Understanding Returns

Reporting

Understanding reporting responsibilities and potential reductions is critical when accounting for capital gains and losses in the securities market.

Securities to Report

Both organizations and individual investors trade a wide variety of financial securities to gain returns on these investments. Securities include exchanges involving:

• Debt securities, bonds, banknotes, debentures, etc.)
  
  
• Equity (mutual funds, stock, commodities, etc.)
  
  
• Derivatives (options, forwards, futures, swaps, etc.)
  
  

Stock Price Index Over Time The securities trading markets have appreciated substantially in recent times, making the scale of investments (and subsequent reporting) more important than ever.

The securities trading markets have appreciated substantially recently, making the scale of investments (and subsequent reporting) more important than ever.

When considering the returns derived from these various investments, organizations, and individuals must be aware of the reporting obligations in the country where those securities are traded. Organizations like the IRS have a wide variety of taxation requisites depending upon different investment situations, and understanding these regulations is critical to ethical trading and adherence to legalities.

Reporting Obligations

Capital Gains

Most commonly, reporting investments fall under reporting capital gains. Both organizations and individuals must report any and all capital gains within a given time period. These capital gains are profits derived from the sale of investments, which means that existing investments where capital is still tied to the underlying asset are not taxable (though they must be reported on the balance sheet for organizations as assets).

When profits from short-term investments are derived during an organization's taxation period, this profit is reported on the income statement and taxed accordingly. Capital gains taxes can differ based on the duration and type of investment made, but for the sake of this discussion, it is enough to understand that an existing investment is an asset on the balance sheet, and profit from the trade of an investment should be reported as profit (or loss) on the income statement.

Potential Reductions and Deferrals

As with most regulatory environments, it is not a one-size-fits-all model. There are various situations where capital gains taxes can be reduced through understanding the legislation and reporting accurately and strategically. A few examples of potential reductions or deferrals in capital gains reporting include:

• In some countries, specific industry investments receive tax breaks to stimulate economic growth. For example, an investment in new green technologies is often a source of potential tax breaks, as it benefits the broader economy and the world at large.
  
  
• Retirement investments are often tax-free (until withdrawn) to stimulate responsible saving and retirement planning. This allows companies to accumulate interest on what would've been taxable income until the capital is removed from the account.
  
  
• The sale of an asset at a loss is often tax-deductible, as are other capital losses.
  
  
• Donations of assets or capital to charity are tax deductible in most situations.
  
  
• Occasionally, the value of certain assets acquired will be reevaluated. In such situations, the difference between the original price and the new price may be a source of tax deduction.

While there are countless other small legislative items that may indicate tax implications on capital gains, this gives a reasonable overview of the types of considerations accountants make when considering capital gains.

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Dollar Returns

The dollar return of a security is the difference between the initial and ending value.

Finding the dollar return for securities that trade in open markets is a matter of finding the difference in price from year to year. For example, consider in which a $100 security earns a stated return of 5% per year. At the end of year one, it is worth $105, which is five more than $100 (its value at the beginning of year one), so the dollar return is $5. The capital value at the end of year two is $110.25, which is 5.25 more than at the end of year one and 10.25 more than at the beginning of year one. Therefore, the dollar gain is 10.25. This continues for each successive year.

Dollar Profit/(Loss) The dollar return is the difference in value from year to year, plus the previous dollar return.

The dollar return does not consider things like the time value of money or how much return is earned per year; it is simply the difference in nominal values. This means that dollar returns can provide an incomplete picture if used incorrectly.

For example, suppose an investor has two investment options, both promising a dollar return of $1,000,000. They cannot tell which option is better without knowing additional details, such as the risk or how long it will take to realize the returns. If the first option has a $1,000,000 return over two years and the other has a $1,000,000 return over 10 years, the first option is clearly more attractive.

Dollar returns are valuable for comparing the nominal differences in investments. If two investments have similar profiles (risk, duration, etc.), then dollar returns are a useful way to compare them. The investor will always choose the option with the higher dollar return.

Furthermore, the dollar return is useful because it provides an idea about how the assets of a firm will change. If a firm is looking for an additional $50,000 from investment, they will only accept investments with a $50,000 dollar return, regardless of the percent return.

Percentage Returns

Historical Returns: Market Variability and Volatility

Markets and securities may follow general trends, but exogenous factors (such as macroeconomic changes) cause variability and volatility.

Historical analysis of markets and specific securities is a useful tool for investors, but it does not predict the market's future. There are general trends and expectations of future behavior, but they are just generalizations. For example, the Dow Jones Industrial Average (DJIA) has generally followed an upward trend from 1900-2009. However, an investor who looked at this graph in early 1929 and decided to invest because s/he would be guaranteed to make money was in for a shock when the market crashed on October 29, 1929. Past performance is not a guarantee of future performance.

DJIA 1900-2009 The Dow Jones Industrial Average has generally increased overall since 1900, but its past performance is not a guarantee of future performance.

Inherent in all markets is something called "systemic risk." Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group, or component of a system. Macroeconomic forces, such as the Great Depression, affect the entire stock market and can't be predicted from past market performance. The failure of one company affects all the companies who purchase from it or sell to it, which in turn affects all the companies that rely on it. These types of interlinkages cause overall market variability and volatility.

Furthermore, market variability and volatility can cause what John Maynard Keynes called animal spirits. Animal spirits are the emotions felt by investors who affect markets. Investors' expectations affect how they act, which in turn affects the markets. If investors are feeling optimistic, for example, the market may go up, even without an improvement in the financials of the underlying companies.

Markets and stocks are affected by many factors beyond the information in their financial statements and past performance. Historical returns may provide an idea of the overall trend but certainly are not enough to accurately predict future performance.

Calculating and Understanding Average Returns

Average returns are commonly found using average ROI, CAGR, or IRR.

The average return on an investment can be calculated in several ways. The three main methods are

1. Return on investment (ROI)
   
   
2. Compound annual growth rate (CAGR)
   
   
3. Internal rate of return (IRR).

For all three methods, the higher the rate, the more desirable the investment.

Return on Investment (ROI)

To calculate the total return on investment (ROI), simply divide the total dollar returns of the investment by the initial value. The average ROI is the arithmetic average: divide the total ROI by the number of periods. If the purchase of a stock led to an ROI of 15% over five years, the average ROI is 3% per year. This is a simple way to calculate the average return.

It is useful for certain securities, such as bonds. If the only source of return on a bond is the coupon payments, then this is an accurate method. A bond purchased at par that pays a 5% coupon per year will return 25% over five years. However, this is a very special case. Average ROI generally does not calculate the actual average rate of return because it does not incorporate compounding returns. A stock that appreciates by 3% annually would not be worth 15% more over five years because the gains compound.

Compound Annual Growth Rate (CAGR)

The compound annual growth rate (CAGR) is calculated by the following formula where V_f is the future value, V_i is the initial value, and t is the number of years:

CAGR, unlike average ROI, does consider compounding returns. CAGR is derived from the compounding interest formula, FV=PV(1+i)^t, where PV is the initial value, FV is the future value, i is the interest rate, and t is the number of periods. The CAGR formula results when solving for i: the interest rate becomes CAGR, FV becomes V_f, PV becomes V_i, and the number of periods is generally assumed to be in years.

CAGR is very useful for finding the rate of return that the investment would have to earn every year for the life of the investment to turn the initial value into the future value over the given time frame.

Internal Rate of Return (IRR)

The internal rate of return (IRR) is another commonly used method for calculating the average return. IRR is the discount rate at which the net present value (NPV) equals 0. Using IRR allows for easy comparison between investment options. It is also known as the effective interest rate.

Internal Rate of Return The IRR is calculated by finding the discount rate at which the investment's NPV equals 0.