Onerous contracts and cost of fulfilling a contract

Learning objectives

• Determine whether a contract is onerous by comparing its unavoidable costs of meeting the obligations with the economic benefits expected (positive least net cost of exiting the contract).L2, L3
• Calculate the cost of fulfilling the contract (incremental costs and an allocation of other costs that relate directly to it) and the least net cost of exiting the contract (the lower of the net cost of fulfilling it, i.e. cost of fulfilment less expected benefits, and the exit penalties).L2, L3
• Analyse the order of treatment: impairment loss on assets dedicated to the contract (IAS 36), then a provision for the balance.L3, L4
• Recognise the provision for an onerous contract.L2, L3
• Justify the classification of a contract that can be cancelled without paying compensation, or of an executory contract that is not onerous, as outside the scope.L3, L4

Normative references

• IAS 37 §66If an entity has a contract that is onerous, the present obligation under the contract is recognised and measured as a provision.
• IAS 37 §67Many contracts (some routine purchase orders, for example) can be cancelled without paying compensation: there is then no obligation. Other contracts establish both rights and obligations for each party; where events make such a contract onerous, it falls within the scope of the standard and a liability is recognised. Executory contracts that are not onerous remain outside the scope.
• IAS 37 §68A contract is onerous when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The unavoidable costs 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.
• IAS 37 §68AThe cost of fulfilling a contract comprises the costs that relate directly to the contract: the incremental costs of fulfilling it (for example, direct labour and materials) 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 that contract among others).
• IAS 37 §69Before a separate provision for an onerous contract is established, the entity recognises any impairment loss that has occurred on assets used in fulfilling the contract (IAS 36).

Original summaries of the paragraphs (reference register), never a quotation of the standard.

17 questions

• If an entity has an onerous contract, the present obligation under the contract is recognised and measured as a provision.L2
• When is a contract onerous under IAS 37?L2
• Lavrel has undertaken to maintain a customer's fleet of forklift trucks until the end of the contract. After the rise in spare-part prices, performing the contract would cost it {cost_of_fulfilling} (cost of fulfilling calculated in accordance with the standard, case data) and bring it {expected_benefits}. The contract allows Lavrel to exit by paying a penalty of {exit_penalty}. Compute the onerous contract provision.L2
• Morlane, an industrial cleaning contractor, remains bound for another {remaining_years} years by a contract to clean a customer's site. After the rise in wages, performing the contract will cost it {annual_cost} a year (cost of fulfilling calculated in accordance with the standard, case data), while the customer pays it {annual_fee} a year. Early termination would cost it compensation of {termination_indemnity}. The effect of discounting is not material. What amount does Morlane provide for?L3
• To assess whether a contract to supply moulded parts is onerous, Nivelane lists the costs still to be incurred: direct labour {direct_labour}; direct materials {direct_materials}; share of the depreciation of the press used for this contract and others, using the key chosen by Nivelane (case data), {depreciation_share}; share of head office administrative costs {head_office_costs}. Compute the cost of fulfilling the contract.L3
• Orvande must deliver, at a fixed price of {contract_price}, components for which the contract provides no way out. Costs still to be incurred: incremental costs {incremental_costs}; share of the depreciation of the press used {press_depreciation}; share of the depreciation of moulds shared with other contracts {mould_depreciation}; share of general administrative overheads {general_overheads}. The shares result from the keys chosen by Orvande (case data). Compute the cost of fulfilling and the provision (no impairment of the equipment).L3
• Pralune signed a fixed-price supply contract that has become onerous; no specific asset is used to fulfil it. The excess of the unavoidable costs over the expected benefits is {onerous_loss}. Record the entry at the reporting date.L2
• The machining contract that Quirel concluded with an equipment manufacturer has become onerous. A machine is used exclusively to fulfil it; the test performed under IAS 36 shows an impairment loss of {impairment} (case data). After this impairment loss, the excess of the unavoidable costs over the expected benefits is {remaining_loss}. Record the entries in the required order.L3
• A purchase order that Rézal can cancel without paying compensation creates no obligation, even if the price terms have become unfavourable to it.L3
• Salvère has firmly committed to buy paper in 20X6; neither party has yet performed its obligations. The paper will be processed and resold at a positive margin. What is the treatment of the contract under IAS 37?L3
• Which of these costs of Tilvane are included in the cost of fulfilling a manufacturing contract?L3
• Urbanel Méca concluded that a contract priced at 500,000 is not onerous: its incremental costs still to be incurred are 470,000. It did not take into account the share, determined using its allocation key (case data), of 60,000 of depreciation of the equipment used for this contract and others. What is the error?L3
• For an onerous contract fulfilled using a dedicated packaging line, Valmondis recognised a provision for the whole expected loss without examining the value of the line, whose carrying amount nevertheless exceeds its recoverable amount. What is the error?L3
• In 20X6, Wavrelle must deliver parts at a total fixed price of 1,020,000; the contract contains no exit clause. The remaining cost of fulfilling, computed in accordance with the standard, is 1,150,000. No asset is used exclusively for this contract. What does Wavrelle conclude at 31 December 20X5?L3
• Xantela is fulfilling a waste treatment contract that has become onerous using an incinerator that it also uses for other customers. Management control proposes three approaches. Which one complies with the standard?L4
• Yrvane has signed a firm, non-cancellable contract to deliver chassis over two years. Remaining incremental costs: 2,300,000; price still to be invoiced: 2,600,000. A press shared with other contracts could be allocated to the contract at 200,000 (key: machine hours) or 380,000 (key: tonnage). The press also shows an indication of impairment. Write a memo on whether the contract is onerous and on the recognition steps, distinguishing rule, data and judgement.L4
• The unavoidable costs of a contract are always equal to its cost of fulfilling.L3