An investment is something that you purchase in the hopes of
generating income, or that you hope to sell in the future for more than
you paid. Using this simple definition, many things could be considered
investments: the house you live in, a valuable painting, stocks in
publicly traded companies, your savings account at the bank, or a
certificate of deposit. These many types of investments will be discussed
in this chapter in terms of how to track them using
Before discussing investments specifically, it will be helpful to present a glossary of investment terminology. The terms presented below represent some of the basic concepts of investing. It is a good idea to become familiar with these terms, or at least, refer back to this list if you encounter an unfamiliar word in the later sections.
Capital gains is the difference between the purchase and selling prices of an investment. If the selling price is lower than the purchase price, this is called a capital loss. Also known as realized gain/loss.
Commission is the fee you pay to a broker to buy or sell securities.
Common stock is a security that represents a certain fractional ownership of a company. This is what you buy when you “buy stock” in a company on the open market. This is also sometimes known as capital stock.
Compounding is the concept that the reinvested interest can later earn interest of its own (interest on interest). This is often referred to as compound interest.
Dividends are cash payments a company makes to shareholders. The amount of this payment is usually determined as some amount of the profits of the company. Note that not all common stocks give dividends.
Equities are investments in which the investor becomes part (or whole) owner in something. This includes common stock in a company, or real estate.
Interest is what a borrower pays a lender for the use of their money. Normally, this is expressed in terms of a percentage of the principal per year. For example, a savings account with 1% interest (you are the lender, the bank is the borrower) will pay you $1 for every $100 you keep there per year.
Liquidity is a measure of how easily convertible an investment is to cash. Money in a savings account is very liquid, while money invested in a house has low liquidity because it takes time to sell a house.
Principal is the original amount of money invested or borrowed.
Realized vs Unrealized Gain/Loss, unrealized gain or loss occurs when you’ve got a change in price of an asset. You realize the gain/loss when you actually sell the asset. See also capital gain/loss.
Return is the total income plus capital gains or losses of an investment. See also Yield.
Risk is the probability that the return on investment is different from what was expected. Investments are often grouped on a scale from low risk (savings account, government bonds) to high risk (common stock, junk bonds). As a general rule of thumb, the higher the risk the higher the possible return.
Shareholder is a person who holds common stock in a company.
Stock split occurs when a company offers to issue some additional multiple of shares for each existing stock. For example, a “2 for 1” stock split means that if you own 100 shares of a stock, you will receive an additional 100 at no cost to you. The unit price of the shares will be adjusted so there is no net change in the value, so in this example the price per share will be halved.
Valuation is the process of determining the market value or the price the investment would sell at in a “reasonable time frame”.
Yield is a measure of the amount of money you earn from an investment (IE: how much income you receive from the investment). Typically this is reported as a percentage of the principal amount. Yield does not include capital gains or loses (see Return). Eg: A stock sells for $100 and gives $2 in dividends per year has a yield of 2%.
Below is presented some of the broad types of investments available, and examples of each type.
Interest-bearing account or instrument
This type of investment usually allows you immediate access to your money, and will typically pay you interest every month based on the amount of money you have deposited. Examples are bank savings accounts (and some interest bearing checking accounts) and cash accounts at your brokerage. This is a very low risk investment, in the US these accounts are often insured against loss, to a specified limit.
Sometimes an interest bearing investment is time-locked. This type of investment requires you to commit your money to be invested for a given period of time for which you receive a set rate of return. Usually, the longer you commit the higher the interest rates. If you withdraw your money before the maturity date, you will usually have to pay an early withdrawal penalty. This is a relatively lower risk investment. Examples are certificates of deposit or some government bonds. Other types of Bonds may have higher yields based on the higher risks from the quality of the issuer’s “credit rating”.
Stocks and Mutual Funds
This is an investment you make in a company, in which you effectively become a part owner. There is usually no time lock on publicly traded stock, however there may be changes in the tax rates you pay on capital gains depending on how long you hold the stock. Thus, stocks are typically quite liquid, you can access your money relatively quickly. This investment is a higher risk, as you have no guarantee on the future price of a stock.
A mutual fund is a group investment mechanism in which you can buy into many stocks simultaneously. For example, a "S&P 500 index fund" is a fund which purchases all 500 stocks listed in the Standard and Poor’s index. When you buy a share of this fund, you are really buying a small amount of each of the 500 stocks contained within the fund. Mutual funds are treated exactly like a single stock, both for tax purposes and in accounting.
Assets that increase in value over time are another form of investment. Examples include a house, a plot of land, or a valuable painting. This type of investment is very difficult to determine the value of until you sell it. The tax implications of selling these items is varied, depending on the item. For example, you may have tax relief from selling a house if it is your primary residence, but may would not receive this tax break on an expensive painting.
Fixed asset investments are discussed in Chapter 9, Capital Gains and Chapter 11, Depreciation. Typically, there is not much to do in terms of accounting for fixed asset investments except recording the buying and selling transactions.