Onerous contracts - Proposals for guidance on accounting for costs of fulfilling a contract

The International Accounting Standards Board recently published Exposure Draft ED/2018/2 Onerous Contracts – Costs of Fulfilling a Contract (ED 287 in Australia) to clarify and provide guidance on what is meant by ‘costs of fulfilling a contract’ when assessing whether an onerous contract provision needs to be recognised in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.

Definition of ‘onerous contract’ in IAS 37

The unavoidable costs reflect the least net cost of exiting the contract, which is the lower of the costs to fulfil the contract and any compensation/penalties arising from failing to fulfil the contract.

	LEAST NET COST OF EXITING THE CONTRACT
	↓
	LOWER OF:
↙		↘
COSTS OF FULFILLING THE CONTRACT		COMPENSATION OR PENALTIES

Why the need for change?

IAS 37 currently does not provide any guidance on what is meant by costs of fulfilling a contract. Guidance previously contained in IAS 11 Construction Contracts has now been withdrawn because IAS 11 has been superseded by the new revenue standard, IFRS 15 Revenue from Contracts with Customers.

What is being proposed?

The costs of fulfilling a contract should only comprise costs that relate directly to the contract.

Examples of costs that relate directly to a contract include:

Direct labour – e.g. salaries and wages of employees who manufacture and deliver the goods or provide the services directly to the counterparty
Direct materials – e.g. supplies used in fulfilling the contract
Allocations of costs that relate directly to contract activities – e.g. costs of contract management and supervision; insurance; and depreciation of tools, equipment and right-of-use assets used in fulfilling the contract
Costs explicitly chargeable to the counterparty under the contract, and
Other costs incurred only because an entity entered into the contract – e.g. payments to subcontractors.

The proposals also clarify that general and administrative costs do not relate directly to a contract unless they are explicitly chargeable to the counterparty under the contract.

Application date and transition

While no application date is specifically noted in the ED (to be determined when final amending standard is issued), it is proposed that the new guidance will only apply to contracts existing at the beginning of the annual period in which the entity first applies the amendments (date of initial application), and comparatives shall not be restated. This modified retrospective transition approach will result in any adjustments being made to the opening balance of retained earnings on the initial date of application.

If for example, it is determined that the amendments will apply to annual periods beginning on or after 1 January 2020, the date of initial application is 1 January 2020. The additional guidance regarding costs of fulfilling a contract would therefore be applied to any contracts that exist at 1 January 2020. Any adjustments will be made to retained earnings on 1 January 2020, and comparatives will not be restated.

Comments due

The Australian Accounting Standards Board is requesting comments by 22 March 2019, and the International Accounting Standards Board by 15 April 2019. We encourage any interested parties to submit comments.