Portfolio Accounting

Portfolio Accounting

A basic understanding of 'portfolio accounting' is necessary when wanting to calculate returns. Portfolio accounting is also very important when it comes to dealing with derivatives. Most of what will follow in this subchapter looks trivial, but can give one or two headaches in practical applications.
'Portfolio accounting' is about recording, classifying, and summarizing financial events that affect an investment portfolio.

Portfolio Definition

Although it might sound trivial, the definition of individual 'portfolios' isn't always that straight-forward in practice.
We shall define a 'portfolio' as an abstract accounting entity including at least one security and one cash account. The term 'abstract' merely points to the fact that this definition does not necessarily correspond to 'real-world' accounting entities.

Basic Relationships

The relationships below are expressed on a "net" basis (net of transactions costs, fees & withholdings taxes).
Ending Market Value = Beginning Market Value
                                     + Net Contributions
                                     + Gains&Losses
Net Contributions = Contributions - Withdrawals
G&L = Income
           + Net Capital Gains&Losses
Net Capital Gains&Losses = Sales - Purchases
                                             + Ending Market Value Securities
                                             - Beginning Market Value Securities
Ending Cash Balance = Net Contributions + Income + Sales -Purchases
Note that for return calculation purposes, "gains and losses" are defined on a 'beginning-of-calculation-period market value basis', and not on a 'cost basis' as in an accounting context. The differences between the two concepts of "gains and losses" are...
  • Valuation: Accounting G&L are calculated based on cost prices at the time each security was purchased. When calculating investment returns, all securities are considered at theirmarket prices.
  • Time Period: In calculating accounting G&L, the holding period of securities are relevant (because different holdings periods are mixed, an inventory model such as LIFO has to be specified additionally. The calculation of investment returns refers to a specific calendar period (for example, "monthly")and stocks and flows during this period only are relevant.
The further decomposition of "net gains and losses" in "realized" and "realized" components is not of particular interest for return calculation purposes. The only thing to remeber is not to include 'realized gains & losses' as 'income' when calculating investment returns: As realized gains & losses are reinvested, this would result in double-counting and therefore distortion of investment returns.
Market values must be calculated including accruals.
The above portfolio accouting realtionships can be illustrated graphically...

Click here for a large version of the above chart.

Market Valuation

Portfolios are valued at market prices ('Mark-to-Market').
Accruals should be reflected in market prices whenever possible. Accrual accounting is a must for fixed-income securities, but typically rather unimportant in the context of dividends on equity. Dividends are not payable unless the stock was owned on the record date, so dividends are accrued as income on valuation dates  from the ex-dividend date up to the payable date trade.
Valuation issues are a very important, but often neglected issue in return calcuation and therefore in investment performance analysis: 'garbage in, garbage out'.
Mark-to-Market versus Mark-To-Model, Mark-to-Market versus OTC...
For illiquid instruments, there is no market price available and MTM can become a serious problem. The choice of valuation model is very often under the control of asset managers. They can therefore take advantage to manipulate the prices so as to smooth the portfolio returns. If this is the case, the auto-correlation coefficient of the portfolio return series will be significant. As a result, volatility of returns (=risk) will be underestimated as well as the correlation of the fund with peer products or the benchmark. The diversification benefits of the portfolio to the investor will therefore be overestimated.

Cash Flows

Income (dividends, coupons) is included in return calculations if income is re-invested. Income is an internal cash flow. Selling/buying securities also generates internal cash flows (transfer of value from securities to cash account or vice versa)
Contributions and withdrawals are external cash flows. For convenience reasons, we use the summary term 'net contributions', defined as contributions minus withdrawals.
Some authors use the term 'cash flow' instead of net contributions. This can easily lead to confusion when mixing up internal with external 'cash flows'. We strongly recommend avoiding the term 'cash flow' in the context of return calcuations and substitute it with the relevant conpcets directly (income, contributions etc.)
Besides actual client orders, there exist other external cash flows (especially withholding taxes, fees). When presenting net contributions, customer orders and other external cash flows should be reported as separate line items.


Terminology: 'after-tax' and 'before-tax' returns.
Difficult to generalize since tax rates are customer specific.
In the context of a specific portfolio, returns are normally stated on a 'before-tax' basis, where values are not subject to any deductions in respect of tax (whether incurred or not). Any payments to the tax office out of the portfolio are then treated as a withdrawal of funds. When calculating returns after taxes, tax payments outside the portfolio have to considered as contributions.
Reclaimable (withholding) taxes versus non-reclaimable taxes: any reclaimable taxes payed have to be consdiered as withdrawals. Reclaimable taxes received are contributions.


Investment fee structures differ significantly across countries and products. In a universal bank setting, for example, investors might use one bank for all investment management services. Such full-service providing banks might work with cross-funded (subsidized) fees, partially bundled or summed up to an all-inclusive fee (also known as wrap account programs). In the case of a wrap account, 'net-of-fee performance' would mean a net-of-management-and-brokerage/custody-fee performance while in a difference setting, 'net-of-fee performance' is understood as net ofmanagement fees only.
Such differences complicate net-of-fee performance calculations considerably and also affect comparability of returns within a company (aggregating different types of clients and accounts to composites) and between different asset management firms.
Another issue in reporting net returns is that a presented net-return might not be achieved by all clients due to differences in characteristics (volume) or simply bargaining power.
Brokerage Commission Costs are usually added to the purchase cost and subtracted from sales proceeds for both gross- and net-of-fee return calculations
Custodial Fees are typically not deducted from either gross or net performance and are treated as a withdrawal. This is justified when the costs are beyond the control of the investment manager.
Management Fees and other charges for advisory services provided by the asset manager are usually charged to the portfolio. These charges are treated as withdrawals in the calculation of 'gross-of-fees returns' (=before deduction of fees charged).  The same withdrawals are excluded in the calculation of a net-of-fees return (=after the deduction of fees charged). Management fees can also be charged outside the portfolio. It is important to include fees charged are in the calculation of net- and gross-of-fees returns. When fees have been paid from outside the fund, they are excluded from calculations when a gross of fees return is required.  They are treated as a contribution to the portfolio when a net of fees return is required.
To avoid distortions and "jumps", fees payed out of the portfolio should be "accrued"  whenever possible.
If fees are calculated as a percentage of average capital invested, the calculation methodology for average captial invested should be specified as detailed as possible.

Transaction Costs

Transaction costs are usually deducted: securities at 'cost prices'.
Often neglected, source of return, quality indicator for operationally efficient investment management.

Exchange Rates

Portfolio base currency, security currency, currency overlays, currency fowards.
Consistency is oftenan issue: consistency not only within portfolio, but also when benchmarks and other entities the portfolio is compared with are involved.
Data source for exchange rates used should always be disclosed.