From the IFRS Institute – August 28, 2020
Under IFRS Standards, onerous contracts – those in which the unavoidable costs of meeting the contractual obligation outweigh the expected benefits – must be identified and accounted for. The International Accounting Standards Board recently revised IAS 371 to clarify which costs should be used to identify onerous contracts. As a result, from 2022 companies may need to recognize more and larger contract loss provisions. Even without the amendments, many revenue-generating or purchasing contracts could become onerous due to COVID-19. This is therefore a good time to revisit the guidance in IAS 37 and compare it to US GAAP.
What makes a contract onerous?
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 the contract. Unavoidable costs are the lower of the costs of fulfilling the contract and any compensation or penalties from the failure to fulfill it. If a contract can be terminated without incurring a penalty, then it is not onerous.
A contract with unfavorable terms is not necessarily onerous; instead, the definition focuses on the costs of fulfilling the obligations compared to the expected benefits. Similarly, a contract not performing as well as anticipated, or as well as possible, is not onerous unless the costs of meeting the obligations under the contract exceed the expected benefits.
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. This assessment is based on the contract as a whole, rather than on an item-by-item or performance obligation-by-performance obligation basis. If a contract is determined to be onerous, then a company applying IAS 37 needs to recognize a provision in its financial statements for the expected loss on the contract. Before establishing the provision, the company tests all assets directly related to the contract for impairment.
This guidance is particularly relevant to revenue-generating and purchasing contracts.2
Why the need for change?
Before the amendments, the definition of the term ‘costs of fulfilling the contract’ was unclear in the context of IAS 37. This led to diversity in practice and two approaches developed: the ‘incremental cost’ approach and the ‘full cost’ approach. The ‘full cost’ approach includes both the incremental costs of the contract (e.g. direct materials and labor) and an allocation of other costs incurred to fulfill the agreement (e.g. allocated depreciation, other shared costs).
In May 2020, the International Accounting Standards Board published 'Onerous Contracts—Cost of Fulfilling a Contract (Amendments to IAS 37)'. The amendments are intended to clarify the definition of the costs of fulfilling a contract for consistency and comparability across companies. The amendments will also increase consistency with other IFRS Standards, such as IFRS 153 and IFRS 174.
The IAS 37 amendments specify that the cost of fulfilling a contract comprises costs that relate directly to the contract, and include both:
- the incremental costs of fulfilling that contract – e.g. direct labor and materials; and
- an allocation of other costs that relate directly to fulfilling contracts – e.g. an allocation of the depreciation charge for an item of property, plant and equipment used in fulfilling that contract.
The amendments apply to all contracts in the scope of IAS 37. Companies currently using the incremental cost approach will likely need to recognize larger provisions for onerous contracts and may have an increase in the number of onerous contracts. The amendments to IAS 37 are less likely to have a significant impact on companies currently using the full cost approach.
Company ABC has a revenue contract with the following fact pattern.
- The economic benefits of the contract: $110,000 (e.g. transaction price remaining to be recognized under the contract). Revenue on the contract is recognized over time.
- Direct labor costs to fulfill the contract: $60,000 (e.g. salaries and wages of employees directly involved with fulfilling the contract).
- Direct materials costs to fulfill the contract: $45,000.
- Allocations of costs that relate directly to contract activities to fulfill this contract: $10,000 (e.g. costs of contract management and depreciation of tools, equipment and right-of-use assets).
- The cost of terminating the contract (contractual termination penalty): $120,000.
|Incremental cost approach||
Direct cost approach
per the amendments (required from 2022)
Costs to terminate
|Costs to fulfill||
($60,000 + $45,000)
($60,000 + $45,000 + $10,000)
The lower of the cost to terminate and fulfill is $105,000, which is lower than the benefits expected under the contract.
The lower of the cost to terminate and fulfill is $115,000, which is higher than the benefits expected under the contract.
The amendments are effective for annual reporting periods beginning on or after January 1, 2022 and apply to contracts existing at the date the amendments are first applied – i.e. January 1, 2022 for a calendar year-end company. At the date of initial application, the cumulative effect of applying the amendments is recognized as an opening balance adjustment to retained earnings or other component of equity, as appropriate. Comparatives are not restated on transition. Earlier adoption of the amendments is permitted.
The incremental cost approach remains acceptable under IAS 37 until the amendments are effective. However, for companies selecting a new accounting policy before the effective date of the amendments, we expect them to base their accounting policy on the direct cost approach under the amendments.
Comparison with US GAAP
US GAAP does not have a general requirement to recognize a loss in advance of performance for onerous contracts. Instead, US GAAP requires companies to use the specific recognition and measurement requirements of the relevant Codification topics/subtopics.
For example, US GAAP has guidance for losses on long-term construction- and production-type contracts, and a company may determine the provision for losses at either the contract level or the performance obligation level. Under IFRS Standards, all revenue contracts (including service contracts) are in the scope of the onerous contracts guidance, and the loss must be assessed for the contract as a whole.
On the purchasing side, like IFRS Standards, US GAAP requires net losses on firm purchase commitments for goods for inventory to be recognized. Unlike IFRS Standards, these are measured in the same way as inventory losses, which can differ from the unavoidable costs approach under IAS 37. Under IFRS Standards, other purchasing contracts are also in the scope of the onerous contracts guidance.
Onerous contracts is an accounting area where differences with US GAAP may be material. It is therefore key that companies have processes and controls in place to identify such contracts for each reporting period. This not only requires a thorough understanding of the contract terms but also of their economics.
This year the effect of COVID-19 on business operations and the uncertainty of the economic environment may result in an increased number of onerous contracts. For example, costs to deliver on existing revenue contracts may rise (e.g. if the company needs to find an alternative supplier or incur extra cleaning costs on the project); benefits expected from existing purchasing contracts may fall (e.g. lower demand may impact customer pricing, making it difficult to resell committed purchases at a profit). Companies should also consider whether the contracts contain any force majeure provisions that may allow termination with no penalty or with a reduced penalty. Read more here.
In this context, the amendments to IAS 37 provide timely clarification on the assessment of onerous contracts. Companies currently applying the incremental cost approach may need to recognize larger provisions for onerous contracts upon adopting the amendments. Although the lead time to the effective date seems long, companies should allow sufficient time to revisit existing contracts.
Additionally, companies who followed the incremental approach and have historically concluded that their contracts are not onerous may need to consider the amendments in their current year accounting policies, and carefully consider the impact of the current economic environment on the assessment of onerous contracts.
- IAS 37, Provisions, Contingent Liabilities and Contingent Assets
- The scope of the guidance formerly included lease contracts. However, under the new lease standard (IFRS 16), lessees recognize leases on-balance sheet and therefore any so-called ‘onerous lease contract’ is addressed by testing the lease right-of-use asset for impairment.
- IFRS 15, Revenue from Contracts with Customers
- IFRS 17, Insurance Contracts
- This example is simplified for illustrative purposes. It is assumed that a reliable estimate can be made of any outflows expected and the impact of any potential impairment of the assets is ignored.
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