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Show Me the Money: Tallying Up Unrealized Gains

A Departing Member Triggers Balance Sheet Reconfigurations

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Several questions have come to me recently concerning the unrealized gain and undistributed earnings line on the balance sheet report. This line is composed of two items: A) unrealized gain and B) undistributed earnings. I’ll start with B first.

The undistributed earnings part is the sum of your current year’s income and expenses. It’s your profit or loss for the current year. It includes realized gains or losses from investment sales, dividends and all expenses. This part will contribute zero to the total of this balance sheet line after you allocate your earnings at the end of the year. Its contribution to club capital will be added to the line Capital Account-Members after the year-end allo­ca­tion of income.
The unrealized gain portion of this bal­ance sheet line comes from the withdrawal of members. It balances out the assets taken out of the club with the member capital account removed from the books by the withdrawal. It stems from the basic equation of double-entry accounting.

    That equation is:
    Assets = Equity (Capital) + Liabilities
Investment clubs generally have no liabilities, so the equation is simplified for clubs to:

    Assets = Equity (Capital)
The total equity for a club is the sum of the capital accounts for all the members. Assets are recorded at cost, not market value.

When a Member Takes Money Out

When a member withdraws, the assets removed from the club generally aren’t exactly the same as the equity removed. This is a consequence of a withdrawal being based on current market value and not cost basis, while the asset value on the books is cost-based. The unrealized gain line is a balancing account to keep the basic ac­count­ing equation balanced. The following example illustrates the concept:
Let’s assume you have a personal capital account of $1,000 in a club with total members’ capital of $10,000. If total capital is $10,000, total assets must also be $10,000. This would be the cost basis of the assets, not the market value.
Let’s also assume the value of your interest is now $2,000 and you receive this in cash when you withdraw.

    Before the withdrawal:
    Assets = Equity or $10,000 = $10,000

Following the Withdrawal

After the withdrawal, you’ve received $2,000 in cash, but your equity (capital) account could only go down by $1,000, the total amount of your capital account. The unrealized gain line is then used to decrease the equity side of the equation by the addi­tional $1,000. The assets (cash) fall by $2,000 and now the equity goes down by $2,000.
The equity decrease is accomplished by a $1,000 decline in your capital account and a $1,000 drop in the unrealized gain account. The balance sheet would then look something like this:

    Capital Account — Members $9,000    
    Unrlzed Gain and Undist Earnings: ($1,000)
    Total Equities: $8,000
If you had a loss instead of a gain, the unrealized gain line would be used to increase the equity part of the equation by adding to the total. Say your capital account was $2,000 and you received only $1,000. Your capital account should go to zero at full withdrawal so that it’s reduced by $2,000. But assets only went down by $1,000. To keep the basic equation balanced, the unrealized gain account has $1,000 added to the account.
Now both the asset side of equation and the equity side have decreased by $1,000. The balance sheet would look like this after such a withdrawal:

    Capital Account — Members $8,000    
    Unrlzed Gain and Undist Earnings: $1,000
    Total Equities: $9,000

This is done for every withdrawal. The unrealized gain on the report then becomes a record of all the gains and losses of withdrawn members. There’s another way to account for this, but it involves very complex calculations (similar to stock withdrawal calculations for cost basis to the withdrawn member) to adjust the cost basis of the stocks held instead of the capital account. You must make a special election with the IRS to do this, and once started it cannot be stopped without IRS permission.

Russell Malley is the Club Accounting Adviser for ICLUBcentral.

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