Adjusting entries can be classified as either:
1) deferrals or accruals.
2) accruals or reversals
3) internal or external.
4) real or nominal.
The correct answer and explanation is:
The correct answer is 1) deferrals or accruals.
Adjusting entries are necessary to ensure that a company’s financial statements accurately reflect the economic activities that occurred during the accounting period, even if the cash flow has not yet occurred. Adjusting entries are classified into two main categories: deferrals and accruals.
Deferrals occur when cash has already been received or paid, but the related revenue or expense has not yet been earned or incurred. In these cases, the adjusting entry is made to allocate the correct amount of revenue or expense to the correct period. Common examples of deferrals include:
- Prepaid expenses: For example, if a company pays for a one-year insurance policy in advance, the expense is initially recorded as an asset. Over time, the adjusting entry recognizes the expense as it is incurred.
- Unearned revenue: If a company receives payment for services or goods to be delivered in the future, it records the cash received as unearned revenue, and adjusting entries are made as the company fulfills its obligation, recognizing revenue.
Accruals, on the other hand, occur when a revenue or expense has been earned or incurred but the cash has not yet been received or paid. These adjustments ensure that income or expenses are recorded in the correct accounting period. Common examples of accruals include:
- Accrued expenses: If a company incurs an expense (such as wages or utilities) but has not yet paid for it by the end of the period, an adjusting entry is made to recognize the expense and the liability.
- Accrued revenues: If a company earns revenue (like interest or service fees) but has not yet received payment by the end of the period, an adjusting entry is made to recognize the earned revenue and the receivable.
By properly classifying adjusting entries into deferrals and accruals, the financial statements will reflect the correct financial position and performance of the company during the period.