contract. [IAS 37.82]. This means that even if the operation being reorganised is loss-
making, its ongoing costs are not provided for. This is consistent with the general
prohibition against the recognition of provisions for future operating losses. [IAS 37.63].
The general requirement in the standard that gains from the expected disposal of assets
cannot be taken into account in the measurement of provisions, [IAS 37.51], is also
relevant to the measurement of restructuring provisions, even if the sale of the asset is
envisaged as part of the restructuring. [IAS 37.83]. Whilst the expected disposal proceeds
from asset sales might have been a significant element of the economic case for a
restructuring, the income from disposal is not anticipated just because it is part of a
restructuring plan.
6.2 Onerous
contracts
Although future operating losses in general cannot be provided for, IAS 37 requires that
‘if an entity has a contract that is onerous, the present obligation under the contract shall
be recognised and measured as a provision’. [IAS 37.66].
The standard notes that many contracts (for example, some routine purchase orders)
can be cancelled without paying compensation to the other party, and therefore there
is no obligation. However, other contracts establish both rights and obligations for each
of the contracting parties. Where events make such a contract onerous, the contract
falls within the scope of the standard and a liability exists which is recognised.
Executory contracts that are not onerous fall outside the scope of the standard. [IAS 37.67].
IAS 37 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’. [IAS 37.10]. This requires that the contract is onerous to the point of
being directly loss-making, not simply uneconomic by reference to current prices.
IAS 37 considers that ‘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’. [IAS 37.68]. This evaluation does
not require an intention by the entity to fulfil or to exit the contract. It does not even
require there to be specific terms in the contract that apply in the event of its
termination or breach. Its purpose is to recognise only the unavoidable costs to the
entity, which in the absence of specific clauses in the contract relating to termination or
breach could include an estimation of the cost of ceasing to honour the contract and
having the other party go to court for compensation for the resultant breach.
There is some diversity in practice in how entities determine the unavoidable costs of
fulfilling their obligations under a contract. In November 2017, the Interpretations
Committee decided to add a narrow-scope standard-setting project to its agenda to
1912 Chapter 27
clarify the meaning of the term ‘unavoidable costs’ in the definition of an onerous
contract. In March 2018, the Committee recommended that the Board should:
a.
specify that the ‘cost of fulfilling’ a contract comprises the costs that relate directly
to the contract;
b.
provide examples of costs that do (and do not) relate directly to a contract to
provide goods and services; and
c.
develop its proposals as a narrow-scope amendment to IAS 37, rather than as an
Interpretation of IAS 37 or as part of the annual improvements process.15
At the time of writing, an exposure draft is expected in the last quarter of 2018.16
As noted above, IAS 37 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’. [IAS 37.10]. There is also some diversity in
practice in how entities determine the economic benefits expected to be received under
a contract. However, the Interpretations Committee decided that the narrow scope
project should not clarify which economic benefits an entity considers when assessing
whether a contract is onerous.
There is a subtle yet important distinction between making a provision in respect of the
unavoidable costs under a contract (reflecting the least net cost of what the entity has
to do) compared to making an estimate of the cost of what the entity intends to do. The
first is an obligation, which merits the recognition as a provision, whereas the second is
a choice of the entity, which fails the recognition criteria because it does not exist
independently of the entity’s future actions, [IAS 37.19], and is therefore akin to a future
operating loss.
Example 27.15: Onerous supply contract
Entity P negotiated a contract in 2016 for the supply of components when availability in the market was
scarce. It agreed to purchase 100,000 units per annum for 5 years commencing 1 January 2017 at a price of
$20 per unit. Since then, new suppliers have entered the market and the typical price of a component is now
$5 per unit. Whilst its activities are still profitable (Entity P makes a margin of $6 per unit of finished product
sold) changes to the entity’s own business means that it will not use all of the components it is contracted to
purchase. As at 31 December 2019, Entity P expects to use 150,000 units in future and has 55,000 units in
inventory. The contract requires 200,000 units to be purchased before the agreement expires in 2021. If the
entity terminates the contract before 2021, compensation of $1 million per year is payable to the supplier.
Each finished product contains one unit of the component.
Therefore, the entity expects to achieve a margin of $900,000 (150,000 × $6) on the units it will produce and
sell; but will make a loss of $15 ($20 – $5) per unit on each of the 105,000 components (55,000 + 200,000 –
150,000) it is left with at the end of 2020 and now expects to sell in the components market.
In considering the extent to which the contract is onerous, Entity P in the example
above should not concentrate solely on the net cost of the excess units of $1,575,000
(105,000 × $15) that it is contracted to purchase but which are expected to be left unsold.
Instead, the entity should consider all of the related benefits of the contract, which
includes the profits earned as a result of having a secure source of supply of
components. Therefore the supply contract is onerous (directly loss making) only to the
extent of the costs not covered by related revenues, justifying a provision of $675,000
($1,575,000 – $900,000).
Provisions, contingent liabilities and contingent assets 1913
6.2.1 Onerous
leases
As discussed at 2.2.1.B above, for entities applying IFRS 16, the scope of IAS 37 has been
amended to apply to leases only in limited circumstances. IAS 37 will apply only to:
• leases that become onerous before the commencement date of the lease; and
• short-term leases (as defined in IFRS 16) and leases for which the underlying asset
is of low value that are accounted for in accordance with paragraph 6 of IFRS 16
and that have become onerous. [IAS 37.5(c)].
The guidance in 6.2.1.A to 6.2.1.C below is mainly relevant to entities that still apply
IAS 17. Paragraph 5(c) of IAS 37 (prior to the consequential amendments in IFRS 16)
noted that, if operating leases become onerous, there are no specific requirements
within IAS 17 to address the issue and thus, IAS 37 applies to such leases.
6.2.1.A Recognition
of
provisions for vacant leasehold property
As discussed at 6.2.1 above, the guidance in this section is mainly relevant to entities not
yet applying IFRS 16. For entities applying IFRS 16, the recognition of a provision for
vacant leasehold property would be appropriate only in respect of property leases that
become onerous before the commencement date of the lease, and short-term property
leases (as defined in IFRS 16) that are accounted for in accordance with paragraph 6 of
IFRS 16. For entities applying IFRS 16, IAS 37 applies also to leases for which the
underlying asset is of a low value and which are accounted for in accordance with
paragraph 6 of IFRS 16, but we would not expect leases of property to qualify as leases
for which the underlying asset is of a low value.
Among entities still applying IAS 17, the most common example of an onerous contract
in practice relates to leasehold property. From time to time entities may hold vacant
leasehold property which they have substantially ceased to use for the purpose of their
business and where sub-letting is either unlikely, or would be at a significantly reduced
rental from that being paid by the entity. In these circumstances, the obligating event is
the signing of the lease contract (a legal obligation) and when the lease becomes
onerous, an outflow of resources embodying economic benefits is probable.
Entities have to make systematic provision when such properties become vacant, and
on a discounted basis where the effect is sufficiently material. Indeed, it is not just when
the properties become vacant that provision would be required, but that provision
should be made at the time the expected economic benefits of using the property fall
short of the unavoidable costs under the lease. This may occur prior to an entity
physically vacating a property. The recognition of onerous lease provisions for
occupied leasehold property when the entity has no current intention of vacating the
property is addressed at 6.2.1.B below. For vacant, or soon to be vacated, leasehold
property consideration will need to be given to the point in time at which the lease
becomes onerous and whether this may occur prior to the property being physically
vacated. Although the Interpretations Committee had a preliminary discussion in
December 2003 about the timing of recognition and the measurement of a provision for
an onerous lease, including its application to other types of executory contracts such as
a take or pay contract, it agreed that the issue should not be taken onto its agenda at
that time.17 In our view, it may be appropriate to recognise an onerous lease provision
1914 Chapter 27
prior to physically vacating a property if an entity has made a commitment to vacate
from which it cannot realistically withdraw or if the unavoidable costs of meeting the
obligations under the lease exceed the economic benefits expected to be received under
that lease (see 6.2.1.B below).
Nevertheless, where a provision is to be recognised a number of difficulties remain. The
first is how the provision should be calculated. It is unlikely that the provision will
simply be the net present value of the future rental obligation, because if a substantial
period of the lease remains, the entity will probably be able either to agree a negotiated
sum with the landlord to terminate the lease early, or to sub-lease the building at some
point in the future. Hence, the entity will have to make a best estimate of its future cash
flows taking all these factors into account.
Another issue that arises from this is whether the provision in the statement of financial
position should be shown net of any cash flows that may arise from sub-leasing the
property, or whether the provision must be shown gross, with a corresponding asset set
up for expected cash flows from sub-leasing only if they meet the recognition criteria
of being ‘virtually certain’ to be received. Whilst the expense relating to a provision can
be shown in the income statement net of reimbursement, [IAS 37.54], the strict offset
criteria in the standard (see 4.6 above) would suggest the latter to be required, as the
entity would normally retain liability for the full lease payments if the sub-lessee
defaulted. However, the standard makes no explicit reference to this issue. It is common
for entities to apply a net approach for such onerous contracts under IAS 37. Indeed, it
could be argued that because an onerous contract provision relates to the excess of the
unavoidable costs over the expected economic benefits, [IAS 37.68], there is no
corresponding asset to be recognised. In its 2005 exposure draft of proposed
amendments to IAS 37, the IASB confirmed that if an onerous contract is an operating
lease, the unavoidable cost of the contract is the remaining lease commitment reduced
by the estimated rentals that the entity could reasonably obtain, regardless of whether
or not the entity intends to enter into a sublease.18
In the past, some entities may have maintained that no provision is required for vacant
properties, because if the property leases are looked at on a portfolio basis, the overall
economic benefits from properties exceed the overall costs. However, this argument is
not sustainable under IAS 37, as the definition of an onerous contract refers specifically
to costs and economic benefits under the contract. [IAS 37.10].
It is more difficult to apply the definition of onerous contracts to the lease on a head
office which is not generating revenue specifically. If the definition were applied too
literally, one might end up concluding that all head office leases should be provided
against because no specific economic benefits are expected under them. It would be
more sensible to conclude that the entity as a whole obtains economic benefits from its
head office, which is consistent with the way in which corporate assets are allocated to
other cash generating units for the purposes of impairment testing (see Chapter 20
at 4.2). [IAS 36.101]. However, this does not alter the fact that if circumstances change and
the head office becomes vacant, or the unavoidable costs of meeting the obligations
under the head office lease come to exceed the economic benefits expected to be
received (see 6.2.2 below), a provision should then be made in respect of the lease.
Provisions, contingent liabilities and contingent assets 1915
IAS 37 requires that any impairment loss that has occurred in respect of assets dedicated
to an onerous contract is recognised before establishing a provision for the onerous
contract. [IAS 37.69]. For example, any leasehold improvements that have been capitalised
should be written off before provision is made for excess future rental costs.
One company which provided for onerous leases under IAS 37 is Jardine Matheson as
indicated by the following extract.
Extract 27.2: Jardine Matheson Holdings Limited (2017)
>
Notes to the Financial Statements [extract]
32 Provisions
[extract]
Obligations
Reinstate-
Motor
under
ment and
Statutory
vehicle Closure cost
onerous
restoration
employee
warranties
provisions
leases
costs
entitlements Others
Total
US$m
US$m
US$m
US$m
US$m US$m
US$m
2017
At 1st January
46
8
17
52
108
32
263
Exchange
differences
4 1 2 2 (1)
–
8
Additional provisions
13 48 6 13 16
12
108
Unused amounts reversed
–
(3)
(10)
(1)
–
(12)
(26)
Utilized
(5) (4) (1) (2) (2)
(10)
(24)
At 31st December
58 50 14 64 121
22
329
Non-current –
1
14
54
100
6
175
Current
58 49 – 10 21
16
154
58 50 14 64 121
22
329
2016
At 1st January
39
8
16
45
101
20
229
Exchange
differences
(1) – (1) (1) 3
–
–
Additional provisions
12 7 2
10 7
15
53
Unused amounts reversed
–
(3)
–
–
(1)
(1)
(5)
Utilized (4)
(4)
–
(2)
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 377