ONEROUS CONTRACTS—COST OF FULFILLING A CONTRACT AMENDMENTS TO IAS 37

Last December 2018, The International Accounting Standards Board (Board) proposes to specify in IAS 37
that, in assessing whether a contract is onerous, companies should include all costs that relate directly to the
contract, not only the incremental costs.

This clarification could particularly affect construction, manufacturing and service companies.

Application of the recognition and measurement rules

ONEROUS CONTRACTS

This Standard 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.

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.

What is unclear?
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 labor
required to construct a building; or
 All costs that relate directly to the contract—both the incremental costs and an allocation of other cost
that relate directly to contract activities. For example, a company may include an allocation of: ƒ
 the depreciation charge for equipment the company uses to construct buildings;
 and ƒ the salary of a contracts supervisor

In May 2020 the Board added paragraph 68A to IAS 37. Paragraph 68A specifies which costs an entity
includes in determining the cost of fulfilling a contract for the purpose of assessing whether the contract is
onerous. The Board added this clarification in response to a recommendation from the IFRS Interpretations
Committee, whose research indicated that:

(a) Differing views on which costs to include could lead to material differences in the financial
statements of entities that enter into some types of contracts.
 (b) The need for clarification was urgent. Following the withdrawal of IAS 11 Construction Contracts,
entities are required to apply IAS 37 instead of IAS 11 to assess whether construction contracts are onerous.
IAS 11 specified which costs to include, but IAS 37 did not.

The cost of fulfilling a contract

Views differed on what an entity should include in the cost of fulfilling a contract when assessing whether the
contract is onerous—whether to include:
(a) only the incremental costs of fulfilling the contract—for example, the cost of materials and labor
required to construct a building; or
(b) all costs that relate directly to the contract—both the incremental costs and an allocation of other
costs that relate directly to fulfilling contracts—for example, an allocation of the depreciation charge for an item
of property, plant and equipment used in fulfilling the contract among others, or an allocation of the costs of
management and supervision of contracts.

The Board decided to require an entity to include all costs that relate directly to a contract. The Board
concluded that:
(a) Including all such costs provides more useful information to users of the entity’s financial statements
(paragraphs BC4–BC7);
(b) The benefits of providing that information are likely to outweigh the costs (paragraphs BC8–BC9);
and
(c) A requirement to include all costs that relate directly to a contract is consistent with other
requirements in IAS 37 and requirements in other IFRS Standards (paragraphs BC10–BC13).

Reasons for including all costs that relate directly to a contract

•Faithful representation—a company may obtain the resources it needs to fulfill 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.

•Consistency with other IFRS Standards— IFRS 17 Insurance Contracts requires insurers to include all
costs that relate directly to the fulfillment 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. They all require companies to
include both the incremental costs of purchasing or constructing the asset and an allocation of other directly
related and 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.

Transitional provisions
Onerous Contracts—Cost of Fulfilling a Contract, issued in May 2020, added paragraph 68A and amended
paragraph 69. An entity shall apply those amendments to contracts for which it has not yet fulfilled all its
obligations at the beginning of the annual reporting period in which it first applies the amendments (the date of
initial application). The entity shall not restate comparative information. Instead, the entity shall recognize the
cumulative effect of initially applying the amendments as an adjustment to the opening balance of retained
earnings or other component of equity, as appropriate, at the date of initial application.

Effective date
Onerous Contracts—Cost of Fulfilling a Contract, issued in May 2020, added paragraphs 68A and 94A and
amended paragraph 69. An entity shall apply those amendments for annual reporting periods beginning on or
after 1 January 2022. Earlier application is permitted. If an entity applies those amendments for an earlier
period, it shall disclose that fact.

USEFUL INFORMATION

 An entity may obtain the resources it needs to fulfill a contract in different ways. For example, if an
entity needs equipment to fulfill a contract to manufacture goods or provide services, it may either hire
the equipment for use only on that contract, or buy the equipment and use it on several contracts. The
Board concluded that to provide a faithful representation of the effect of a contract on an entity’s
financial position, the entity should identify the resources needed to fulfill the contract and include the
cost of those resources, regardless of how it expects to obtain them. Including only incremental costs in
that assessment—for example, the costs of hiring equipment but not an allocation of the depreciation of
purchased equipment —would fail to recognize the costs of resources shared with other contracts.

 The Board considered contracts an entity will fulfill using existing assets with idle capacity. If the income
from such a contract will exceed the incremental cost of fulfilling it, the contract will improve the entity’s
financial position and performance. But, unless the income will fully cover the cost of the capacity used,
including that cost in assessing whether the contract is onerous might suggest otherwise because the
entity will recognize an onerous contract provision and a loss when it incurs a present obligation by
entering into the contract. If that capacity were not used to fulfill the contract, such a loss would not be
recognized.

 The Board concluded that, even for a contract that will be fulfilled using existing idle capacity, including
all costs that relate directly to the contract (that is, including the cost of the capacity used) provides
useful information. By entering into a contract at a price that does not fully cover the cost of the capacity
used, the entity has committed itself to using that capacity to provide goods or services at a price that
would not be sustainable if all contracts were similarly priced. The entity has effectively committed itself
to making a loss on that capacity for the life of the contract. In the Board’s view, including the cost of
the capacity used in assessing whether a contract is onerous provides information that is relevant to
users of financial statements and faithfully represents the effect of the contract on the entity’s financial
position and performance. The Board noted that an entity would disclose additional information about
the contract if such information is relevant to an understanding of the entity’s financial statements.

 The Board also considered requirements in other IFRS Standards. Several IFRS Standards—such as
IAS 2 Inventories—specify the costs to include in measuring a non-monetary asset. Although their
detailed requirements differ, they all require an entity to include both the incremental costs of
 purchasing or constructing the asset, and an allocation of other directly related and directly attributable
costs, such as production overheads. The Board concluded that, in assessing whether a contract to
deliver goods is onerous, the way an entity determines the cost of fulfilling the contract should be
broadly consistent with the way it measures the cost of the goods when it holds them. Such consistency
leads to more useful information.

COST OF APPLYING THE REQUIREMENTS

 The Board discussed suggestions that it might be costly for a manufacturing entity to estimate and
allocate all the costs that relate directly to a contract if the entity has not yet manufactured the
goods it will deliver under the contract.

 The Board noted that IAS 2 requires an entity to measure the cost of manufactured inventories at
an amount that includes both the incremental costs of production and an allocation of production
overheads. Further, a manufacturing entity that enters into contracts to supply inventory is likely to
need information about these costs to make pricing decisions. Therefore, the entity is likely to have
already the information it needs to estimate and allocate the costs that will relate directly to
contracts into which it has entered. The Board therefore concluded that a requirement to estimate
and allocate costs that relate directly to a contract would not impose costs that outweigh the
usefulness of the information provided.

CONSISTENCY WITH OTHER REQUIREMENTS IN IAS 37 AND REQUIREMENTS IN OTHER IFRS

STANDARDS
 The Board discussed whether including costs other than the incremental costs of fulfilling a contract
would be inconsistent with other requirements in IAS 37. Those holding this view suggested that,
because an entity will incur those other costs regardless of whether it fulfills the contract under
consideration, the costs are not cost of ‘fulfilling the contract’—they are costs of operating the business.
Paragraph 18 of IAS 37 specifies that no provision is recognized for costs that need to be incurred to
operate in the future, and paragraph 63 prohibits recognition of future operating losses.

 However, the Board concluded that a requirement to include all costs that relate directly to a contract in
assessing whether the contract is onerous is consistent with other requirements in IAS 37. It concluded
that:
 (a) In recognizing an onerous contract provision, an entity would not be recognizing a
provision for the costs themselves—that is, it would not be identifying those costs as
present obligations in their own right. Instead, the entity would be recognizing its present
obligation to deliver goods or provide services in exchange for other economic benefits,
measuring that obligation at an amount that includes the cost of all the resources to be
used to fulfill the obligation.
 (b) Paragraph 63 of IAS 37 prohibits an entity from recognizing future operating losses
because such losses are not liabilities; in other words, the entity does not have a present
obligation to incur those losses. In contrast, in assessing whether a contract is onerous,
an entity determines the cost of fulfilling its present obligation under an existing contract.
Therefore, including all costs that relate directly to a contract in assessing whether the
contract is onerous does not result in an entity recognizing future operating losses.

 The Board noted that a requirement to include all costs that relate directly to a contract is
consistent with IFRS 17 Insurance Contracts. IFRS 17 requires insurers to include all costs that
relate directly to the fulfillment of a contract in assessing whether an insurance contract is
 onerous. These costs include an allocation of fixed and variable overheads directly attributable
to fulfilling insurance contracts.

PROVISION
A provision is a liability of uncertain timing or uncertain amount. Provisions differ from other liabilities because
of the uncertainty in the timing of their settlement or the amount needed to settle them.

RECOGNITION OF PROVISION
A provision is recognized when all the following conditions are met:

a. The entity has a present obligation, legal or constructive as a result of a past event.
b. It is probable that an outflow of resources embodying economic benefits will be required to settle the
obligation.
c. The amount of the obligation can be measured reliably.

CONTINGENT LIABILITIES
A contingent liability is a possible obligation that arises from past event and whose existence will be confirmed
only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of
the entity; or

A present obligation but:

I. It is not probable that it will cause an outflow in its settlement; or
II. Its amount cannot be reliably estimated.

CONTINGENT ASSET
A contingent asset is those that are not recognized because they do not meet all of the asset recognition
criteria.

Contingent assets include possible inflows of economic benefits from unplanned or unexpected events such as
claims that an entity is seeking through legal processes where the outcome is uncertain.

Contingent assets are disclosed only, if the inflow of economic benefits is probable.

EXAMPLE
ABC Co. engages in the manufacture of plastic wares. During the year, environmental auditors from a
government agency issued their findings that ABC is not compliant with existing laws. ABC is then directed by
the government to rectify damages caused to the environment and to pay penalty for the unlawful
environmental damage. ABC estimates that total cost of rectifying the damage and settling the penalty
amounts to P200M. Should ABC recognize a provision for the environmental damage?

Present obligation as a result of past event? YES

Outflow of economic benefits probable? YES
Reliable Estimated? YES

EXPLANATION
YES, because the government has been directed ABC Co. to pay for the penalty caused by the past event
resulting to damages to the environment. Therefore, there is a present obligation with probable outflow and the
outflow can be measured reliably.

EXAMPLE
The board of directors of ABC Co. decided on December 15, 2020, to wind up international operations in
Country B and move them to Country C. The decision was based on a detailed formal plan of restructuring.
This decision was conveyed to all workers and management personnel at the headquarters in Country A. The
cost of restructuring the operations in Country B as per this detailed plan was P10M. Should ABC recognize a
provision?

Present obligation as a result of past event? NO

Outflow of economic benefits probable? NO
Reliable Estimated? NO

EXPLANATION

NO, This is an example of restructuring. Relocating the business activities from one country to another. There
is no obligating event because the detailed formal plan and the decision made was not communicated to the
country that will wind up (Country B).