Accounting Online Program Certification Practice Test

How are profits affected when accrued income of £1,750 is misclassified as deferred income?

1. Profits are overstated by £3,500

2. Profits are understated by £3,500

3. Profits are accurate

4. Profits are overstated by £1,750

The correct answer is: Profits are understated by £3,500

When accrued income of £1,750 is misclassified as deferred income, profits are indeed understated. Accrued income represents money that has been earned but not yet received, meaning it should be recognized as income in the current period, thereby increasing profits. On the other hand, deferred income refers to money received for services not yet performed or goods not yet delivered, which means that it cannot be recognized as income in the current period. If accrued income is recorded as deferred income, it implies that this income will not be recognized in the current period, leading to an understatement of profits by the amount of the misclassification. Since the accrued income of £1,750 is not recognized when it should be, profits are understated by that same amount. Thus, the financial statements reflect a lower profit than they should have, indicating that the business appears less profitable than it truly is. This is a vital nuance in understanding accrual accounting, where timing and classification of income directly impact the accuracy of reported profits.