Learning Outcomes
After reading this article, you will be able to explain what constitutes an onerous contract and a restructuring under IAS 37. You will know when a provision must be recognised, how to calculate and measure it, and what requirements must be met for a restructuring provision. You will also be able to distinguish between provisions, contingent liabilities, and future operating losses for ACCA exam purposes.
ACCA Financial Reporting (FR) Syllabus
For ACCA Financial Reporting (FR), you are required to understand the accounting treatment of provisions, contingent liabilities, and contingent assets, with a particular focus on onerous contracts and restructuring. Specifically, you need to be comfortable with:
- The definition and recognition criteria for provisions under IAS 37
- Identifying and recognising provisions for onerous contracts
- Recognition and measurement rules for restructuring provisions, including required disclosure
- The distinction between provisions, contingent liabilities, and future costs
- Calculation and measurement of provision amounts, including discounting where relevant
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which three criteria must be met for a provision to be recognised under IAS 37?
- What makes a contract "onerous" and when is a provision required?
- State two key conditions required before a restructuring provision can be recognised.
- True or false? A general intention to sell a business division in future creates a valid restructuring provision.
Introduction
Provisions are liabilities of uncertain timing or amount. IAS 37 sets strict rules for when to recognise a provision, especially for onerous contracts and restructuring plans—areas often tested in the ACCA FR exam. Understanding the recognition, measurement, and disclosure requirements is essential for accurate financial reporting and avoiding common mistakes that lead to exam errors.
Key Term: provision
A liability of uncertain timing or amount, recognised when there is a present obligation from a past event, an outflow of resources is probable, and the amount can be reliably estimated.
Onerous Contracts
An onerous contract exists where the unavoidable costs of fulfilling a contract are higher than the economic benefits expected to be received from it. The "unavoidable costs" refer to the least net cost of exiting from the contract—either fulfilling it or paying compensation to exit.
Key Term: onerous contract
A contract in which the unavoidable costs of meeting the obligations exceed the expected economic benefits to be received under it.
When a contract becomes onerous, a provision must be made for the net unavoidable cost. If a company must pay penalties to exit rather than deliver, the lower of the costs should be used.
Worked Example 1.1
Oberon Ltd has an agreement to buy inventory for $100,000. Contractual penalties for not taking delivery are $70,000. The expected selling price of goods dropped, and Oberon estimates it can only sell the inventory for $60,000, with delivery costs of $5,000. Should a provision be recognised, and for what amount?
Answer:
Oberon compares the cost of fulfilling the contract ($100,000 + $5,000 – $60,000 = $45,000 loss) versus the penalty for non-fulfilment ($70,000). Since fulfilling is less costly, an onerous contract provision of $45,000 is required, representing the loss from contract fulfilment.
Exam Warning
A frequent error is to recognise a provision before a contract is onerous (i.e., before the unavoidable costs exceed benefits). Only when a loss is unavoidable must a provision be made.
Restructuring Provisions
A restructuring involves a planned, material change in the scope of a business or its operations. Under IAS 37, a provision for restructuring is only permitted if specific criteria are met:
- A detailed, formal plan exists
- The plan creates a valid expectation in those affected (usually by public announcement to employees or others impacted)
Key Term: restructuring
A planned and controlled program that materially changes the scope of a business or the way it is conducted.
Only direct expenditures resulting from restructuring and not applicable to ongoing activities are included (e.g., redundancy costs, asset write-downs). Ongoing costs such as retraining or marketing are excluded.
Key Term: constructive obligation
An obligation that arises from an entity’s actions, where a pattern of past practice, published policies or a specific statement has created a valid expectation among other parties that the entity will accept certain responsibilities.
Worked Example 1.2
Bolt plc decides in February to close a factory and has drafted a plan, but as of the reporting date (31 March) this has not been communicated to employees or other affected parties. Can Bolt plc recognise a restructuring provision at year-end?
Answer:
No. Without communication to affected parties, there is no constructive obligation. A board decision alone is insufficient. The provision can only be recognised once those affected have a valid expectation that the restructuring will proceed.
Worked Example 1.3
Merton Ltd announces a plan to close a division, with expected redundancies and loss on asset disposal. The plan excludes retraining costs for staff who will stay with the company post-restructure. What costs should be included in the restructuring provision?
Answer:
The provision can include redundancy payments and any losses on disposal of assets, as these are direct costs. Retraining costs are not included as they relate to future operations, not directly to the closure event.
Measurement of Provisions
Provisions for onerous contracts and restructuring should be measured at the best estimate of the expenditure required to settle the obligation at the reporting date. When cash flows occur in the future and the effect of the time value of money is material, the provision should be discounted to present value.
Key Term: best estimate
The amount an entity would rationally pay to settle an obligation or transfer it to a third party at the reporting date.
Revision Tip
Always consider which costs are unavoidable and relate directly to the restructuring—exclude costs connected with ongoing activities.
Contingent Liabilities and Future Operating Losses
Future operating losses do not meet the provision criteria and must not be recognised. Intended future expenditures where no present obligation exists cannot be provided for. If the outcome is possible but not probable, or cannot be measured reliably, disclose as a contingent liability.
Key Term: contingent liability
A present obligation from a past event that is not recognised because it is not probable or cannot be measured reliably; or a possible obligation arising from a past event depending on future events not wholly within the entity’s control.
Summary
IAS 37 requires provisions for onerous contracts only when there is a present obligation and a likely cash outflow. For restructuring provisions, a detailed and communicated plan is mandatory, and only certain direct costs are included. Future operating costs and restructuring costs relating to future operations must not be provided for.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and identify onerous contracts as per IAS 37
- Explain the recognition and measurement criteria for restructuring provisions
- List the types of costs that can and cannot be included in a restructuring provision
- Distinguish between provisions, contingent liabilities, and future operating losses
- Calculate the required provision for an onerous contract using the lowest net cost
Key Terms and Concepts
- provision
- onerous contract
- restructuring
- constructive obligation
- best estimate
- contingent liability