Insight

Businesses must now identify extra costs in onerous contracts

Mark Hucklesby Mark Hucklesby

Some areas of accounting have what could be described as geography issues; you’ve got a map of an area, but there might be two versions showing slightly different boundaries.

This is currently the case for onerous contracts. However, the standards for these types of contracts are currently being updated to improve consistency and replace variations in application that currently exist.

Incremental vs. direct

A contract is onerous when it contains unavoidable costs of meeting the obligations under the agreement that exceed the economic benefits expected to be received from the contract.

The current international accounting standard (NZ IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’) does not specify what to include in determining the cost of fulfilling a contract, and this leads to variations in accounting practices. This issue becomes particularly relevant when assessing what revenue should be reported under the latest revenue recognition standard (NZ IFRS 15 ‘Revenue from Contracts with Customers’), because depending on how one assesses fulfilment costs, contracts that on the surface might appear to be profitable, could indeed be loss-making, and if they are, this needs to reflected in financial statements as soon as this fact has been identified.

This ambiguity prompted the International Accounting Standards Board (IASB) to recently issue the Exposure Draft ‘Onerous Contracts – Cost of Fulfilling a Contract’. The IASB outlined two approaches for determining the cost of fulfilling a contract:
a. The incremental cost approach
b. The directly related cost approach

The difference between these two methods is the 'directly related' cost approach includes all the costs an entity cannot avoid because the contract is in place. Included in these costs are the incremental costs of the contract and an allocation of other costs incurred on activities required to fulfil the agreement. Examples of these other costs might be insurance and depreciation of the equipment being used to fulfill the contract.

When life happens

The changes aim to provide one process and more consistency; onerous contracts can involve significant amounts of money, so having a consistent approach will benefit all investors.

Anyone can find themselves in an onerous contract situation, even when due diligence was completed. Sometimes life happens. Take for example, a startup company who project they are about to grow rapidly, pack up and move into an office in the city and enter an office lease above the market rate. They enter into a contractual arrangement with a landlord for five years, leasing 100 square metres of office space. However, a competitor comes along with a similar idea one year after their office move, so they reduce their employee headcount and consequently they no longer need all of the office space they originally committed to for the remaining four years of the leasing contract. Fortunately, the startup company can sublease its office space, but only for an amount significantly below their current rental amount for the remaining lease period, so an economic loss from this subcontracting arrangement should be recognised as soon as it is put in place.

Another example where onerous contracts can arise is when one is dealing with revenue contracts with customers and assessing the costs of fulfilling that business arrangement. An evaluation of what are the incremental costs versus the directly related costs may not end up being the same. That is because all costs directly related to an onerous contract situation must, if applicable, now take into consideration:

  • Direct labour: eg, salaries and wages of employees who will attend to and monitor the contractual arrangement(s)
  • Direct materials: eg, any supplies used in fulfilling the contract
  • Allocations of costs that relate directly to contract activities: eg, 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. Other costs incurred only because an entity entered into the contract: eg, payments to subcontractors

Consistency creates clarity

Having to use the 'directly related' cost approach means that businesses will probably recognise onerous contract arrangements earlier than they might otherwise have. Particular care will be needed when an entity has several contracts in place at the same time, because they might be assessed as being profitable when the economic benefits are compared only with incremental costs being taken into account, but they are loss-making once all the shared costs (ie directly related) are included.

Clarification of what should and should not be included in assessing whether an onerous contract arrangement is present is a good move by the IASB. The New Zealand Accounting Standards Board has indicated that it intends to mirror this change in its financial reporting standards as well because it will reduce existing variations in how to account for onerous contracts.