Paper Profit (Profit Loss)When profit isn't actual profit

Generating profit should be the primary purpose of forming and running a business.

So the higher the profit, the better, right?

Well, in general, it should be.

If the profit that appears on the income statement translates to actual cash inflow, there’s no issue.

But the thing is, there are ways to inflate the profit that you see on your business’s income statement.

By inflating, I mean that the profit figure might be more than what the business truly earned.

For example, the sales figure might be high, but about 80% of it is sales on credit.

This won’t be an issue if the business can collect a majority, if not all, of the credit sales.

But what if the business has a history of being only able to collect 10% from its credit sales?

The issue then is that there’s a disproportionate amount between profits and cash flow.

There’s also the cause of inflating a business’s value by way of recognizing what was meant to be unrealized gains or profit as actual profit.

For example, the value of an investment increases (as per its market value), but there’s no corresponding cash inflow.

In such a case, there is paper profit.

When the investment is sold, that’s that time when the paper profit becomes actual profit.

In this article, we will be learning about what paper profit is and what it means for your business.

Is it important for your business to keep track of it?

Read on to find out.

What is Paper Profit (Paper Loss)?

Paper profit is commonly referred to as unrealized gain (or unrealized loss for paper loss).

You “accumulate” paper profit when the value of an investment increases but there’s no corresponding cash inflow.

This usually happens when the current market value of the investment becomes greater than its purchase price.

In contrast, a paper loss occurs when the investment’s market value becomes lesser than its purchase price.

The reason why we call it “paper” profit is because the gain is only on paper.

There’s no actual cash inflow yet.

It only becomes actual profit when the investment is sold or when there is an actual cash inflow.

For example, you purchased 100 shares for $5 each, or a total of $500.

After a month, the value of the shares you purchased increased from $5 to $6 each, increasing the value of your investment by $100.

Great right? But such an increase in value is only paper profit.

The gain from the increase in value only becomes actual profit when you sell your investment.

We can also refer to paper profit (loss) as book profit (loss), or unrealized gain (loss).

Why Paper Profit Matters

While it’s exciting to see the value of investment go up, keep in mind that you’re not actually making a profit from the increase unless you sell it.

I think the saying “don’t count your chickens before they hatch” goes best when dealing with paper profit.

Until you sell your investment, any increase or decrease in its value shouldn’t be taken for actual profit or loss.

Putting too much value on paper profit can be dangerous.

Probably the most egregious example of this is when the dot-com bubble burst.

The dot-com bubble resulted in the creation of many paper millionaires – millionaires only on paper.

These paper millionaires “profited” from the hype, experiencing massive increases in the value of their stocks.

The problem is that they were restricted stocks, meaning that the paper millionaires cannot cash out on the increase in value.

When the dot-com bubble finally burst, many paper millionaires became broke.

Another example of relying on paper profit too much is when an investor successfully invests in a stock that is soaring in value.

The investor will feel great about the increase, and may even want more.

So the investor holds on to the investment despite hearing not-so-good news about the stock.

The value of the stock decreases, to the point that any paper profit that the investor had was now all gone.

The prospect of “earning” more paper profit blinded the investor from earning an actual profit.

The point here is that not dealing with paper profit properly can result in actual losses instead.

Keep in mind that paper profit is not yet actual profit until there is a cash inflow.

It’s better to look at it as the profit that you’ll actually earn when you do a certain action (e.g. selling your investment).

Should I Account for Paper Profit?

The short answer is yes.

You would want to account for paper profit (or loss) to keep track of your investment’s value.

Ideally, you want to cash out on your paper profit when it is at its peak. And for you to know that, you’ll need to monitor the value of your investment.

Accounting for paper profit (via unrealized gains or losses) gives you an amount of what you’ll be earning or losing when you actually sell your investment.

Do note that your actual profit or loss may not be the same as your recorded paper profit or loss.

This happens when you sell your investment for other than its market value.

Aside from that, keep in mind that you can always lose any paper profit that you accumulate.

Paper profit isn’t actual profit until you cash out on it after all.

On the other hand, you can also shake off any paper loss when the value of your investment bounces back up.

Paper Profit and Capital Gains Tax

Since paper profit isn’t actual profit yet, you don’t have to pay any capital gains tax on it.

You only pay capital gains tax when you actualize your paper profit.

This means that if you’re still holding on to your investment, any increase or decrease in its value won’t amount to any capital gains tax liability.

When you do decide to sell your asset, you should consider anything that can cut into your profit.

This includes any fees, taxes, and other charges.

Assess whether or not it’s still financially beneficial for you when you sell your investment.