IFRS Definition (so different from underwriting and other finance terms) of firm purchase commitment:
– An agreement with an unrelated party, binding on both parties and usually legally enforceable, that:
- specifies all significant terms, including the price and timing of the transactions, and
- includes a disincentive for non-performance that is sufficiently large to make performance highly probable.
In other words – Purchase commitments are commitments by a business to purchase goods or services at some future date at a fixed price. A business will agree to a purchase commitment in order to fix its prices over a period of time. For example, a business might contract to purchase 2,000 units of inventory at a contract price of 1.25 a unit within 6 months.
While purchase commitments can protect the business from price increases they also create a problem when the price of the product falls below the contract price. If the contract cannot be cancelled, the business is committed to purchasing products at a price higher than the current market value of that product and needs to account for the purchase commitment loss.
Impairment of firm purchase comittments
Net losses on firm purchase commitments to acquire goods for inventory result from a contract price that exceeds the current market price. If a firm expects that losses will occur when the purchase occurs, expected losses, if material, should be recognised in the accounts and separately disclosed as losses (impairment) on the income statement of the period during which the decline in price takes place.
Purchase Commitments Example
Suppose a business has contracted to purchase 4,000 units of a product within 6 months at a fixed price of 2.25, resulting in a total cost of 9,000 (4,000 x 2.25).
At the year end none of the product has been delivered and the unit price has fallen to 2.00. Since the purchase order commitment contract cannot be cancelled the business is now contracted to purchase the 4,000 units at a price higher than the current market price of the product and must therefore recognize a loss.
The purchase commitments loss (impairment) is calculated as follows:
|Contracted commitment: 4,000 * 2.25 = 9,000 |
Market value at delivery: 4,000 * 2.00 = 8,000
Purchase commitment loss (impairment): market value less contract commitment = 8,000 – 9,000 = -1,000
|Loss (impairment) on purchase commitment||1,000|
|Purchase commitment liability||1,000|
The debit represents the loss recorded in the income statement of the business in the period in which the decline in price occurred. The credit reflects the balance sheet liability the business has to purchase inventory at a price higher than the current market value.
A note: Virgin Atlantic announced in March last year that it was ordering 15 of the 787-9 Dreamliners – with options on ordering another eight 787-9s and purchase rights on a further 20 aircraft.
An order means that the buyer has made a firm purchase commitment to purchase a certain aircraft in the production line, at a certain price. In the airline industry the buyer may cancel, but there will probably be a substantial penalty for doing so. In other industries it is more regular to fulfil a firm purchase commitment to ensure timely delivery of (critical) raw materials and components used in the manufacturing process.
An option means that the manufacturer has reserved a certain aircraft in the production line for the buyer, usually at a certain price. However, the buyer will make the decision on whether to convert this to an “order” at a later date. There is less commitment than with an “order”.
A purchase right is even less of a commitment than an “option.” This just means that the buyer has agreed to purchase aircraft at a certain price, but it’s not tied to a specific aircraft at that time.