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IAS 37 — Considering whether a contract is onerous

Date recorded:

IAS 37 Provisions, Contingent Liabilities and Contingent Assets Costs considered in assessing whether a contract is onerous (Agenda Paper 5)

Background

In its September 2017 meeting, the Committee tentatively decided to add a project to clarify the meaning of the term ‘unavoidable costs’, which is used in the definition of an onerous contract in IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

At the November 2017 meeting the staff recommended that the clarification be by way of an amendment to IAS 37 and that the scope of the project be limited to clarifying the meaning of ‘unavoidable costs’, and not consider broader issues related to identifying or measuring an onerous contract.  The Committee agreed with the Staff’s recommendation but decided to leave open what form the clarification should take until the project is more mature.

At this (March 2018) meeting, the Committee will be asked to decide what requirements to propose and whether to develop a draft Interpretation or propose narrow-scope amendments to IAS 37.

Staff analysis

In June 2017, the Committee assessed that the costs of fulfilling a contact could be limited to the costs the entity would avoid if it did not have the contract, ie the incremental costs of the contract or they could also include an allocation of overhead costs incurred for activities required to fulfil the contract.

The staff considered these alternatives. Limiting the costs to the incremental costs could be considered to be consistent with the general requirements of IAS 37 which specify that no provision should be recognised for costs that need to be incurred to operate in the future. Furthermore, costs that are shared across several contracts will be incurred by the entity regardless of whether it fulfils that particular contract. So those other costs are not costs of ‘fulfilling the contract’. They are instead costs that need to be incurred to operate in the future.

Even if the overhead costs are expected to give rise to operating losses, the expectation of losses would not be enough to justify recognising a provision for those costs. Paragraph 63 of IAS 37 prohibits recognition of provisions for future operating losses. Paragraph 64 explains that this is because future operating losses do not meet the definition of a liability.

However, the staff think that including an allocation of overhead costs incurred for activities required to fulfil the contract would be consistent with other requirements in IAS 37, result in a more faithful representation of the cost of fulfilling a contract than would result from including only incremental costs, and enable the Committee to specify requirements in IAS 37 that are broadly consistent with those of other Standards—IFRS 15, IAS 2, IAS 16, IAS 38 and IAS 40 all use some notion of ‘directly related’ or ‘directly attributable’ costs when specifying which costs to include in the measurement of the initial cost of the asset.

The staff conclude that in the context of IAS 37.68, the ‘cost of fulfilling’ a contract should include both the incremental costs of fulfilling the contract and an allocation of overhead costs incurred for activities required to fulfil the contract.

The staff then consider whether and how to specify the types of overhead costs that should be included in the ‘cost of fulfilling’ a contract. They considered whether to describe them as ‘costs that an entity cannot avoid because it has the contract’ or whether to use one of the terms used in other Standards (‘costs that relate directly to a contract’; ‘directly related costs’; or ‘directly attributable costs’). They settled on ‘costs that relate directly to the contract’.

The staff considered whether including examples in IAS 37 would be helpful. They note that IAS 37 covers a wide range of transactions. However, because the purpose of the examples would to illustrate the types of costs to include be included, it would be possible to create general examples of costs that do and do not relate directly to a contract using the examples in IFRS 15, adapted to apply to contracts with counterparties other than customers. The paper includes examples.

The staff think that their proposed approach would add new requirements to IAS 37 that would apply to all onerous contracts rather than clarify how existing requirements should apply to particular types of onerous contracts. They also think that the new could be inserted into IAS 37 without disrupting the structure of the Standard.

Staff recommendations

The staff recommend that the Committee propose that:

  • a) the ‘cost of fulfilling’ a contract should include both the incremental costs of fulfilling the contract and an allocation of overhead costs incurred for activities required to fulfil the contract;
  • b) specify that the ‘cost of fulfilling’ a contract comprises the ‘costs that relate directly to the contract’;
  • c)include examples of costs that do and do not relate directly to a contract to provide goods or services; and
  • d) develop its proposals as separate narrow-scope amendments to IAS 37, rather than as an Interpretation of IAS 37 or as part of the annual improvements process.

Discussion

This was an open discussion about which costs should be considered in measuring n onerous contract provision. The paper had suggested the costs of fulfilling the contract plus an allocation of overhead costs incurred for activities required to fulfil the contract.

There were mixed views.  Some members preferred a narrow set of costs (just the costs to fulfil) because they were concerned that if the meaning of costs that relate directly to the contract was too wide it would be inconsistent with the requirement in IAS 37 that states that provisions must not be recognised for future losses. Accordingly, much of the discussion was about the extent to which related costs should be included in the provision and how to word the requirement.  The unit of account was discussed briefly, with one member stating that definition of a contract refers to “the contract”, which implies a narrower focus than the broader costs being considered. When comparing costs to fulfil with unavoidable costs, the latter are costs you have to incur anyway so they are not part of the costs of the contract.

One member thought that referring the “an allocation of overhead costs” was not a good example when discussing costs directly attributable to a contract.

Overall, the members were generally comfortable with the direction. It should be made clear why broadening the cost pool is not bringing future losses into the provision. Committee members were asked to think about examples that would be useful in developing the amendment, and might be able to be used as an illustrative example. One member noted that the most common contracts that become onerous are leases and sale contracts (and the other side i.e. purchase contracts). 

The Committee decided to develop a proposal to amend IAS 37 (14:0) that would specify that the ‘cost of fulfilling’ a contract comprises the ‘costs that relate directly to the contract’ (13:1), with examples to illustrate the application of this (14:0).

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