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Has an external event resulted in an unavoidable liability or a loss-making contract?

      

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(This article was published on 4 January 2021 and updated on 31 October 2023)

What’s the issue?

External events – e.g. geopolitical unrest, natural disasters, climate effects or inflationary pressures – may impact companies adversely – e.g. affecting their production processes, disrupting their supply chains, causing labour shortages and leading to closures of stores and facilities. 

This means that in such circumstances some existing purchase or sale contracts may become loss-making and require a provision. In addition, some companies may struggle to fulfil legal or contractual obligations and may be subject to penalties – e.g. for delays or non-performance – also resulting in a provision.

However, a provision is recognised only for an existing present obligation – not for future operating losses.

Brian O'Donovan

Global IFRS and Corporate Reporting Leader

KPMG International

If an external event results in a liability, or a contract becoming loss-making, then the company needs to recognise a provision.

Getting into more detail

Onerous contracts

IFRS® Accounting Standards provide specific guidance for onerous (loss-making) contracts – i.e. those in which the unavoidable costs of meeting the obligations exceed the economic benefits expected to be received under the contract. The unavoidable costs are the lower of the net costs of fulfilling the contract and the cost of terminating it.

A sales contract may become onerous if costs rise or are expected to rise – e.g. because the company needs to incur additional labour or subcontractor costs caused by high inflation. A sales contract may also become onerous if benefits are expected to be lower – e.g. because a fall in demand affects the pricing. When assessing the unavoidable costs, companies should consider the contract terms carefully, including termination and force majeure clauses. 

When preparing projections of costs and benefits for the onerous contract test, a company needs to reflect expectations at the reporting date and use assumptions that are consistent with those used for other recoverability assessments – e.g. impairment of non-financial assets. If a situation related to a specific external event – e.g. a natural disaster, geopolitical unrest, climate effects or inflationary pressures – is rapidly changing, then a company may need to update projections it made before the reporting date to reflect the information available, conditions and outlook at the reporting date.

The provision for an onerous contract is discounted if the effect of the time value of money is material. Central banks may cut or increase interest rates in response to concerns about the economic impact of a specific external event; this in turn may impact risk-free rates, which are often used to discount provisions. Companies need to update the discount rate if it has changed. 

Before recognising a provision for an onerous contract, a company tests all assets dedicated to the contract for impairment.

Read our seven-step guide to find out more.


Penalties

Under IFRS Accounting Standards, if a company has a present obligation, which it cannot avoid and is expected to result in the outflow of economic resources, then it recognises a provision if the amount can be estimated reliably.

In the case of an external event that may result in economic uncertainty, companies may need to review their existing contracts and consider the interpretation of applicable law, particularly force majeure clauses, to determine whether they have an obligation triggered by that event. In some cases, this may require them to recognise additional provisions – e.g. for failure to comply with applicable laws and regulations. Conversely, in some countries the event may be regarded as force majeure and penalties for non-performance, late delivery or cancellation may be waived. This assessment may require legal advisers to be involved. 


Future operating losses

A provision is recognised only for an existing present obligation – i.e. a company cannot recognise a provision for future operating losses or business recovery costs.

Actions for management

  • Consider whether an external event has triggered a liability that would result in an outflow of resources.
  • Review termination clauses in key purchase and sales contracts to determine whether the cost of exiting a contract is lower than the cost of fulfilling it. 
  • Update projections of costs and benefits for the onerous contracts test. Ensure that the assumptions are consistent with projections made for other purposes – e.g. impairment analysis. Check whether the risk-free rate used to discount provisions has changed.
  • Perform the impairment test first before recognising a provision for an onerous contract.
  • Provide clear and meaningful disclosures about judgements and estimates made in recognising and measuring provisions.