Accounting Methods for Investments

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Accounting Methods for Investments

Different asset classes have different ways to account for the value of their assets. Since any asset may be put to several uses, it is important to use perspective in deciding how the investor intends to use that asset. For example, silver may be used by an electronics manufacturer, in which case it is an asset used in production. For a speculator, the silver is primarily held as a hedge against inflation and would be used in safekeeping in a commodities account. It is the use of an asset that gives it different values that the market is constantly trying to re-evaluate in light of changing economic circumstances.

  1. Mark-to-Market: Calculating Profit or Loss

    • The most important financial accounting technique is the mark-to-market, which immediately tells the investor whether he has a profit or loss on his investment. Mark to market is basic: you look at the last trade in a security and assume the next trade will be close to the same value. Investors risk the possibility of market news changing the worth of the asset. Most importantly with mark-to-market accounting is the immediate snapshot of profitability it gives.

    Mark to Model Accounting

    • Mark to market presumes investments that trade regularly and are fungible or interchangeable. For assets that do not trade regularly, mark to model or a theoretical value is worked up by using different scenarios of valuation. Much risk premium must be added for the uncertainty of using such a model. The logic for the model might be outdated or just plain wrong. Particular concern must be given if the investment is unique and the model was written for that particular investment. Mortgage-backed securities were commonly priced this way, leading to the financial debacle of 2007 and the following recession.

    Accrual Accounting: Accounting for Investment Cashflows

    • Investors looking at balance sheets of companies are constantly faced with a statement of values, when, in fact, the values are predicated on events that may not have yet occurred. For example, a sale, and therefore revenue, is realized when a customer makes a deposit on an equipment order. If that order is later withdrawn due to poor economic conditions, inability to pay by the customer or misstatement of product specifications by the manufacturer, the sales, profit and cash must be restated. Accrual accounting reflects the difference between when a sale is made and the receipt of the cash payment. Accrual accounting is a basic concept of balance sheet analysis.

    Risk-Based Accounting for Fixed Income

    • Accounting for bonds goes beyond their value on a particular date. Variations in credit or changing interest rates both affect bond values. In addition, mandatory calls or optional calls can affect price. Accounting procedures exist that stress test the value of bonds. These procedures vary interest rates of individual securities and the relationship of interest rates along the yield curve. Results are then tested, measured and blended by statistical measures into a worst case scenario.

    Cost Accounting for Investments

    • Cost accounting is the most technical of all accounting techniques used in business, yet its misapplication can lead to catastrophic mistakes. Cost accounting refers to the allocation of costs in the production of assets. Cost accounting can be as simple as deciding how long amortization should take in order to depreciate assets or whether a new building should be charged to one department who will occupy it or the company at large. The result can be to make a particular department, product or company appear to be more or less profitable than it really is. It is in the footnotes of a company balance sheet that details the cost accounting process in use.

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