Onerous Contracts and Contract Costs

Costs to obtain and fulfil a contract, and where IAS 37 takes over

The five-step model tells a company how to recognise revenue once a contract is up and running profitably. It has much less to say about two related, and commercially important, questions: what happens to the costs a company incurs to win and fulfil a contract, and what happens when a contract turns out to be a loss maker. This tenth article in our series covers both, starting with contract costs, which IFRS 15 does address directly, before turning to onerous contracts, which are governed by a different standard entirely, a distinction that trips up more finance teams than you might expect.

Costs to Obtain a Contract

IFRS 15 requires an entity to capitalise the incremental costs of obtaining a contract, provided the entity expects to recover those costs. Incremental costs are costs that would not have been incurred if the contract had not been obtained, the clearest example being a sales commission paid only when a deal closes. Costs that would have been incurred regardless of whether the contract was won, such as a salesperson's base salary or general marketing spend, are not incremental and are expensed as incurred.

***IN PRACTICE** *A sales representative earns a 5,000 dirham commission for closing a new three year services contract, payable only on signature. Because this commission would not have been paid if the deal had fallen through, it is incremental and, provided the entity expects to recover it through the contract's margin, must be capitalised as an asset and amortised over the period the related goods or services are transferred, rather than expensed immediately in the period the sale was made.*"

IFRS 15 does include a practical expedient here as well: an entity may expense costs to obtain a contract immediately if the amortisation period of the resulting asset would have been one year or less. This spares companies from capitalising and amortising small, short cycle commission payments where the accounting effort would outweigh any meaningful difference in the numbers.

Costs to Fulfil a Contract

Costs incurred in fulfilling a contract that are not already covered by another standard, such as inventory guidance or property, plant and equipment guidance, are capitalised under IFRS 15 only if all three of the following conditions are met.

1. The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify.
2. The costs generate or enhance resources of the entity that will be used in satisfying performance obligations in the future.
3. The costs are expected to be recovered.

Costs that fail any one of these three tests, general administrative overhead not chargeable to the customer, costs of wasted materials or labour not reflected in the contract price, or costs relating to obligations already satisfied, are expensed as incurred rather than capitalised.

Amortisation and Impairment

Capitalised contract costs, whether costs to obtain or costs to fulfil, are amortised on a systematic basis consistent with the transfer to the customer of the goods or services to which the asset relates. This amortisation basis often mirrors the revenue recognition pattern of the associated performance obligations, though it is not automatically identical to it. Capitalised contract cost assets are also subject to impairment testing: an entity recognises an impairment loss to the extent the carrying amount of the asset exceeds the remaining amount of consideration the entity expects to receive, less the costs that relate directly to providing those goods or services that have not yet been recognised as expenses.

Onerous Contracts: A Different Standard Entirely

Here is where many finance teams, quite reasonably, expect IFRS 15 to provide guidance and find that it does not. IFRS 15 explicitly does not address the accounting for contracts that have become loss making. Instead, this falls under IAS 37, Provisions, Contingent Liabilities and Contingent Assets, which requires an entity to recognise a provision for the present obligation under an onerous contract.

Under IAS 37, a 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 the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. When a contract meets this definition, the entity recognises a provision for the full amount of the expected loss, generally before any of that loss has actually been incurred, because the obligation to complete the contract at a loss is itself a present obligation arising from a past event, namely entering into the contract.

***IN PRACTICE** *A construction company signs a fixed price contract to build a bridge for 40 million dirhams. Midway through construction, unexpected ground conditions and steel price increases push the total estimated cost to complete to 46 million dirhams. The contract is onerous, and the company must recognise a provision under IAS 37 for the full expected loss on the remaining work, not merely defer recognising a margin, as soon as the loss becomes evident, rather than waiting for the loss to actually be incurred through the normal revenue recognition process.*"

How the Two Standards Interact

In practice, the two standards work together rather than in conflict. IFRS 15 governs how revenue and any associated contract asset or liability are recognised as the entity performs, while IAS 37 separately requires a provision for any onerous element identified at a reporting date. When applying an overtime measure of progress using a cost to cost method, for example, an entity recognises revenue for work performed to date under IFRS 15, but if the overall contract is expected to result in a loss, it must additionally recognise an IAS 37 onerous contract provision for the remaining expected loss on the work not yet performed. The two entries are not substitutes for one another, and companies that overlook the IAS 37 provision because they assume IFRS 15 covers it entirely can materially understate their liabilities.

Practical Points for Managing Both Areas

• Build a clear process for tracking incremental contract acquisition costs separately from base compensation and overhead, so the capitalisation assessment is not left to memory at period end.
• Apply the one year amortisation practical expedient consistently, and document the population it covers.
• Track estimated costs to complete on long duration contracts regularly, not only at year end, so an emerging onerous position is identified as early as possible.
• Keep the IFRS 15 revenue recognition analysis and the IAS 37 onerous contract assessment as two distinct, clearly documented exercises performed in parallel for long term contracts.

How CLA Can Help

Applying IFRS 15 correctly is rarely just a technical exercise. It touches contract drafting, sales operations, systems configuration, and the judgment calls that auditors will test closely. CLA's revenue recognition specialists work alongside finance teams to translate the standard into practical, defensible policy. Specifically, our team can help with:

• Reviewing sales compensation structures to identify which costs qualify for capitalisation under IFRS 15.
• Building amortisation and impairment models for capitalised contract cost assets.
• Assessing long duration contracts for onerous contract indicators and quantifying IAS 37 provisions where required.
• Advising on the interaction between IFRS 15 progress measurement and IAS 37 provisioning for the same contract.
• Designing estimate to complete processes for project based businesses to catch loss making contracts early.

Whether you are implementing IFRS 15 for the first time, refreshing a legacy policy, or preparing for an audit or transaction, CLA can bring the technical depth and industry experience to get it right the first time.

Conclusion

Contract costs and onerous contracts sit just outside the five-step model, yet both directly affect the profitability picture a company presents. Capitalising the right costs, amortising them sensibly, and recognising loss provisions under IAS 37 as soon as they become evident are all part of a complete and defensible revenue and margin story. In our final article of this series, we turn to principal versus agent considerations, a question that determines whether a company reports revenue on a gross or net basis.