versus total cash received, ignoring the non-cash P&L entry for grant income. This view provides the clearest, most honest picture of your runway.

When reporting to your board or investors, it is crucial to present both views. Use clear commentary to bridge the gap and avoid misunderstanding. For example:

"Our Q1 P&L shows a net loss of £50k, reflecting the recognition of £100k in Innovate UK grant income which offset R&D expenses as per IFRS (IAS 20). However, our net cash burn for the quarter was £150k, which is the key figure for our runway calculations. The grant provides excellent non-dilutive funding, but our operational cash outflow remains consistent with our plan."

This dual approach satisfies auditors and gives your investors the clarity they need to understand the underlying health of the business. Consider adding a simple management report that reconciles P&L grant recognition back to cash spend. For more advanced tracking, you can implement grant budget variance analysis to compare planned spend against actuals.

Key Actions for Compliant Grant Accounting

Successfully managing Innovate UK grant accounting under IFRS does not require a full-time CFO. It requires a disciplined process built on a few core principles. For founders in biotech, deeptech, and SaaS, getting this right provides financial clarity, investor confidence, and audit security.

If you plan to claim R&D tax credits on your grant-funded project, be aware that the grant may affect the amount you can claim. It is wise to check HMRC's AIF guidance to understand the interaction between the two schemes.

Here are the four key actions to implement today:

1. Embrace the Matching Principle: Remember that grant income can only be recognised on your P&L in the same period you incur the expenses it is meant to cover. This is the foundation of IAS 20.
2. Use Your Balance Sheet First: When grant cash arrives, it is not revenue. Record it in a 'Deferred Grant Income' liability account in Xero. This single step is the key to compliant accounting for government funding.
3. Document Everything, Always: Build your evidence locker from day one with timesheets, invoices, and bank statements. Assume you will be audited and make it easy for auditors to approve your spending. A clear audit trail is non-negotiable.
4. Report Both Views to Your Board: Present the official IFRS P&L alongside a clear Management View of your net cash burn and runway. Don't let accounting rules obscure your true runway.

By following these steps, you can ensure your Innovate UK grant reporting is compliant, auditable, and a source of strategic clarity rather than confusion. For more on applying project-based accounting to grants and funded collaborations, explore the hub on Government Grants & Contract Accounting.

Frequently Asked Questions

Q: What happens if we underspend our Innovate UK grant budget?
A: If you underspend, you generally cannot claim the full grant amount. Income recognition is tied to actual eligible costs incurred. Any unspent cash received upfront may need to be returned to Innovate UK at the end of the project, depending on the specific terms of your grant agreement.

Q: How does grant funding affect our R&D tax credit claim?
A: Receiving a notified state aid grant like one from Innovate UK typically means you cannot claim for the same project costs under the SME R&D tax credit scheme. However, you may still be able to claim those costs through the less generous R&D Expenditure Credit (RDEC) scheme. Always seek specialist advice.

Q: Can we recognise income for costs incurred before the grant was formally approved?
A: Generally, no. Most grant agreements state that only costs incurred after the official project start date are eligible for reimbursement. Recognising income against pre-award costs is a common mistake that would likely be disallowed during an audit, leading to a potential clawback of funds.