The IASB has issued Onerous Contracts— Cost of Fulfilling a Contract, an exposure draft of proposed amendments to IAS 37, with comments to be received by April 15, 2019.
I recall that when Canada was making the conversion to IFRS, the “onerous contract” requirements of IAS 37 received a disproportionate amount of attention in summaries of differences from old Canadian GAAP (possibly second only to the “componentization” of property, plant and equipment). These require, you’ll recall, that if an entity has a contract that is onerous, it recognizes the measures the present obligation under that contract as a provision. It 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.
Fortunately, this hasn’t come up too much in practice: I say it’s fortunate because the potential application challenges are evident. It likely didn’t come to the boil before now because onerous contracts most often arise in the construction industry, and IAS 11 previously specified which costs an entity would include when identifying, recognising and measuring an onerous contract provision for contracts within its scope. IAS 11 was withdrawn when IFRS 15 became effective, but IFRS 15 doesn’t address this issue, instead directing preparers toward IAS 37. Subsequently, IFRIC received a request to clarify the definition, leading in due course to these proposed amendments.
The IASB now proposes the following additional language:
- The ccst of fulfilling a contract comprises the costs that relate directly to the contract.
- Examples of costs that relate directly to a contract to provide goods or services include: (a) direct labour (for example, salaries and wages of employees who manufacture and deliver the goods or provide the services directly to the counterparty); (b) direct materials (for example, supplies used in fulfilling the contract); (c) allocations of costs that relate directly to contract activities (for example, costs of contract management and supervision; insurance; and depreciation of tools, equipment and right-of-use assets used in fulfilling the contract); (d) costs explicitly chargeable to the counterparty under the contract; and (e) other costs incurred only because an entity entered into the contract (for example, payments to subcontractors).
- General and administrative costs do not relate directly to a contract unless they are explicitly chargeable to the counterparty under the contract.
This reflects a “direct cost” approach, of including all the costs an entity can’t avoid because it has the contract. The alternative would be to apply an incremental cost approach, including only the costs an entity would avoid if it didn’t have the contract. The difference between the two may not be immediately self-evident, but an example in the material refers to a situation where an entity needs to use equipment to manufacture goods or to provide services, and has the choice either of hiring that equipment for the period required by the contract, or of buying the equipment and using it for other contracts afterwards. An “incremental cost” approach might exclude costs arising from the latter approach, because once the equipment has been acquired, the associated cost can’t be avoided whether or not the contract is canceled. But the IASB put weight on the premise that: “Choosing to buy equipment or employ experts that can be used for other contracts or purposes does not mean that the use of the equipment or information necessary to fulfil a contract are cost-free.” In addition, it considered a direct cost approach to be more consistent with the rest of IAS 37 and with IFRS as a whole.
This doesn’t necessarily cover all the interpretation issues that could arise in this area: the Board considered whether to develop additional requirements for measuring an onerous contract, but decided not to, as this “could cause the project to take longer,” and the main imperative was to deal with the issue addressed above. Also, the Board didn’t propose any new disclosure requirements, noting among other things that IAS 11 didn’t contain any such requirements for onerous contracts, and that where the determination of the cost requires the use of estimates, disclosure may already be required under IAS 37 and/or IAS 1.
It would be interesting to know what percentage of onerous contracts go undetected, for instance because an entity’s internal tracking doesn’t make it easy to identify them. Perhaps the new requirements, once finalized, will prompt some issuers to focus on making changes to their systems. Who knows, for some issuers (perhaps those at an earlier stage, for which the economics of the business are still taking shape), the greater benefit may lie not in more effective accounting for such provisions, but in being better attuned to the possibility of incurring them, and thus to what it takes to avoid them.
The opinions expressed are solely those of the author