Loss-making or onerous construction contracts

Loss-making or onerous construction contracts

These are just two names for the same thing, an onerous contract is an accounting term that refers to a contract that will cost a company more to fulfill than what the company will receive in return. Loss-making or onerous construction contracts

IAS 37 defines an onerous contract as “a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.” Loss-making or onerous construction contracts

The term “unavoidable costs” also has a specific meaning for accounting purposes. The IASB explains it as “the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfill it.” However in May 2020 IASB issued amendments to IAS 37 regarding Onerous contracts – Cost of Fulfilling a contract. The amendment specifies which costs a company includes when assessing whether a contract is loss-making. The new IAS 37 paragraph 68A reads as follows: Loss-making or onerous construction contracts

The cost of fulfilling a contract comprises the costs that relate directly to the contract. Costs that relate directly to a contract consist of both:

  1. the incremental costs of fulfilling that contract—for example, direct labour and materials; and
  2. an allocation of other costs that relate directly to fulfilling contracts—for example, an allocation of the depreciation charge for an item of property, plant and equipment used in fulfilling that contract among others.

The amendment also clarifies that, before a separate provision for an onerous contract is established, an entity recognises any impairment loss that has occurred on assets use in fulfilling the contract, rather than on assets dedicated to the contract.

Something else -   Non-refundable upfront fees

The amendment more strictly describes unavoidable costs which has very likely resulted in the recognition of more onerous contract provisions, because previously some entities only included incremental costs in the cost to fulfil a contract.

The amendment is applied to financial statements prospective (i.e. in new financial statements only), see the IAS 37 94A below:

Transitional provisions

94A Onerous Contracts—Cost of Fulfilling a Contract, issued in June 2020, added paragraph 68A and amended paragraph 69. An entity shall apply those amendments to contracts for which it has not yet  fulfilled all its obligations at the beginning of the annual reporting period in which it first applies the  amendments (the date of initial application). The entity shall not restate comparative information.  Instead, the entity shall recognise the cumulative effect of initially applying the amendments as an  adjustment to the opening balance of retained earnings or other component of equity, as appropriate,  at the date of initial application.

Loss-making or onerous construction contracts

A contract can be onerous from its outset, or it can become onerous when circumstances change and expected costs increase or expected economic benefits decrease. Loss-making or onerous construction contracts

Small example – Construction contract

A construction contractor for the first time obtained a construction contract in the middle of a city. After construction started it appears that construction costs are much higher than what the construction company normally experiences. The area is difficult to access, neighbors are constantly complaining and holding up construction and so on….

 

IFRS 15 / IAS 37

This part relates to a complete explanation of IFRS 15 Revenue from contracts with customers in respect of Engineering & Construction contracts, see Revenue from Engineering & Construction contracts. Loss-making or onerous construction contracts

IFRS 15 does not provide specific guidance on loss-making contracts, which are instead within the scope of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The consideration in such cases is that a present obligation exists as a result of a past obligating event—the entity is contractually required to pay out resources for which it will not receive commensurate benefits. So, if an entity has a contract that is onerous, the entity recognises and measures the present obligation under the contract as a provision. Loss-making or onerous construction contracts Loss-making or onerous construction contracts

The requirements in IAS 37 for onerous contracts apply to all contracts in the scope of IFRS 15. IFRS 15 states that entities that are required to recognise a liability for expected losses on contracts under IAS 37 will continue to be required to do so. IAS 37 requirements for onerous contracts are described in IAS 37 66 – 69. Loss-making or onerous construction contracts

IAS 37 Onerous contracts – current text

IAS 37 66 If an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision.

IAS 37 67 Many contracts (for example, some routine purchase orders) can be cancelled without paying compensation to the other party, and therefore there is no obligation. Other contracts establish both rights and obligations for each of the contracting parties. Where events make such a contract onerous, the contract falls within the scope of this Standard and a liability exists which is recognised. Executory contracts that are not onerous fall outside the scope of this Standard.

IAS 37 68 This Standard defines an onerous contract as a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it.

IAS 37 68A The cost of fulfilling a contract comprises the costs that relate directly to the contract. Costs that relate directly to a contract consist of both:

  1. the incremental costs of fulfilling that contract—for example, direct labour and materials; and
    an allocation of other costs that relate directly to fulfilling contracts—for example, an allocation of the depreciation charge for an item of property, plant and equipment used in fulfilling that contract among others.

IAS 37 69 Before a separate provision for an onerous contract is established, an entity recognises any impairment loss that has occurred on assets dedicated to that used in fulfilling the contract (see IAS 36).

Something else -   IFRS 15 Presentation in main statements

Loss-making or onerous construction contractsThe wording of the requirements in IAS 37 does not exactly mirror the equivalent requirements in IAS 11 which states, “when it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognised as an expense immediately”. While these standards use different terminology, the timing of recognition of an onerous contract provision under IAS 37 and the related expense will likely be consistent with when an expected loss would be recognised under IAS 11. Loss-making or onerous construction contracts

An onerous contract is a contract in which the unavoidable costs (i.e. the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfil it) exceed the economic benefits expected to be received under the contract. The liability for an onerous performance obligation is reassessed at every reporting date. Under IAS 37, an entity considers only the ‘unavoidable costs’ of fulfilling an obligation when identifying onerous contracts and measuring any required provision (see above).

Loss-making or onerous construction contracts Loss-making or onerous construction contracts Loss-making or onerous construction contracts Loss-making or onerous construction contracts

Loss-making or onerous construction contracts

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

Something else -   Revenue recognition over time enforceable payment right

Leave a comment