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Onerous contracts
Extract from FRS 102 – Section 21.10-21.11A
21.11A If an entity has an onerous contract, the present obligation under the contract shall be recognised and measured as a provision (see Example 2 of the Appendix to this section)
OmniPro comment
Appendix 1 to FRS 102 defines an onerous contract as one in which the unavoidable costs of meeting the obligation under the contract exceed the economic benefits expected to be received under it. The unavoidable costs under a contract reflect the least net cost of exiting from the contract. This is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. It is irrelevant as to whether an entity intends to make the cheapest choice or not, the least net cost is the only amount that should be provided for. The economic benefits to be considered are both the direct and indirect benefits.
Where such a contract exists the future operating losses on these contracts should be provided for.
Example 10: Onerous lease
Company A entered into a lease on an office block in year 1 for a 10 year period for CU100,000 per annum. At the end of year 4, due to economic circumstances and reductions in staff the entity no longer has any use for the property and cannot sublease it but are contractually tied in for a further 6 years from that date. The company has discussed with the landlord as to the cost of terminating the lease early which they stated would be CU500,000.
As the entity is contractually committed to pay the lease, there is a present obligation as a result of a past event i.e. the signing of the contract to take on the lease for 10 years for which no further benefits will be obtained and a reliable estimate can be determined, a provision should be recognised for the lower of the cost to terminate of CU500,000 or the future lease amounts payable for 6 years of CU600,000. Therefore a provision should be recognised for CU500,000 and should be present valued where it is considered material.
Example 11: Onerous lease
Take example 10, and this time the entity can sublet the property for the remaining 6 years to a tenant for CU50,000 per annum. In this case a provision would be required for the amount by which the costs exceed the economic benefits which would be the amount net of sublease income which is CU300,000 present valued where material ((CU100,000-CU50,000)*6 years). Even if the premises has not been sublet by the end of year 6, the CU300,000 should still be used where it can be proven that there is a market for the property maybe through evidence provided by an auctioneer and there is evidence of the likely lease per annum that can be obtained. The income received from the sub-tenant would be shown as other income in the financial statements. The provision would be reduced year on year for the amount paid to the tenant in the year. The journals assuming present valuing was not required would be to:
|
|
CU |
CU |
|
Dr Provision |
50,000 |
|
|
Cr Rent Cost |
|
50,000 |
Being journal to reflect the reduction of the provision at each year end
|
|
CU |
CU |
|
Dr Rent Costs |
100,000 |
|
|
Cr Bank |
|
100,000 |
Being journal to reflect the payment of funds to the landlord
|
|
CU |
CU |
|
Dr Bank |
50,000 |
|
|
Cr Rental Income |
|
50,000 |
Being journal to reflect the receipt of funds from the subtenant.
Example 12: Onerous supply contract
Company A entered into a purchase contract with a supplier for 3 years (minimum amount of units to be ordered per annum is 50,000) at a time when supply of raw materials were scarce for a cost of CU10 per unit. A year later, the price for the same raw material was CU4, however the entity is contractually obliged to purchase a further 100,000 at a minimum from that supplier. The company can still sell the finished goods product which incorporates this part at the higher price at a profit of CU5.
Given that the entity makes a profit overall on the product there is no onerous contract so therefore no provision is required.
If we take the above example and this time assume that the product will be discontinued at the end of year 2 and during year 2, 40,000 finished goods will be sold incorporating the profit of CU5. Therefore in assessing whether an onerous contract exists there would be a need to take the net additional costs of the excess units of CU360,000 (60,000*(CU10-CU4) from the total profit from the sale of the 40,000 units in year 2 of CU200,000 (CU5 profit on finished good * 40,000 units). Therefore a provision should be made for the difference of CU160,000 at the end of year 1.
The same logic as example 12 would be applied to an onerous sales contract.
Future operating losses
Extract from FRS 102 – Section 21.11B
21.11B Provisions shall not be recognised for future operating losses (see Example 1 of the Appendix to this section).
OmniPro comment
Section 21 does not allow future operating losses to be recognised as a provision. This is consistent with old GAAP and IFRS. However under old GAAP, FRS 3 did allow future operating losses to be incorporated into a provision for termination of operations where the decision had been made and communicated prior to the balance sheet date. FRS 102 does not allow this treatment.
The reasoning for not allowing operating losses to be provided for is due to the fact that the entity has the choice to cease trading immediately/earlier and therefore it would not have to incur these losses. Hence there is no present obligation. This contrasts with provision for onerous leases where the entity has a contractual obligation to hold on to the lease for its life. However it may indicate that an impairment exists on the assets of the business which is dealt with under Section 27.
See further example extracted from FRS 102, Section 21A.1
Example 13: Future operating losses (Extracted from Section 21A.1 of FRS 102)
An entity determines that it is probable that a segment of its operations will incur future operating losses for several years.
Present obligation as a result of a past obligating event: There is no past event that obliges the entity to pay out resources.
Conclusion: The entity does not recognise a provision for future operating losses. Expected future losses do not meet the definition of a liability. The expectation of future operating losses may be an indicator that one or more assets are impaired (see Section 27 Impairment of Assets).
Restructuring
Extract from FRS 102 – Section 21.11C-21.11D
21.11C A restructuring gives rise to a constructive obligation only when an entity:
(a) has a detailed formal plan for the restructuring identifying at least:
(i) the business or part of a business concerned;
(ii) the principal locations affected;
(iii) the location, function, and approximate number of employees who will be compensated for terminating their services;
(iv) the expenditures that will be undertaken; AND
(v) when the plan will be implemented; AND
(b) has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.
21.11D An entity recognises a provision for restructuring costs only when it has a legal or constructive obligation at the reporting date to carry out the restructuring.
OmniPro comment
FRS 102 – Appendix 1 defines a restructuring ‘as a programme that is planned and controlled by management and materially changes either:
- the scope of a business undertaken by an entity; OR
- the manner in which the business is conducted.
Examples of items that would come within the remit of a restructuring are:
- changes in management structure including redundancies of staff to so as to significantly reduce the cost base
- the sale or termination of a line of business
- the closure of business locations in a country or region
- fundamental reorganisations that have a material effect on the nature and focus of the entity’s operations.
Section 21.11C above details the requirements in order for a constructive obligation to have arisen before the balance sheet date.
The key requirement in order for a provision to be created is that:
- management have communicated their plans to affected parties prior to the year end date;
AND
- there is evidence to prove this.
For example, if a board meeting is held before the year end by management whereby they approved a significant restructuring which involved significant redundancies as a result of the closure of a product line but they have not communicated this to any of the outside/effected parties, then a provision cannot be made as they have not created a valid expectation to third parties, hence they could still pull out of the reorganisation as they could realistically withdraw.
Examples which may prove the management have implemented a detailed restructuring plan are:
- communication to the parties affected by the restructuring whether that be a formal communication to employees as a whole or to employee representatives etc
- physically dismantling plant that is going to be scrapped/sold
- selling the excess assets as a result of the decision
- making public announcements of the plan
The following are examples of items that could be included in restructuring provisions:
- voluntary redundancies which if not accepted will become mandatory
- compulsory redundancies
- lease cancellation fees for the premises being vacated due to the closure.
The following are examples of items that could not be included in restructuring provisions as they are determined to be costs of ongoing activities:
- relocation expenses of employees
- retraining of the remaining employees
- recruitment costs for new staff
- marketing costs to develop new marketing image
- investments in a new distribution network due to the closure of the old one
- relocation expenses
- Future operating losses up to the date of cessation and closure
- Impairment provision for warehouses etc. as these should be assessed for impairment in accordance with Section 27
- Consulting fees to identify future corporate strategies or organisational structures
- Cost of relocating inventory and equipment that will be used in other factories/locations
- Cost of upgrading computer systems
Example 14: Closure of a division: no implementation before end of reporting period (Extracted from Section 21A.6 of FRS 102)
On 12 December 20X0 the board of an entity decided to close down a division. Before the end of the reporting period (31 December 20X0) the decision was not communicated to any of those affected and no other steps were taken to implement the decision.
Present obligation as a result of a past obligating event: There has been no obligating event, and so there is no obligation.
Conclusion: The entity does not recognise a provision.
Example 15: Closure of a division: communication and implementation before end of reporting period (Extracted from Section 21A.6 of FRS 102)
21A.7 On 12 December 20X0 the board of an entity decided to close a division making a particular product. On 20 December 20X0 a detailed plan for closing the division was agreed by the board, letters were sent to customers warning them to seek an alternative source of supply, and redundancy notices were sent to the staff of the division.
Present obligation as a result of a past obligating event: The obligating event is the communication of the decision to the customers and employees, which gives rise to a constructive obligation from that date, because it creates a valid expectation that the division will be closed.
An outflow of resources embodying economic benefits in settlement: Probable as it can be reliably measured.
Conclusion: The entity recognises a provision at 31 December 20X0 for the best estimate of the costs that would be incurred to close the division at the reporting date.
Example 16: Restructuring provision – no formal plan
Company A has approved a restructuring of its operations at a board meeting. They have made a formal announcement to all those effected parties. However management have a very general plan as to what locations are to be closed but no final decision has been made.
In this instance although they have a constructive obligation (i.e. the formal communication to the effected parties) they have not a detailed plan of action detailing which locations will be closed and the number of employees that will be made redundant. As there is no detailed plan as required by Section 21.C(a) a provision cannot be created at the year end.
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