Onerous contracts – Example on recognising and measuring provisions
An onerous contract is one 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.
For example, an entity may be contractually required under an operating lease to make payments to lease an asset for which it no longer has any use.
Present obligation 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.
Conclusion—if an entity has a contract that is onerous, the entity recognises and measures the present obligation under the contract as a provision.
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.
How do companies report onerous contracts?
As soon as a contract is assessed to be onerous, a company applying IAS 37 records a provision in its financial statements for the loss it expects to make on the contract.
IAS 37 does not specify which costs to include in estimating the cost of fulfilling a contract. People have reached different views on whether to include:
- only the incremental costs of fulfilling that contract—for example, the cost of materials and labour required to construct a building; or
- all costs that relate directly to the contract—both the incremental costs and an allocation of other costs that relate directly to contract activities.
For example, a company may include an allocation of: Onerous contracts
- the depreciation charge for equipment the company uses to construct buildings; and Onerous contracts
- the salary of a contracts supervisor. Onerous contracts
If a construction company decided to include only incremental costs it would be less likely to give early warning of expected contract losses.
The Board does not agree that IAS 37 prevents companies from including costs shared across several contracts. A general view is that:
- by including an allocation of such costs in determining the cost of fulfilling a contract, a company is not recording a provision for those future costs. Instead, it is recording a provision for its obligation to deliver goods and services under an existing contract and measuring that obligation to reflect the cost of the goods or services it must deliver.
- the ‘unavoidable’ costs of fulfilling a contract are the costs the company cannot avoid because of the contract’s existence—in other words, unavoidable costs comprise both incremental costs and an allocation of other costs that relate directly to contract activities. Onerous contracts
There is also general consensus that there are reasons for including all costs that relate directly to a contract in assessing whether the contract is onerous.
For these reasons, it seems most faithful that in determining the cost of fulfilling a contract, companies should include both the incremental costs and an allocation of other costs that relate directly to contract activities. Onerous contracts
Reasons for including all costs that relate directly to a contract Onerous contracts
- Faithful representation—a company may obtain the resources it needs to fulfil a contract in different ways. For example, it may hire equipment for use only for that contract or buy equipment for use on several contracts. A company incurs costs regardless of the way it obtains resources—including only incremental costs would fail to record the cost of resources shared with other contracts. Onerous contracts
- Consistency with other IFRS Standards—IFRS 17 Insurance Contracts requires insurers to include all costs that relate directly to the fulfilment of a contract, including an allocation of fixed and variable overheads, in assessing whether an insurance contract is onerous. Also, several IFRS Standards—such as IAS 2 Inventories—specify the costs to include in measuring a non-monetary asset. Onerous contracts Onerous contracts Onerous contracts
They all require companies to include both the incremental costs of purchasing or constructing the asset and an allocation of other directly related or directly attributable costs. The way a company determines the cost of fulfilling a contract to deliver goods should be consistent with the way it measures the cost of those goods when it holds them.
- Reduced complexity—a company may have contracts that appear individually profitable when only incremental costs are included but are loss-making as a group when other directly related costs are included. To ensure that individual contracts are identified as onerous, an incremental cost approach would need additional requirements on when to assess contracts as a group or individually. Such requirements could add complexity.
- Providing relevant information—including all costs that relate directly to a contract gives earlier warning of expected losses.
All of the entities in the examples have 31 December as their reporting date. In all cases, it is assumed that a reliable estimate can be made of any outflows expected. In some examples the circumstances described may have resulted in impairment of the assets; this aspect is not dealt with in the examples. References to ‘best estimate’ are to the present value amount, when the effect of the time value of money is material.
See also: The IFRS Foundation