Companies naturally focus on liabilities and losses at year end, but potential gains can also create accounting issues. A contingent asset may arise when a company expects to receive an economic benefit from an uncertain future event, including an insurance claim, legal claim against a third party, compensation dispute, tax recovery or claim arising from a contractual breach.
Management should exercise caution before recognising any such amount as an asset or income because premature recognition can overstate profit and net assets. Before closing the books, finance teams should identify material claims and potential recoveries, assess the degree of certainty surrounding them and determine whether recognition or disclosure is appropriate.
Apply the recognition threshold carefully
For Hong Kong companies applying full HKFRS Accounting Standards, HKAS 37 Provisions, Contingent Liabilities and Contingent Assets provides the relevant principle. A contingent asset is not recognised while the inflow remains uncertain; where an inflow of economic benefits is probable, disclosure may be required, while recognition is appropriate only when the inflow becomes virtually certain.
The conclusion should be based on the status of the claim and the evidence available at the reporting date. Management confidence, even when strongly held, is not a substitute for objective evidence that the applicable recognition criteria have been met.
Examine insurance claims beyond submission
The fact that an insurance claim has been lodged does not automatically support recognition of an insurance receivable. Management should consider whether the insurer has accepted liability, whether the amount has been agreed, whether further documents or investigation are required and whether any significant uncertainty remains.
The year-end assessment should be supported by the insurance policy, correspondence with the insurer, claim calculations and other relevant records. Where material questions remain unresolved, the accounting treatment should reflect that uncertainty rather than the amount management hopes to recover.
Assess legal claims and tax recoveries at their current stage
A company involved in litigation may believe that it has a strong claim against another party, and legal advice may support that view, but management should still evaluate whether the recognition criteria have been satisfied. The assessment should reflect the current stage of the matter, the advice received, the counterparty’s position and the uncertainty over the amount and timing of any recovery.
Potential tax refunds require similar care. A company may expect to recover tax following an objection or reassessment, but its accounting treatment should reflect the actual status of the matter, including correspondence with the tax authority and any outstanding information or decisions, rather than management’s preferred outcome.
Prepare a complete year-end claims file
Finance teams should discuss significant potential recoveries with the relevant operational personnel and, where appropriate, legal, tax or other professional advisers. For each material item, the year-end file should document:
- The nature of the claim and the amount claimed.
- Correspondence with the insurer, tax authority, legal counterparty or other relevant party.
- Legal, tax or other professional advice obtained.
- The current status of negotiations, proceedings or review.
- The significant uncertainties and expected timing of resolution.
- Management’s conclusion on recognition or disclosure and the evidence supporting it.
The accounting records should also be consistent with legal letters, board minutes, insurance correspondence and other documents that describe the same matter. Any conflicting assessment should be resolved before the financial statements are finalised.
Establish a year-end reporting procedure
Significant contingent assets should not be ignored merely because they do not qualify for recognition. Depending on the likelihood of an economic benefit and the applicable accounting requirements, disclosure may still be appropriate.
Finance teams should therefore establish a year-end procedure requiring senior management and relevant departments to report significant claims and possible recoveries to the accounting function. Auditors will typically ask about legal disputes, insurance claims and other potential recoveries and may seek external evidence where the amounts are material, so identifying the matters early allows management to assemble the supporting records and resolve the accounting treatment before audit fieldwork.
Record potential gains only when the evidence supports it
Potential gains should be recorded only when the required degree of certainty has been reached. Until then, careful assessment, consistent documentation and appropriate disclosure are more reliable than premature recognition.