A colleague recently passed me a question that was sent to him: what is the proper treatment of class action settlement proceeds from securities-related lawsuits or bankruptcies, which are then deposited into an investment portfolio.

You may have encountered this yourself. When a firm goes into default on their bonds, the bondholders are left wondering if they’ll ever see any money flow their way again. And at times, lawsuits are filed. Sometimes it takes years before a payment arrives. But when it does, how do you treat it?

First, do you treat it as an accrual? No, since there was no anticipation of any payment. Accruals should only be applied when there is a high degree of confidence or probability that a payment will be made. Once a bond goes into default, “all bets are off.”

Second, is it income or a cash flow? Here, I think the answer is an “it depends.” Technically, it’s income. However, what if the bond was purchased by a prior asset manager, and your firm had no involvement in it at all. Because it’s the same custodian, the income comes in and gets passed to you. For you to treat it as income would, I believe, be improper; for you, it’s a cash flow. But if you were the manager who made the decision to purchase the bonds, then it’s your income.

I hope this makes sense. Please comment if you have further thoughts or ideas you wish to share.