Onerous

This is an overview of the use of onerous in the IFRS Standards, the major Standard being IAS 37 (see below).

IAS 37: ‘Onerous Contracts – Cost of Fulfilling a Contract’

IAS 37 defines an onerous contract as one in which the unavoidable costs of meeting the entity’s obligations exceed the economic benefits to be received under that contract. If an entity has a contract that is onerous the present obligation under the contract should be recognized and measured as a provision. 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 amendment to IAS 37, that will become effective 1 January 2022, clarifies the meaning of ‘costs to fulfil a contract’.The amendment was part of some narrow-scope amendments issued by IASB in May 2020.

The amendment explains that the direct cost of fulfilling a contract comprises:

• 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 PP&E used to fulfil the contract). (IAS 37.68A)

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 used in fulfilling the contract, rather than on assets dedicated to that contract.

The amendment could result in the recognition of more onerous contract provisions, because previously some entities only included incremental costs in the costs to fulfil a contract.

The additional rules for onerous contracts are provided in IAS 37.66 – 69:

• If an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision. (IAS 37.66)
• 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 IAS 37 and a liability exists which is recognised. Executory contracts that are not onerous fall outside the scope of IAS 37. (IAS 37.67)
• 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. (IAS 37.69)

Conceptual Framework – Executory contracts

It is current practice not to recognise executory contracts to the extent that they are unperformed by both parties (unless the contract is onerous). IAS 37 describes executory contracts as ‘contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent’.

Paragraph 4.56 of the Framework provides the complete definition:

In practice, obligations under contracts that are equally proportionately unperformed (for example, liabilities for inventory ordered but not yet received) are generally not recognised as liabilities in the financial statements.

However if the terms of the exchange under the contract are currently favorable for the entity, then it has an asset. Conversely, if the terms are currently unfavorable for the entity, then it has a liability.

Here is a disclosure example in respect of securitisations and executory contracts: As part of certain securitisation transactions that result in the Group derecognising the transferred financial assets in their entirety, the Group retains servicing rights in respect of the transferred financial assets. Under the servicing arrangements, the Group collects the cash flows on the transferred mortgages on behalf of the unconsolidated securitisation vehicle. In return, the Group receives a fee that is expected to compensate the Group adequately for servicing the related assets. Consequently, the Group accounts for the servicing arrangements as executory contracts and has not recognised a servicing asset/liability. The servicing fees are based on a fixed percentage of the cash flows that the Group collects as an agent on the transferred residential mortgages. Potentially, a loss from servicing activities may occur if the costs that the Group incurs in performing the servicing activity exceed the fees receivable or if the Group does not perform in accordance with the servicing agreements.

IFRS 3 Business combinations

In allocating the cost of a business combination to the acquiree’s identifiable assets, liabilities and contingent liabilities that satisfy the relevant recognition criteria at their fair values at the acquisition date, for onerous contracts and other identifiable liabilities of the acquiree the acquirer shall use the present values of amounts to be disbursed in settling the obligations determined at appropriate current interest rates.

Contracts between acquirer and acquiree entered into before business combination

The parties may trade with each other before the business combination is affected. If the liabilities resulting from the agreement are higher than forecasted benefits the contract is onerous. However the unprofitable activity of the acquiree is not always an onerous contract.

The contract should be recognized as liability measured at fair value if the contract is classified as onerous at combination date. If so the acquirer should be aware of all key assumptions such as: market price, necessary costs of meeting obligations under the contract. (IFRS 3.B52)

Relationship	Measurement
Non-contractual	measured at fair value
Contractual	the lesser of the following: the amount by which the contract is favorable or unfavorable from the acquirer’s perspective when compared to market terms the amount of any stated settlement provisions available to the counterparty to whom the contract is unfavorable if the latter amount is the lesser, the difference is included as part of the accounting for the business combination

Note: any gain or loss on settlement will be affected by any related asset or liability previously recognised by the acquirer

Case – Settlement of pre-existing supply agreement Company A purchases raw materials from Company B at fixed rates under a 5 year-supply agreement. Company A is able to cancel the agreement by paying a fee of CU4 million. Two years into the agreement, Company A acquired the entire equity of Company B for CU40 million. On that date, the terms of the supply agreement are unfavorable to Company A since the fixed rates are higher than current market prices. The estimated fair value of the contract for Company B is CU5 million, with CU2 million representing the component that is ‘at market’ terms and a CU3 million component relating to the unfavorable pricing for Company A. Prior to the acquisition, Company A has concluded that the supply agreement is not an onerous contract and no liability related to the agreement has been recorded in its financial statements. Analysis: Company A’s acquisition of Company B effectively settles the supply agreement. Company A accounts for this settlement as a separate transaction and recognises a settlement loss of CU3 million* (as this amount is lower than the cancellation fee). In accounting for the business combination, the consideration transferred is measured at CU37 million representing the contractual price of CU40 million reduced by CU3 million attributable to the loss on settlement of the supply agreement. The CU2 million representing the ‘at market’ component of the fair value of the supply agreement is subsumed into goodwill. No separate intangible asset (ie a reacquired right) is recognised as the business combination does not represent a reacquisition of a previously granted right to use Company A’s assets. * If Company A had previously considered the supply agreement to be an onerous contract (under IAS 37), the loss on settlement would be reduced by any previously recognised liability for this onerous contract.

IFRS 9 Own use contracts

Many commodity purchase and sale contracts meet the criteria for net settlement in cash because the commodities are readily convertible to cash and would be accounted for similar to financial derivatives. However, such contracts are excluded from the scope of IFRS 9 if they were entered into, and continue to be held, for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.

This is commonly referred to as the ‘own use’ scope exception. Own use contracts are accounted for as normal sales or purchase contracts (i.e., executory contracts), with the idea that any fair value change in the contract is not relevant given the contract is for the entity’s own use. An own use contract would only be accounted for in the case that it becomes onerous, in which case the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets would apply.

IFRS 15 Revenue from contracts with customers

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.

IFRS 16 Leases

IFRS 16 .C10(b) provides a practical expedient that lessees do not have to test right-of-use assets for impairment under IAS 36 at the date of initial application.

Event – Impairment review on date of initial application of a lease contract

Rely on its assessment of whether leases are onerous in accordance with IAS 37 Provisions, contingent liabilities and contingent assets immediately before the date of initial application as an alternative to performing an impairment review. If so, lessee adjusts the right-of-use asset at the date of initial application by the amount of any provision for onerous leases recognised in the statement of financial position immediately before the date of initial application.

It could be costly for a lessee to perform an impairment review of each of its right-of-use assets on transition. In addition, any onerous lease liability identified under IAS 37 would likely result in the right-of-use asset being impaired. This practical expedient will provide a cost savings without any significant impact on reported information for the lessee.

This expedient can be applied on a lease-by-lease basis for those leases previously classified as operating leases.

IFRS 17 Mutualisation

The amounts and/or timing of payments to a particular population of policyholders may be interdependent. The nature and extent of this interdependence varies and could be defined contractually, by regulation or by legislation. This is sometimes referred to as ‘mutualisation’, although this term is not defined in IFRS 17 and this narrative instead uses the IFRS 17 term ‘risk sharing’ i.e. when insurance contracts in one group affect the cash flows to policyholders in a different group. In practice, the term covers a variety of effects such as individual contract requirements, risk-diversification or cross-subsidisation.

The following is an extract of the IASB tentative decisions of November 2016:

(a) To retain the definition of a portfolio in draft IFRS 17 Insurance Contracts, i.e. that a portfolio is a group of contracts subject to similar risks and managed together as a single pool. IFRS 17 would provide guidance that contracts within each product line, such as annuities or whole-life, would be expected to have similar risks, and hence contracts from different product lines would not be expected in the same portfolio.

(b)To require entities to identify onerous contracts at inception and group them separately from contracts not onerous at inception. IFRS 17 would provide guidance that entities could measure contracts together if the entity can determine that those contracts can be grouped with others based on available information at inception.

(c) To require entities to measure insurance contract not onerous at inception by dividing the portfolio into two groups – a group of contracts that have no significant risk of becoming onerous and a group of other profitable contracts.

The EFRAG Secretariat understands that mutualisation may interact with the level of aggregation for the determination of a group of onerous contracts and for the allocation of the CSM. The EFRAG Secretariat understands that the term mutualisation is when the returns from the underlying items is reduced for policyholders in order to pay other policyholders who share the returns from the same identified pool of underlying items.

Grouping

As a result at inception insurance contracts have to be grouped (or classified in the level of aggregation as per IFRS 17 terminology) into annual cohorts using the following three step approach:

Step 1	Identification of portfolios of insurance contracts issued at inception (IFRS 17.14)
Step 2	Divide portfolios of contracts into annual time buckets (cohorts) (IFRS 17.22)
Step 3	Divide annual cohorts into groups of contracts, at inception (if any): (IFRS 17.16)
	▼	▼	▼
	Onerous	Possibility of becoming onerous (“remaining contracts”)	No significant possibility of becoming onerous subsequently
	‘Clearly loss making’	‘No clear result (profit or loss)’	‘Clearly profit making’
	Apply the recognition and measurement requirements to each group
	Expected losses on onerous groups of contracts immediately in profit or loss		Expected profits on groups of contracts over the coverage period—by recognising the contractual service margin of a group of contracts in profit or loss as services are provided.

Regulatory exemption

Law or regulation may constrain entity’s practical ability to set a different price or level of benefits for policyholders with different characteristics, e.g. gender, age, etc. (IFRS 17.20)

IFRS 17 permits such contracts to be aggregated into the same group.

Possibility of becoming onerous

The group of contracts with the possibility of becoming onerous has to be monitored in the internal reporting with an important trigger being the sensitivity of fulfilment cash flows.

One year cohorts

The limitation to one year cohorts ensures:

• The carrying amount of CSM (contractual service margin = unearned profit) for the group reflects coverage to be provided under contracts within the group (i.e. contracts that have not lapsed or expired)
• The allocation of the CSM to P&L faithfully depicts profitability in contracts over time
• Full run-off of CSM to P&L once coverage period has ended

Onerous Contracts

• Identified at initial recognition
• May assess onerousness by measuring a set of contracts rather than individual contracts
• Remains a separate group and loss recognised immediately in profit or loss

Simple examples of grouping

Case – A set of 100 identical contracts are written with a probability that 5 of the policyholders will claim

100 contracts are a group; the company does not treat the 5 contracts as a separate group

Case – A company issues 500 contracts; there is information that a set of 200 identical contracts are under-priced, but the company expects that a set of 300 profitable identical contracts will cover losses (or possible losses) on the other set of 200 under-priced contracts

Group A –losses on the 200 under-priced contracts are recognised immediately Group B –profits on 300 contracts recognised over the coverage period

IAS 1 Preparing financial statements not on a going concern basis

If financial statements are prepared on a basis other than that of a going concern, an entity shall prepare the financial statements on a basis that is consistent with IFRSs but amended to reflect the fact that the ‘going concern’ assumption is not appropriate. Among other things, such a basis requires writing assets down to their recoverable amounts.

It also requires recognising a liability for contractual commitments that may have become onerous as a consequence of the decision to cease trading. However, it would not be appropriate to recognise provisions for future losses or liabilities for which there was no present legal or constructive obligation at the end of the reporting period.

IAS 41 Agriculture

IAS 41 Agriculture explains that, in the case of contracts in terms of which the biological assets or agricultural produce will be sold at a future date, such contract prices are not necessarily relevant in determining fair value, as fair value should reflect the current market in which a willing buyer and seller would enter into a transaction.

IAS 41 Agriculture requires that such a contract be provisioned if it is an onerous contract.

IAS 40 Investment properties under construction

An entity might enter into a binding forward purchase agreement to purchase a completed property after construction is completed. Where the contract requires the entity to pay a fixed purchase price, the entity will need to consider whether the contract is onerous. A provision for onerous contracts is recognised if the unavoidable costs of meeting the obligations under the contract or exiting from it exceed the economic benefits expected to be received under it. [IAS 37.66–69].

For example, if this fixed price had a net present value of CU100 million at the reporting date, and the estimated economic benefits of the completed investment property at the reporting date is below that (say, CU80 million), a loss of CU20 million is recognised immediately in the income statement. The resulting provision is recognised on the balance sheet.

If there is an onerous contract as defined above, an impairment test is performed on any asset dedicated to the contract (for example, prepayments made in relation to the purchase). Such assets relating to an onerous contract are written down to the recoverable amount, if this is less than the carrying amount. [IAS 37.69]. A provision is recognised only after such asset is reduced to zero.

Regardless of the assessment as to whether or not there is an onerous contract, contractual obligations to purchase, construct or develop investment property, or for repairs, maintenance or enhancements, should be disclosed. [IAS 40.75(h)].

Natural disasters

When a natural disaster has occurred, contracts should be reviewed to determine if there are any special terms that may relieve an entity of its obligations (e.g., force majeure).

Unit of account

Assessing the appropriate unit of account is important in the evaluation of such contracts. Contracts will be evaluated individually in certain cases (e.g. where an underlying purchase contract or lease of space is not expected to be needed). Contracts may be factored into the assessment of impairment for the overall cash generating unit in other cases. Considering whether an onerous contract should be provided for is often complex.

For example, an oil and gas company entered into a fixed price long-term supply contract with a customer. The cost of extraction and/or production increases subsequently and the total cost to fulfil the contract is expected to exceed the contract price. An impairment trigger results. The cash flows from this contract will be factored into the value in use or fair value less cost of disposal of the underlying cash generating unit. It is unlikely that an onerous contract would exist in this scenario before the carrying amount of the underlying CGU is zero.