Portfolio Accounting for Individual Investors
By Thomas R. Craig, PhD, CPA, professor of accounting, Illinois State University
The number of active investors in the equities market has increased dramatically in the last few decades. Many of these investors have very inadequate portfolio accounting practices and a practical, self-checking portfolio accounting system that individual investors could use to monitor their investing activities and prepare tax information, including quarterly tax installments, would be welcomed by many. Such a system does not require accounting expertise, only the motivation to maintain accurate portfolio records and the willingness to spend the time to make the system work.
Example 1: Basics
Exhibit 1 is a summary of a hypothetical brokerage statement for the month of January 2002, showing the assets owned as of the close of business on January 31, 2002, along with the activity in Mr. Smith’s brokerage account for January 2002.
The first objective is to compute “comprehensive portfolio income” for the month based upon the broker’s statement. Comprehensive portfolio income refers to the sum of all components of income for a period, including realized sources of income and expense and unrealized holding gains or losses.
Comprehensive portfolio income can be calculated in two ways, with each calculation a check upon the other. First, comprehensive portfolio income can be calculated as the sum of individual transactions and holding gains or losses for the period. Thus, as shown in Exhibit 2, comprehensive portfolio income can be calculated to be $7,100 for January 2002, consisting of realized dividend income and interest expense of $140 and $40, respectively, and a $7,000 unrealized holding gain for the increase in value of XYZ stock.
Second, comprehensive portfolio income can be calculated as the increase in equity during the period, adjusted for transactions with the owner. To use this method, first compute owner’s equity in the portfolio at the beginning and end of the month by subtracting liabilities from assets. Next, analyze the activity in the owner’s equity account for the month, using the account activity equation illustrated in Exhibit 3: the beginning balance of an account, plus inputs to the account and minus outputs from the account, must equal the ending balance. Knowledge of any three of the four components in account activity determines the solution for the unknown fourth component. Since the beginning and ending owner’s-equity balances are known (i.e., $81,600 and $79,500) and the output from owner’s equity is known ($5,000), the input to owner’s equity (comprehensive portfolio income) must be $7,100.
Simplified Chart of Accounts
Exhibit 4 provides a simplified chart of accounts for an individual investor’s portfolio accounting system.
The cost-to-market account. This account represents the signed difference between the sum of the market values of investments at a point in time and the sum of their costs. Unrealized appreciation exists when market value exceeds cost; unrealized depreciation exists when market value is below cost. The cost-to-market account is adjusted each period, and the signed amount of the period-to-period change in the account’s balance represents the period’s net unrealized holding gain or loss.
The cumulative profits earned account. Realistically, individuals that have been investing for more than a few years might find it impracticable to decompose their total equity into a cumulative paid-in capital account and a cumulative profits earned as of the date they adopt a portfolio accounting system. A dated cumulative profits earned account would be set to zero as of the date the portfolio accounting system is adopted. A cumulative paid-in capital account would represent the cumulative sum of owner’s equity as of the date of adoption of the portfolio accounting system, plus all capital contributions or withdrawals after that date.
Example 2: Preparing a Portfolio Accounting Worksheet
The following example extends the basic concepts introduced above and illustrates the utility of a portfolio accounting worksheet. Consider the brokerage statement for the month of July 2002, as summarized in Exhibit 5-A.
A practical, systematic way to proceed is to prepare a portfolio accounting worksheet to reflect the month’s transactions and the end-of-month adjustment to the cost-to-market account as shown in Exhibit 5-B.
The July 8 transaction (to record the purchase of GHI stock on margin) is entered on the worksheet by increasing both the cost of investments and margin liability balances. In contrast, the July 10 transaction (to record the receipt of a capital contribution) has offsetting effects within the liabilities-and-equities section of the worksheet. Offsetting effects can also be observed for the cash dividend received on July 20 and the margin interest charged on July 31. Note that these last two transactions affect the second equity account, that is, the cumulative profits earned account. Transactions that represent items of revenue, expense, gain, or loss are reflected in the cumulative profits earned account, while transactions with the owner are reflected in the cumulative paid-in capital account.
The 300-share sale of ABC stock is recorded on the worksheet by reducing the cost of investment account by $14,436, reducing the margin liability account by $16,399 (the net proceeds on the sale), and increasing the cumulative profits earned account by $1,963 (the realized gain on the sale). Finally, the July 31 adjustment to the cost-to-market valuation account “marks to market” the investor’s holdings at period-end and records the unrealized holding gain or loss for the period. This step preserves the cost basis of investments to distinguish between realized and unrealized gains and losses, crucial for tax purposes. The calculation of the month-end adjustment to the cost-to-market account at July 31, 2002, is shown in Exhibit 5-C. Note that the amount of the end-of-month adjustment, $9,051, is entered on the portfolio worksheet by increasing both the cost-to-market account and the cumulative profits earned account. If the balance in the cost-to-market account decreases during the period, an unrealized holding loss is indicated. If the balance in the cost-to-market account is negative, unrealized depreciation exists.
Financial statements. Financial statements can be prepared directly from Exhibit 5-B’s worksheet. Three month-end statements are illustrated: a balance sheet, an income statement, and a statement of cumulative profits earned, which reconciles the beginning balance in the cumulative profits earned account on the income statement with the cumulative profits earned account on the balance sheet.
Example 3: Maintaining Subsidiary Cost-Detail Records and Calculating Realized Gains or Losses
The most intricate, error-prone part of a portfolio accounting system is calculating realized gains and losses and updating cost-detail records to reflect security sales, especially when a security has been purchased and sold in multiple lots and the quantities sold do not match quantities acquired in identifiable purchase lots. A set of subsidiary cost-detail records can effectively track the original acquisition cost of individual purchase lots, the cost of securities sold during the period, and the cost of individual purchase lots unsold at period end.
Recording purchases and handling splits. Exhibit 6-A illustrates how the cost-detail record for a purchase of 300 shares XYZ on September 2, 1999, for $24,628 and a purchase of 450 shares for $35,154 on April 20, 2000, would appear. Exhibit 6-A also shows the effect of a two-for-one split on March 1, 2000, and the recalculated cost-per-share for the lot after the split.
Determining cost of securities sold. In general, when a broker holds stock, taxpayers must use the FIFO (first-in, first-out) method to the determine cost of shares sold. A taxpayer may use the specific-identification method, however, if the securities sold are specifically identified. According to IRS Publication 550, Investment Income and Expense, a taxpayer will make an adequate identification if the broker holds the stock and the taxpayer “tell(s) the broker or other agent the particular stock to be sold or transferred at the time of the sale or transfer, and receive(s) written confirmation of this from [the] broker or other agent with[in] a reasonable period of time.” Specifically identifying the shares that produce the highest cost of securities sold (thereby producing the lowest realized gain) would encompass all 450 shares of the 4/20/00 purchase lot plus 350 shares from the 9/2/99 lot, for a total of $49,462.
Updating subsidiary cost-detail records and calculating realized gain or loss. Exhibit 6-B updates the cost-detail records to reflect the 800-share sale of XYZ; assuming FIFO, the sales proceeds were $73,888.
Exhibit 6-B has both a cost section, which is completed at the time of purchase, and a sale (or Schedule D) section, which is completed at the time of sale. The columnar headings for the sale-information section conform generally to Form 1040’s Schedule D, “Capital Gains and Losses.” Keeping the columns in this same sequence minimizes errors in preparing Schedule D, especially if portfolio records are maintained on a spreadsheet or manual accounting worksheet. Exhibit 6-B also reminds users that stock transactions are to be dated on Schedule D as of the trade date, not the settlement date.
The physical layout of the schedule in Exhibit 6-B is self-documenting, that is, it provides useful checks on the internal consistency and accuracy of purchase-lot calculations. A common weakness of informal approaches to cost-of-sales calculations is their tendency to erase or delete information on underlying schedules, thereby destroying the historical record of the sequence of transactions.
Exhibit 6-B also captures the complex layering that may be required for individual purchase lots, the diverse information that must be reported on Schedule D, and the cost of securities remaining in a portfolio as a direct consequence of the cost of securities previously deemed sold.
Summary schedules. An investor that has only a few stock positions or sales trades per year might calculate balances in the cost of investments account and realized gains or losses account directly from the subsidiary cost-detail records. As the scope of the investor’s activities increases, however, it is often useful to prepare separate summary schedules that link information on the subsidiary cost-detail records to the financial statement balances. Columnar headings for a summary schedule of investments might include: company name, symbol, shares held, total cost, total market value, and net unrealized appreciation (depreciation). In addition, it is a good idea to periodically compare the number of shares shown on the summary schedule to the number reported on the broker’s statement. This comparison may reveal unrecorded events (e.g., a stock split) or other inconsistencies.
To illustrate, suppose an investor maintains subsidiary cost-detail records on a computerized spreadsheet, and has about 10 stock positions, 50 individual purchase lots, and about three sales transactions per month. This investor should probably maintain a separate schedule of year-to-date realized gains and losses and should update the schedule on a monthly basis. On a quarterly basis, the investor might delete all purchase lots completely closed out during the quarter (and hence showing a zero balance on the left-hand side of the cost-detail file).
A “fresh-start” date for cost of investments. Under this approach, an investor would accumulate the actual cost of investments acquired after the fresh-start date, but assign a cost of zero to all security positions acquired before the fresh-start date. This approach would permit an investor to calculate correct amounts of unrealized holding gains and losses in periods when no securities were sold from the zero-basis portfolio.
Of course, when securities are sold from the zero-basis portfolio, the investor would have to determine the securities’ actual cost for tax purposes and adjust the underlying portfolio accounting records to reflect the transfer of securities between the two portfolios. The easiest way to reflect the transfer is to simultaneously increase the beginning-of-month balance in the cost of investments account and decrease the beginning-of-month balance in the cost-to-market account by the actual cost of securities sold during the month.
Income taxes. It is easy for investors to overrate the success of their investing activities if they only focus on pretax results and returns. The tendency is particularly prevalent among active investors, which tend over time to generate taxable realized gains, rather than the nontaxable holding gains that buy-and-hold investors generate.
Two basic issues are involved in accounting for income taxes for an individual investor: the estimation of income tax liabilities, and the settlement of estimated liabilities. In addition, the current liability on taxable income generated by the portfolio during the tax year (e.g., from dividends, net realized capital gains, net interest income) should be distinguished from the deferred liability for income taxes that would be payable on the unrealized appreciation of investments if sold.
To illustrate the estimation of income tax liabilities, consider a combined (federal and state) marginal income tax rate of 35% on ordinary income and 23% on net long-term capital gains and a portfolio that generated $10,000 of ordinary income in 2002, $15,000 of realized net long-term capital gains, and that has a $60,000 balance in the cost-to-market valuation account at December 31, 2002. The investor would record a current provision for income tax expense and a related liability for income taxes currently payable of $6,950 for 2002. The deferred tax liability of $13,800 at December 31, 2002, represents the capital gain taxes payable if all the securities were sold at December 31, 2002, market values.
View Exhibit 5-D for this article.
Robert H. Colson, PhD, CPA
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