Loss-making or onerous construction contracts

Loss-making or onerous construction contracts – 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

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

Onerous contracts

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 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 contract (see IAS 36).

Loss-making or onerous construction contracts The 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. Loss-making or onerous construction contracts

What exactly ‘unavoidable costs’ are is not defined in IFRS 15, however there are costs to be made before the constructor and its customer come to a mutual agreement. For example, construction entities that employ full time staff may not be required to include the costs of this staff in the calculation of a loss making (onerous) contract; however, construction entities that employ sub-contractors to perform obligations may be required to include these costs in their calculations. Costs that are not considered unavoidable are expensed as incurred because they are considered to be the costs to operate the business. Loss-making or onerous construction contracts

This distinction between what is and isn’t considered unavoidable may have a significant impact on whether a contract is considered onerous and how a contractual loss is calculated.

Loss-making or onerous construction contracts

Loss-making or onerous construction contracts

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