Accounting for Onerous Contracts under IAS 37
IAS 37, Provisions, Contingent Liabilities and Contingent Assets includes specific guidance on the accounting for onerous contracts, including when to recognize a provision for an onerous contract, and if a provision is recognized, the amount of that provision. This post takes a look at the guidance.
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. 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 fulfill it.
Onerous contracts give rise to provisions being recognized in the financial statements. However, before a separate provision for an onerous contract is established, an entity must recognize any impairment loss that has occurred on assets used in fulfilling the contract under IAS 36, Impairment of Assets.
The best way to illustrate the guidance is through an example.
Scenario: Onerous contract
In October, Mountain Chalets entered into an agreement with Ultra Luxury Holidays under which it agreed to rent out its chalet for $5,000 per day for 60 days during February and March. Mountain Chalets incurs fulfilment costs of $7,000 per day to run this chalet. Mountain Chalets can cancel the contract by paying a penalty of $250,000. However, Mountain Chalets’ management has decided not to cancel this contract as they believe it would adversely affect their reputation in their very prestigious target market.
Questions and answers: Cash flow statement classification
So, is this an onerous contract? If so, what is the maximum amount of provision that could be recognized under the guidance in IAS 37? You will notice that the questions says, “maximum amount of provision.” That is because we haven’t yet discussed what exactly constitutes fulfilment costs; therefore, we are taking Mountain Chalets’ word for the fact that the $7,000 in costs qualify.
The maximum amount of the provision is $120,000 ($7,000 daily fulfilment costs – $5,000 daily income x 60 days). A contract is onerous if the unavoidable costs exceed the economic benefits expected to be received. Unavoidable costs are the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfill it. In this example, the net cost of fulfilling the contract of $120,000 ($2,000 x 60 days) is lower than the penalties of $250,000. It appears the contract may be onerous. However, further analysis will be necessary to determine whether the costs included in the $7,000 qualify as costs to fulfill the contract under IAS 37. Remember, Mountain Chalets would also need to recognize any impairment loss on any assets used in fulfilling the contract (e.g. the chalet) before calculating and establishing a provision.
So, what exactly are costs to fulfill a contact? IAS 37 provides guidance on what is included in costs to fulfill a contract. The standard states that the cost of fulfilling a contract comprises the costs that relate directly to the contract. Those costs include both incremental costs and an allocation of other costs so long as they relate directly to fulfilling contracts. Examples of incremental costs are direct labor and direct materials. Allocable costs include other permanent staff costs, depreciation of assets used in fulfilling a contract, among others, so long as they relate directly to fulfilling contracts. This chart summarizes the guidance:
So, assuming that the costs included in the $7,000 qualify as costs to fulfill the contract under this guidance, Mountain Chalets will recognize a provision for an onerous contract in the amount of $120,000 in its financial statements.
Bonus plan: How does this compare to U.S. GAAP?
While IFRS includes specific guidance on the general accounting for onerous contracts, U.S. GAAP does not. In general, under U.S. GAAP, a loss and corresponding provision is not recognized in advance of performance for onerous contracts. However, U.S. GAAP does include guidance on specific types of onerous contracts, such as long-term construction and production-type contracts (guidance found in ASC 606), firm purchase commitments for inventory (guidance found in ASC 330), and certain others. It is important to note that application of this specific guidance may result in differences with how these contracts would be accounted for in accordance with IAS 37.
Final thoughts
Failing to correctly recognize a provision for loss on an onerous contract, or recognizing one in error, can lead to misstated financial statements and potential regulatory findings. This is why understanding and applying IAS 37 accurately is critical for accounting professionals.
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
