A companys accounting profit and taxable income can be different in certain reporting periods

because of the differences in financial reporting and tax filing. While accounting profit is computed
using the accrual method of financial accounting based on generally accepted accounting principles, or
GAAP, taxable income is calculated using the cash method of tax accounting based on tax rules. As a
result, companies report accrued revenues and expenses in financial reporting to derive accounting
profit, and cash revenues and expenses in tax reporting to obtain taxable income.
Accrued Revenues
Accounting profit may exceed taxable income in certain reporting periods due to accrued revenues.
Using the accrual method of financial accounting, companies report revenues when earned in the
reporting period even though customers have not paid for the revenue-related sales. Consequently,
such revenue recognition increases the accounting profit. On the other hand, using the cash method of
tax accounting, companies dont report any revenues unless they have collected cash from customers
for the sales. As a result, the taxable income in the same period is potentially lower than the
accounting profit.
Prepaid Expenses
Accounting profit may also exceed taxable income in certain reporting periods due to prepaid
expenses. Prepaid expenses are cash expenditures for future expenses but paid in the current
reporting period. Using the accrual method of financial accounting, companies report expenses when
incurred. As a result, only a portion of the prepaid expenses is reported as the expense incurred in the
current period. Thus, the less expense reported in financial reporting, the higher the accounting profit.
Using the cash method of tax accounting, companies report the full amount of cash expenditures as
the expense in the current period, lowering taxable income.
Unearned Revenues
Accounting profit may be lower than taxable income in certain reporting periods due to unearned
revenues. Unearned revenues are cash receipts from customers for receiving goods or services over
time through multiple periods. Using the accrual method of financial accounting, companies report
only a portion of the total unearned revenues as the revenue earned in the current period, potentially
having a lower accounting profit. Using the cash method of tax accounting, companies report the full
amount of cash receipts as the revenue in the current period, increasing taxable income.
Accrued Expenses
Accounting profit may also be lower than taxable income in certain reporting periods due to accrued
expenses. Using the accrual method of financial accounting, companies accrue and report expenses
when incurred rather than when paid. As a result, the more accrued expenses, the lower the
accounting profit. Using the cash method of tax accounting, companies dont report any expenses for
tax filing in a period unless cash has been paid for related expense items. Thus, with less expenses
reported, the taxable income is potentially higher than the accounting profit in the same period

Asset-Liability Matching is the process of investing, purchasing, selling and otherwise adjusting a
company's asset holdings so that cash is available when it is needed to cover the company's liabilities.

When the duration of the portfolio of assets and the portfolio of liabilities is equivalent, changes in
interest rates should have a negligible effect on the structure: the portfolio is said to be duration
matched. This is a prime example of the benefit of Asset-Liability Matching (ALM). Although, there are
risks other than changing interest rates. Furthermore, duration itself is not static, and portfolio
rebalancing must be dynamic to account for such changes. However, in principle, this form of ALM can
work to help investment managers put some control on at least one form of risk in our ever-more
complex investment world.
LCM
Assume it is the end of December 2014 and your retail store has 20 digital cameras in inventory. You
purchased the cameras directly from the manufacturer at a cost of $150 each and you planned to sell
the cameras at a retail price of $200, a price that is in line with competing retailers.
Unexpectedly, on December 31, the camera manufacturer announces a permanent price reduction
you and the other retailers can now purchase the cameras for $135 instead of $150. You know that
your competitors will buy up these cameras and pass the savings on to their customers by
immediately advertising a retail price reductionselling the cameras for $185 instead of $200. If you
drop your retail price to $185, however, your gross profitwill be just $35 each on the 20 cameras you
already have in stock, instead of the $50 per camera that you had planned on. This means your profits
will be $300 less than you projected ($15 less profit times 20 cameras). Much to your dismay, you will
have to drop your price to meet that of your competitors. There is nothing you can do to avoid this
"holding loss" of $300.
When and how should this loss be reported on your store's income statement? Should the loss be
reported as a smaller gross profit when the cameras are sold in January 2015? Or, should the entire
$300 of loss be reported in December 2014, when the manufacturer announced the lower price?
Should your December 31 balance sheet report inventory at $3,000 (20 cameras at the actual cost of
$150) or at $2,700 (20 cameras at the lowerreplacement cost of $135)?
The conservatism principle and a specific accounting pronouncement, Accounting Research Bulletin
No. 43 (ARB No. 43) leads to an accounting valuation method known as the lower of cost or market,
or LCM. In this method the term "market" includes both the market in which the
company purchases its merchandise as well as the market in which it sells its merchandise. We will
discuss the details of the rule later, but for now, think of the lower of cost or market rule as the lower
of cost or replacement costwith certain limitations placed on the replacement cost amount.

Conservatism
Accountants usually associate the lower of cost or market (LCM) rule with the conservatism
principle. This principle gives accountants guidance when they are faced with a choice between two
divergent amounts. The conservatism principle directs them to choose the amount that results in a
smaller asset amount and/or less profit.

How would the conservatism principle affect your camera "holding loss" described in the Introduction?
On your December 31 balance sheet, the accountant must decide between reporting the cameras in
inventory at their actual cost of $150 each, or at their replacement cost of $135 each. The
conservatism principle and the Accounting Research Bulletin No. 43 direct the accountant to report
them at $135 each and to recognize the $300 loss on your 2014 income statement. (In other words,
the loss should be reported as a loss in 2014, and not as a reduction in profits in 2015 when the
cameras are sold.) However, there are some limitations on the replacement cost. The limitations
involve the net realizable value (NRV), which will be defined in the next section.
While the conservatism principle and the lower of cost or market rule in ARB No. 43 may require that
inventory be reported at less than cost, the cost principle and the revenue recognition principle
prevent the reporting of inventory at more than cost. (However, there are exceptions for a few select
industries such as mining, commodities, securities, etc.)
NRV
Net realizable value (NRV) is defined as the expected selling price in the ordinary course of
business minus the cost necessary for completion and disposal.
To illustrate NRV, let's assume that a company has an item in inventory that could be sold for $5. It will
cost $0.80 to get the item ready for sale (by way of such costs as packaging the item), and to actually
sell it (by way of such costs as sales commissions). This makes the net realizable value $4.20 (selling
price of $5.00 less $0.80 of cost to complete and dispose).
Net realizable value is a key component in determining "market" in the lower of cost or market rule.
Market
In the term lower of cost or market the word "market" refers to an item's current replacement
cost (whether through purchase or production). The market amount is constrained or limited by two
amounts: (1) an upper limit, or "ceiling," and (2) a lower limit, or "floor." An item's market amount (or
replacement cost) cannot be higher than the ceiling nor lower than the floor.
Both the upper limit (the ceiling) and the lower limit (the floor) are related to the net realizable
value (defined above) in the following ways:
1.

Upper Limit or Ceiling for Market The upper limit, or ceiling, for the market amount is
the net realizable value (NRV). In other words, the market amount cannot be higher than
NRV. If the current replacement cost of an item in inventory is greater than NRV, the NRV is
used as the market amount.

2.

Lower Limit or Floor for Market The lower limit, or floor, for the market amount is the net
realizable value (NRV) minus the normal profit. In other words, the market
amount cannot be lower than NRV minus the normal profit. If the current replacement cost of
an item in inventory is less than the NRV minus the normal profit, the NRV minus the normal
profit is used as the market amount.

Here's a recap on how to determine the market amount used in the lower of cost or market rule:

If the current replacement cost is between the floor and the ceiling, the current replacement
cost is the market amount.

If the current replacement cost is greater than the ceiling, the ceiling amount is the market
amount.

If the current replacement cost is lower than the floor, the floor amount is the market amount