Definition
Realized profit or loss occurs when a transaction is completed, typically when goods, services, or assets are sold and legally disposed of. In accounting, the profit or loss is considered realized when the ownership of the asset is transferred, rather than when the cash is received. This can occur even if the transaction was executed on credit, as the disposed asset is exchanged for another asset – the debtor.
Examples
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Sale of Goods: A retailer sells inventory worth $10,000 for $15,000. The $5,000 difference is considered realized profit when the sale is confirmed, even if the payment is delayed.
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Asset Disposal: A company sells a piece of machinery worth $50,000 for $40,000. The $10,000 difference is a realized loss when the machinery is legally transferred to the buyer.
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Stock Sale: An investor sells shares purchased at $20,000 for $30,000. The $10,000 profit is realized once the shares are sold, even if the payment is received later.
Frequently Asked Questions
What is the difference between realized and unrealized profit/loss?
Realized profit/loss is generated from completed transactions where ownership has been transferred. Unrealized profit/loss refers to potential gains or losses from holding assets that have not yet been sold.
How does realized profit affect financial statements?
Realized profits increase the company’s net income, enhancing the earnings reported on the income statement, and subsequently increasing retained earnings on the balance sheet. Realized losses have the opposite effect.
Can realized profit be reversed?
No, once profit or loss is realized, it is final. However, subsequent changes in the debtor’s ability to pay might affect future accounting periods through bad debt expense adjustments.
How is realized loss handled for tax purposes?
Realized loss can often be deducted from taxable income, reducing the tax burden. However, tax regulations about realized losses can vary by jurisdiction.
Paper Profit
Paper Profit is a potential profit that exists on paper due to the appreciation of an asset that has not yet been sold. Paper profits become realized profits when the asset is sold.
Unrealized Gain/Loss
Unrealized Gain/Loss refers to the increase or decrease in value of an asset that has not yet been sold. These are not recognized on the income statement but may be disclosed in the notes to the financial statements.
Online References
- Investopedia - Realized Gain/Loss
- AccountingTools - Difference between Realized and Unrealized Gains
Suggested Books for Further Studies
- “Financial Accounting: An Introduction” by Pauline Weetman
- “Accounting and Finance for Non-Specialists” by Peter Atrill and Eddie McLaney
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
Accounting Basics: “Realized Profit/Loss” Fundamentals Quiz
### When is profit generally regarded as 'realized' in accounting?
- [ ] When cash is received.
- [ ] When goods are produced.
- [x] When an asset is legally disposed of.
- [ ] When the invoice is issued.
> **Explanation:** Profit is considered realized when an asset is legally disposed of, regardless of whether cash has been received. The exchange of the asset creates a new asset in the form of a debtor if sold on credit.
### Which type of transaction results in a realized profit or loss?
- [x] Completed sale of an asset.
- [ ] Issuance of shares.
- [ ] Increase in stock value.
- [ ] Purchase of inventory.
> **Explanation:** A completed sale where the ownership of the asset is transferred results in a realized profit or loss.
### Can profit be realized if the sale is made on credit?
- [x] Yes, it can be realized.
- [ ] No, it can't be realized until payment is received.
- [ ] Only if a deposit is made.
- [ ] Only if it’s fully prepaid.
> **Explanation:** Profit can be realized when an asset is sold on credit. The asset's disposal is exchanged for another asset, a debtor.
### How does a realized loss appear in financial statements?
- [ ] Increases net income.
- [ ] Decreases liabilities.
- [x] Decreases net income.
- [ ] Increases cash balance.
> **Explanation:** Realized losses decrease net income, reducing earnings reported on the income statement.
### What term describes profit on paper due to asset appreciation but not yet sold?
- [x] Paper Profit
- [ ] Realized Profit
- [ ] Deferred Profit
- [ ] Accumulated Profit
> **Explanation:** Paper profit refers to gain in value that exists only on paper due to asset appreciation that hasn't been realized through a sale.
### What differentiates a realized gain from an unrealized gain?
- [x] Ownership transfer occurs.
- [ ] Tax is applied.
- [ ] Only legal if paid in cash.
- [ ] Regulated by department policies.
> **Explanation:** Realized gain occurs when ownership is transferred, whereas unrealized gain occurs from changes in asset value without asset disposal.
### What type of expense is recognized if a debtor cannot pay their dues?
- [ ] Operating expense.
- [ ] Capital expense.
- [x] Bad debt expense.
- [ ] Deferred revenue.
> **Explanation:** If a debtor cannot pay, the company records a bad debt expense, adjusting for the non-collectible amount.
### What impacts net income more immediately, realized or unrealized profit?
- [x] Realized Profit
- [ ] Unrealized Profit
- [ ] Not applicable
- [ ] Both equally
> **Explanation:** Realized profit impacts net income immediately since they result from completed transactions and affect current earnings.
### For tax reporting, what must businesses sometimes adjust for realized transactions?
- [x] Deductions for losses.
- [ ] Inventory counts.
- [ ] Deferred revenue.
- [x] Partial payments.
> **Explanation:** For tax reporting, businesses may adjust for deductions for losses and partial payments to correctly report taxable income.
### In asset sales, what typically alternates with the sold asset?
- [ ] Shares.
- [x] Debtor.
- [ ] Liability.
- [ ] Prepaid account.
> **Explanation:** When an asset is sold, typically on credit, the sold asset is alternated by creating a debtor who owes the payment.
Thank you for studying the realized profit and loss term with us and tackling our detailed sample exam questions. Keep enhancing your knowledge in accounting and finance!
