If your small business has some excess cash, you might invest it in stocks, bonds or other securities. An unrealized gain occurs when the value of an investment you own rises. The "unrealized" part means that the gain occurs only on paper and has yet to be recognized by selling the investment. How you report an unrealized gain depends on how you classify the investment on your balance sheet. Only some unrealized gains are reported on the income statement and increase your net income, or profit.
A business categorizes an investment on the balance sheet based on its reason for buying it, among other factors. When a company buys an investment that it intends to sell in the near future, it classifies it as a trading security. This is one of two categories in which unrealized gains can occur. Unrealized gains on trading securities are reported on the income statement and increase net income. For example, if your small business buys stock that you expect to sell within a month, you would categorize it as a trading security.
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Figuring Unrealized Gains on Trading Securities
An unrealized gain equals an investment's market value at the end of an accounting period minus its market value at the end of the previous period. If the end-of-period value is less than the previous value, you get an unrealized loss. The market value equals the market price per share, or unit, times the number of shares you own. If you bought the investment more recently than the end of the last period, use the purchase price instead of the value at the end of the last period.
Unrealized Gain Calculation Example
Assume your small business bought 500 shares of stock during the quarter for $20 per share that you classify as a trading security.
Assume the shares increase to $22 at the end of the period. The initial purchase price equals $10,000, or 500 times $20. The value at the end of the quarter equals $11,000, or 500 times $22.
Your unrealized gain equals $1,000, or $11,000 minus $10,000. Because this is a trading security, you would report a $1,000 unrealized gain on the income statement, which increases net income by $1,000.
The second category in which unrealized gains occur is called available-for-sale securities. A company uses a process of elimination to place investments in this category. If a business buys an investment and doesn't plan to sell it soon, doesn't intend to hold it until it matures -- such as a bond -- and the investment makes up less than 20 percent of another company's outstanding stock, it classifies the investment as an available-for-sale security. An example of an available-for-sale security is a stock that you plan to hold long term.
Accumulated Other Comprehensive Income
A business calculates an unrealized gain on available-for-sale securities the same as it does for trading securities, but it records the unrealized gain in the stockholders' equity section of the balance sheet on a line called "accumulated other comprehensive income." This income increases stockholders' equity directly without affecting net income on the income statement or retained earnings on the balance sheet. For example, if your small business has a $5,000 unrealized gain on an available-for-sale security, you would add $5,000 to the accumulated other comprehensive income account.