Realized Loss
Losses incurred when an asset is sold less than its original acquisition value.
What Is A Realized Loss?
Realized losses are losses incurred when an asset is sold for a monetary value in the current market condition (market price) that is less than its original acquisition value (book value).
Have you ever wondered why you can’t sell a product you recently acquired from a vendor, realizing it is not much use to you better make a buck out of it? And then you are forced to set a price below what you initially purchased since the competition is tough out there?
“Yup, congrats, you just realized you have made a loss!” Oh God, anyway, Dad jokes apart. We know it sucks, but that is exactly what a realized loss is in a nutshell. Anyone who sold anything at any time would have experienced this at least once in their lifetime.
Knowing what realized or unrealized loss and gain mean makes a huge difference for not just the company but anyone related to that company, be it internal or external, a shareholder or a stakeholder. Either way, it indirectly affects everyone.
Be it realized or unrealized, it has a direct influence on the decision-making process. So, shall we indulge in getting to know more about what realized loss is? I take that as a yes. Well then, let us understand further what it means to realize loss (or gain).
Key Takeaway
- A realized loss occurs when you sell an asset for less than its original purchase price due to market competition, and it can be a common experience for anyone who has sold something.
- Realized losses differ from unrealized losses, only reflected on paper. The true realization of a loss happens when an asset is sold for less than its carrying value (also known as book value) in this context.
- Losses that are realized have practical applications, such as reducing tax liabilities by offsetting capital gains. This can be beneficial for businesses during tax filing seasons.
- Realized losses can occur when assets are sold, donated, scrapped, or otherwise removed from a company's books at a value below their original cost, affecting the company's financial statements and tax obligations.
Understanding Realized Loss
Capital losses occur in many forms depending upon the nature of the loss incurred. Such losses can be on a short-term basis, which can be less than a year, while some can be on a long-term basis, which can be more than a year.
Realized losses are those incurred losses from a transaction that yielded a market value much lower than the original value of the commodity acquired. A transaction is realized when the asset is sold successfully at a fair value in the market.
But the determining factor, whether the realized transaction is a loss or a gain, is when the asset's fair market value is compared to its original purchase value (book value). In a nutshell, a realized loss occurs when the sale price of the sold asset is lower than its carrying value.
"But why should a business spend their productive time determining what is realized and unrealized losses?" we hear you say.
Well, an unrealized loss is just a loss of value that is shown on the paper. Meanwhile, realized losses have useful, practical implications, especially for tax.
Realized losses allow companies to be deemed eligible for tax reductions/tax credits for the incurred realized losses, which reduce the current year’s taxable amount by carrying it forward to future years, offsetting future gains.
Due to this, companies take tax reduction tactics such as tax-loss harvesting to reduce the tax burden and even consider realized losses as a viable strategy to reduce tax by maintaining it at a safe level.
Note
Tax-loss harvesting is a strategy used by companies to lower the tax burden on realized losses by replacing low-performing assets with similar assets, thereby offsetting realized gains for the realized loss that may have exceeded the tax bracket. Any remaining losses can be carried forward to future years.
Real-World Application Of Realized Loss For Businesses
Now that we've explored the concept of realized losses, let's delve into a real-life application of realized loss to better understand its implications for businesses.
Suppose a US-based medium-sized retail company, Everyday Co., has stores across 15 locations in the US. Two of its stores are located in an industrial area that does not have much of a population.
Everyday Co decided to establish there due to an expectation that the population would thrive in the region in upcoming years due to factories relocating and expecting suburban construction and settlement.
Unfortunately, this expectation did not materialize, resulting in annual loss over the past five years. The expectation came with a huge price tag as the two hypermarkets the company bought cost $120,000 and $140,000, respectively. Due to this, Everyday Co. decided to scrap the store in that locality.
Unfortunately, the company realized a loss of $55,000 after the deduction of $120,000 purchase cost, with revenue from the sale of the first store amounting to $65,000.
But when the second store was sold for $187,000, after deducting the $140,000 acquisition cost, the company realized a whopping $47,000 in gain.
When the tax filing season comes, Everyday Co. is mandated by law, just like everyone, to pay the taxable amount to the tax authority, i.e., the IRS in the US, to avoid getting fined or backlisted, which can heavily hinder the reputation of the company.
The company is now eligible for tax reduction for the loss made from the sale of two stores. Why? We hear you say. Well, Everyday Co has incurred both the realized loss and realized gain; it has incurred a loss from total sales ($2,000), from which tax reductions were made possible.
If the incurred loss or gain was not realized and shown, the estimated loss on the resale value, i.e., the sale did not occur. Then, these assets cannot be used for tax reductions, and the company must pay the obligatory tax amount to the IRS.
Realized Loss FAQs
A realized loss is those losses incurred from selling an asset at market value, which is below its book value. In contrast, unrealized losses are those expected to incur if such a sale were to occur at the market value.
A realized loss occurs for an asset or security when sold at a market value that is less than its carrying amount. Thus, it incurs a loss on the sale of the asset.
Realized losses and gains are recorded in the Income statement. Since the realized losses and gains deal from an occurred and recognized transaction, they need to be reported in the income statement, addressing the effect of the transaction that has taken place.
The unrealized losses and gains are recorded in the Balance Sheet in the accumulated other comprehensive income under the owner’s equity section, as it deals with future-based expectations on possible gains or losses.
A realized loss is an expense for an enterprise from the trade. Therefore, any expense increase is to be debited, and any decrease in assets is to be credited. Therefore, the realized loss is a debit and credit the Fair value adjustment.
Not necessarily, as companies incurring losses that are realized in nature do pose an advantage, which any strategist might exploit the opportunity, namely, tax reductions; generally, any company that incurs a realized loss receives tax deductions from the tax authorities, as tax is generally implied on taxable gains (the progressive tax system).
Therefore, incurring loss results in reductions from taxation, which many companies take advantage of by engaging in tax reduction strategies such as tax-loss harvest.
Researched and authored by Muhammed Ishfaque Ishaque | LinkedIn
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