When you purchase any type of investment, you hope to earn a profit or gain on your investment. When evaluating your assets, you consider what a specific investment has gained or lost to date. Generally accepted accounting practices (GAAP) require businesses to include this unrealized gain or loss information on the business’s financial statements.
What Is Unrealized Gain?
An unrealized gain is the potential profit you could realize by cashing in the investment. However, because you have not cashed in the investment, the gain is currently unrealized. An unrealized gain is also referred to as a paper profit because the gain is only theoretical until you sell the investment. Additionally, you do not pay taxes on an unrealized gain. However, a business can use unrealized gains as assets to increase creditworthiness.
Recording Unrealized Gain
If you have an unrealized gain or loss from an investment, you record the unrealized gain or loss as "accumulated other comprehensive income" in the owner’s equity section of the company’s balance sheet. This generally accepted recording method allows investors and other individuals evaluating a business’s financial statements to recognize that the gains or losses are unrealized at the current time.
The moment you sell an investment, the gain becomes realized. Once you realize the gain, you must pay taxes on the gain based on the length of time you held the investment and the amount of profit you earned from the sale. A business records the realized gain on the income statement as income. This income represents the capital gain made on the investment. The IRS imposes either a long-term or short-term capital gains tax based on the length of time you held the investment. If you owned the investment for less than a year, you will pay tax on the gain as regular income. If you held the investment for more than one year, you can pay the lower capital gains tax rate.
Unrealized and Realized Loss
You should record realized and unrealized losses in the same manner as realized and unrealized gains. As with gains, the losses do not become actual or realized until you sell the asset. Depending on your portfolio, income bracket and other criteria, you may have the ability to use a realized loss to reduce your tax liability by offsetting other types of income.
- CliffsNotes: Balance Sheet: Classification, Valuation
- "Principles of Finance"; Scott Besley and Eugene Brigham; 2008
- AccountingCoach: What is an Example of an Unrealized Gain?; Harold Averkamp
Brian Bass has written about accountancy-related topics and accounting trends for "Account Today." He works as a senior auditor specializing in manufacturing and financial services companies for one of the Big 5 accounting firms. Bass hold a master's degree in accounting from the University of Utah.