What is an Unrealized Loss?
An unrealized loss is a loss that results from holding onto an asset after it has decreased in price, rather than selling it and realizing the loss. An investor may prefer to let a loss go unrealized in the hope that the asset will eventually recover in price, thereby at least breaking even or posting a marginal profit. For tax purposes, a loss needs to be realized before it can be used to offset capital gains.
Understanding Unrealized Losses
An unrealized loss stems from a decline in value on a transaction that has not been completed yet. The entity or investor would not incur the loss unless they chose to close the deal or transaction while it is still in this state. For instance, while the shares in the above example remain unsold, the loss has not taken effect. It is only after the assets are transferred does that loss become substantiated. Waiting for the investment to recoup those declines could result in the unrealized loss being erased, or becoming a profit.
An unrealized loss can be calculated for a period of time. This may span from the date the assets were acquired to their most recent market value. An unrealized loss can also be calculated for specific periods to compare when the shares saw declines that brought their value below an earlier valuation.
The decision to sell an unprofitable asset that turns an unrealized loss into a realized loss may be a choice to prevent continued erosion of the shareholder’s overall portfolio. Such a choice might be made if there is no perceived possibility of the shares recovering. The sale of the assets is an attempt to recoup a portion of the initial investment since it may be unlikely that the stock will return to its earlier value. If a portfolio is more diversified, this may mitigate the impact if the unrealized gains from other assets exceed the accumulated unrealized losses.
- Unrealized losses are losses from holding onto an asset that has decreased in price but has not been sold.
- Unrealized losses turn into realized losses, when an asset is sold.
- Depending on the type of security, unrealized losses may or may not have an effect on a firm's accounting.
Unrealized Losses in Accounting
While unrealized losses are theoretical, they may be subject to different types of treatment depending on the type of security. Securities that are held to maturity have no net effect on a firm's finances and are, therefore, not recorded in its financial statements. The firm may decide to include a footnote mentioning them in the statements. Trading securities, however, are recorded in a balance sheet or income statement at their fair value. This is primarily because their value can increase or decrease a firm's profits or losses. Thus, unrealized losses can have a direct impact on a firm's earnings per share. But their effect on a firm's cash flow is neutral. Securities that are available for sale are also recorded in a firm's financial statement at fair value as assets.
Example of an Unrealized Loss
For example, assume an investor purchased 1,000 shares of Widget Co. at $10, and it subsequently traded down to a low of $6. The investor would have an unrealized loss of $4,000 at this point. If the stock subsequently rallies to $8, at which point the investor sells it, the realized loss would be $2,000. For tax purposes, the unrealized loss of $4,000 is of little significance, since it is merely a "paper" or theoretical loss; what matters is the realized loss of $2,000.