13.5 Onerous Performance Obligations

Both U.S. GAAP and IFRS Accounting Standards include guidance on accounting for certain types of onerous contracts. A contract is considered onerous if the aggregate cost required to fulfill the contract is greater than the expected economic benefit to be obtained from the contract. When this condition is met, the guidance may require an entity to recognize the expected future loss before actually incurring the loss. Onerous contracts have historically been accounted for as follows:

U.S. GAAP — As indicated in ASC 605-10-05-4, existing guidance under U.S. GAAP addresses the recognition of losses on the following specific transactions:
- Separately priced extended warranty and product maintenance contracts (ASC 605-20).
- Construction- and production-type contracts (ASC 605-35).
- Certain software arrangements (ASC 985-605).
- Certain insurance contracts (ASC 944-605).
- Certain federal government contracts (ASC 912-20).
- Continuing care retirement community contracts (ASC 954-440).
- Prepaid health care services (ASC 954-450).
- Certain long-term power sales contracts (ASC 980-350).
  
  In addition, ASC 450-20 provides overall guidance on accounting for loss contingencies. Such guidance requires an entity to recognize an expected loss if the contingency is probable and the amount is reliably estimable. Further, ASC 330-10-35-17 and 35-18 provide guidance on the recognition of losses on firm purchase commitments related to inventory.
IFRS Accounting Standards — IAS 37 provides general guidance on the recognition and measurement of losses on onerous contracts.

In developing the revenue standard, the FASB and IASB considered including guidance on identifying and measuring onerous performance obligations (i.e., an “onerous test”). As stated in paragraph BC294 of ASU 2014-09, the boards initially (1) believed that “an onerous test was needed because the initial measurements of performance obligations are not routinely updated” and (2) “noted that including an onerous test would achieve greater convergence of U.S. GAAP and IFRS [Accounting Standards].”

Many stakeholders disagreed with including an onerous test in the revenue standard. Those stakeholders provided feedback indicating that application of an onerous test at the performance obligation level may result in the recognition of a liability for an onerous performance obligation even if the overall contract is expected to be profitable. In addition, stakeholders believed that the existing guidance on accounting for onerous contracts was sufficient and that additional guidance was unnecessary.

The boards considered this feedback and ultimately agreed that the existing guidance under both U.S. GAAP and IFRS Accounting Standards sufficiently addresses onerous contracts. Consequently, the boards decided not to include specific guidance on accounting for onerous contracts in the revenue standard, but rather to retain existing onerous contract guidance. Accordingly, contracts within the scope of the guidance referred to above may need to be evaluated as onerous contracts.

Connecting the Dots

As noted above, one of the reasons that the boards initially wanted to include an onerous test in the revenue standard was to promote convergence between U.S. GAAP and IFRS Accounting Standards. Although achieving convergence was one of the goals of the revenue standard, paragraph BC296 of ASU 2014-09 states the boards “noted that although their existing guidance on onerous contracts is not identical, they are not aware of any pressing practice issues resulting from the application of that existing guidance.” Accordingly, the absence of an onerous test in the revenue standard is not expected to hinder overall convergence of revenue recognition under U.S. GAAP and IFRS Accounting Standards; however, differences in the accounting for onerous contracts will remain. While the existing guidance on accounting for onerous contracts has not changed, there have been changes to other guidance on recognizing revenue and costs as a result of the revenue standard. Therefore, entities should carefully consider the interaction between the revenue standard and existing guidance on onerous contracts to ensure that no changes result.

13.5.1 Technical Corrections to ASC 605-35-25

The revenue standard supersedes most of the guidance in ASC 605-35-25. However, the existing guidance in ASC 605-35-25 on provision for loss contracts was retained because the FASB decided not to include specific guidance on onerous contracts in the revenue standard but to retain the practice under U.S. GAAP of recording losses on onerous contracts within the scope of ASC 605-35. The technical corrections of ASU 2016-20 include an update to ASC 605-35-25 that allows an entity to determine the provision for losses on contracts within the scope of ASC 605-35 at the performance obligation level or the contract level as an accounting policy election.

13.5.1.1 Providing for Anticipated Losses

As noted above, the guidance on onerous contracts within the scope of ASC 605-35 was not superseded by ASU 2014-09 or any of the amendments to the ASU’s guidance. Consequently, the following guidance is still applicable to construction type contracts:

ASC 605-35

Provisions for Losses on Contracts

25-45 For a contract on which a loss is anticipated, an entity shall recognize the entire anticipated loss as soon as the loss becomes evident.

25-46 When the current estimates of the amount of consideration that an entity expects to receive in exchange for transferring promised goods or services to the customer, determined in accordance with Topic 606, and contract cost indicate a loss, a provision for the entire loss on the contract shall be made. Provisions for losses shall be made in the period in which they become evident.

25-46A For the purpose of determining the amount that an entity expects to receive in accordance with paragraph 605-35-25-46, the entity shall use the principles for determining the transaction price in paragraphs 606-10-32-2 through 32-27 (except for the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration) and allocating the transaction price in paragraphs 606-10-32-28 through 32-41. In addition, the entity shall adjust that amount to reflect the effects of the customer’s credit risk.

25-47 If a group of contracts are combined based on the guidance in paragraph 606-10-25-9, they shall be treated as a unit in determining the necessity for a provision for a loss. If contracts are not combined, the loss is determined at the contract level (see paragraph 605-35-25-45). As an accounting policy election, performance obligations identified in accordance with paragraphs 606-10-25-14 through 25-22 may be considered separately in determining the need for a provision for a loss. That is, an entity can elect to determine provisions for losses at either the contract level (including contracts that are combined in accordance with the guidance in paragraph 606-10-25-9) or the performance obligation level. An entity shall apply this accounting policy election in the same manner for similar types of contracts.

Losses on contracts should not be allocated to future periods by spreading them over the remaining contract years or deferring them in expectation of receiving future or follow-on contract awards. In addition, contract losses should be accrued when known regardless of whether they are currently deductible for tax purposes.

When an entity concludes that a loss on a contract within the scope of ASC 605-35 has been incurred (i.e., total estimated contract costs exceed the consideration expected to be received), the entity should apply the guidance in ASC 605-35-25-49 to determine which costs to factor into the calculation of the loss. Such costs include all costs allocable to the contract under ASC 340-40-25-5 through 25-8.

Example 13-19

Entity Y sells and leases battery storage solutions systems. In addition, as part of the arrangement, Y is required to manufacture the batteries and install and commission them at the customer’s site. The installation services are determined to be a separate performance obligation that is satisfied over time through the use of a cost-to-cost method to measure progress. The installation services involve constructing a platform to support the batteries along with significant electrical work to connect the batteries in the system to the customer’s network or infrastructure. The installation services also include surveying, obtaining safety certifications, and environmental controls necessary to perform construction and installation in a manner consistent with customer specifications. The installation services are therefore determined to be within the scope of ASC 605-35 on construction-type and production-type contracts. Entity Y’s accounting policy is to record onerous contract losses at the performance obligation level as permitted by ASC 605-35-25-47.

Entity Y receives fixed fees that are allocated to the battery system and the installation services at contract inception on the basis of their relative stand-alone selling prices. On the basis of the amounts allocated to the installation services and in accordance with Y’s current projections, Y estimates that it will incur a loss on the installation services, primarily because of delays and disruptions caused by the government (i.e., permitting process) to Y’s established construction schedule. As a result of such delays and disruptions, Y will incur additional direct costs to complete the installation services. Since the installation services are within the scope of ASC 605-35, a provision for loss would be estimated and recognized for the installation services in accordance with ASC 605-35-25-49.

ASC 605-35-25-49 states that the estimated loss should include costs allocable to contracts under ASC 340-40-25-5 through 25-8. In accordance with ASC 340-40-25-7(d) and 25-8(a), when Y determines the loss to record on its contracts, it would include general and administrative expenses in the provision for anticipated losses if they are costs that are explicitly chargeable to the customer under the contracts.

13.5.2 Application of the Loss Guidance in ASC 605-35 That Affects Impairment of Capitalized Contract Cost Assets

The example below illustrates how to record an impairment of an asset related to the capitalized costs of fulfilling a contract in a manner consistent with the guidance in ASC 605-35-45-2.

Example 13-20

Company M provides a cleaning and restoration service for certain outdoor spaces after natural disasters have occurred. On June 30, 20X0, M enters into a contract with a customer to clean up and restore a beach after a disastrous hurricane. Since the service that M provides under the contract requires the use of construction vehicles and the assembly of temporary infrastructure (e.g., a piping system for moving sand or water to and from various locations), M incurs significant up-front costs to fulfill the contract. Company M expects that the costs of mobilizing the necessary construction vehicles and assembling the temporary infrastructure will be recovered through the contract with the customer. In addition, M determines that it should recognize revenue from the contract over time by using an input method based on costs incurred.

At contract inception, M estimates or determines the following:

One year later, on June 30, 20X1, M updates its EAC calculation and now expects to incur a loss on the contract. The updated calculations are as follows:

As a result, M will recognize the expected contract loss immediately (as of June 30, 20X1) in accordance with the guidance in ASC 605-35 in the amount of $300,000. Note that M will also have to record a cumulative catch-up adjustment to revenue in the same period (as of June 30, 20X1).8

Company M should first record an impairment of the asset related to the capitalized costs of fulfilling the contract. If the expected loss on the contract caused an impairment of the entire asset related to the capitalized costs of fulfilling the contract, M should then account for the remainder of the expected loss as a loss reserve, which would be classified as a liability on M’s balance sheet. Recording impairment in this order is consistent with the guidance in ASC 605-35-45-2, which states the following:

Provisions for losses on contracts shall be shown separately as liabilities on the balance sheet, if significant, except in circumstances in which related costs are accumulated on the balance sheet, in which case the provisions may be deducted from the related accumulated costs. In a classified balance sheet, a provision shown as a liability shall be shown as a current liability. [Emphasis added]

On the basis of the guidance above, which was issued before the guidance in ASC 606 but has not been amended or superseded, the expected loss first impairs the capitalized contract costs of fulfilling the contract. Subsequently, a provision for a loss is established on the balance sheet.

Company M should record the following journal entry:

Since the expected loss on the contract ($300,000) is larger than the remaining asset related to the capitalized costs of fulfilling the contract ($120,000), M needs to establish a loss reserve (liability) to account for the remainder of the expected loss ($180,000).

13.5.3 Separately Priced Extended Warranty Contracts and Product Maintenance Contracts

The recognition of losses resulting from separately priced extended warranty or product maintenance contracts is addressed in ASC 605-20-25-1 and ASC 605-20-25-6. These contracts provide warranty protection or product services not included in the original price of the product covered by the contracts. Under ASC 605-20-25-6, a loss on such contracts is recognized if the expected costs plus the amount of any asset recorded for the incremental cost of obtaining a contract exceed the contract liability plus any amount not yet due from the customer related to the performance obligation. To record a loss, an entity should first expense any asset recorded for the incremental cost of obtaining a contract and then recognize a liability for the remainder of the loss. In determining whether a loss should be recognized, an entity should group contracts in a consistent manner.

Footnotes

For simplicity, any adjusting revenue entry (and any corresponding adjustment to the loss provision) is not illustrated in this example.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.