Series 7

By Investopedia AAA

Equities - Determining Gains and Losses

At this point, the sensible investor may pause amid the complexity and wonder, "How do I know if I'm getting rich?" The answer lies in a comparison of what he paid for his investments and what their current market value is, but this is actually harder to determine than you might think. It is not always easy to figure out exactly how much you spent on a particular security.

When-issued Securities
Let's say you bought 800 shares of Descartes Corporation common shares at $10 six months ago. The price shot up quickly, and it looked like there was no end in sight. Three months later you bought another 200 shares at $18. But this past month, as the share price stalled out at $20, you figured the rocket ride was over and Descartes stock had a lot more downside potential than upside, so you sold 500 of your 1,000 shares and kept the rest because you still believe that Descartes has strong long-term potential.

How much did you make?

Well, you clearly sold your holdings for $10,000 ($20 x 500 shares), but how much of a gain did you realize?
A share is a commodity. That is, one share is completely indistinguishable from any other share of the same issue. So did you sell 500 of the first 800 shares, or did you sell the 200 shares you bought most recently plus 300 of the first 800?

Your gain or loss will depend on the accounting treatment you choose to apply to selling a partial position. The first scenario would be an example of the treatment called First In, First Out or, FIFO. The second is called Last In, First Out, or LIFO.

  • Under FIFO, you sold the first shares you bought, the ones at $10, so your cost for these shares was $5,000 ($10 x 500 shares). Subtract that from your $10,000 selling price, and you made $5,000.

  • Under LIFO, you sold the last shares you bought, the ones at $18. But wait, you only have 200 of those. Your cost for those 200 shares is $3,600 ($18 x 200 shares). Your cost for the other 300 you sold is $3,000 ($10 x 300 shares). Combined, then, your LIFO-calculated investment is $6,600 ($3,600 + $3,000). Subtract that from your $10,000 selling price, and you made $3,400.

In this example, this simple difference in inventory accounting caused a difference of $1,600; the FIFO calculation, in other words, was almost half the LIFO calculation. If you did this enough times throughout the year, it would make a significant difference in how much taxable revenue from capital gains your client would have to report. As you can see, LIFO accounting is better for the client - for tax purposes, if not for bragging rights - in a rising market.

Specific Shares Method
Another option, one that usually requires much more bookkeeping, is identifying specific shares by registration number when buying and selling. This is rarely done, but it is legal, and the Series 7 exam taker needs to be aware of it.

Gifted Securities
Securities given as gifts or bequests are to be valued by the donor at the market value on the day of the transfer. To the recipient this could well be taxable income, and she should value it as if she purchased it for $0.

Shares from Conversion
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