Loss Contracts

Loss contracts, also called onerous contracts, arise when the costs to fulfill a contract exceed the consideration expected from the customer. Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, does not specifically address loss contracts. Instead, guidance for loss contracts is found in ASC 605 and in other ASC topics. This article brings these topics together as a resource for determining the accounting for loss contracts.

Loss Contracts Codification Background

A loss contract is a contract in which the expected consideration from the customer is less than the expected costs of fulfilling the contract. When the Financial Accounting Standards Board (FASB) first released an exposure draft for ASC 606, the draft included guidance on accounting for loss performance obligations. However, after receiving feedback from respondents, the FASB decided to remove this guidance and retain the previous guidance for loss contracts in ASC 605, Revenue Recognition.

ASC 605-10-5-4 provides references for the provision of losses associated with certain revenue arrangements. If a loss contract does not fit into one of these arrangements, companies must develop a policy for accounting for the contract. In many instances, this will mean analogizing to one of the Subtopics listed ASC 605-10-5-4 or following the loss contingencies guidance in ASC 450-20. The next section provides more detail on each Subtopic listed in ASC 605 related to loss contracts.

Loss Contract Types With Specific ASC 605 Guidance                                                                    

Separately Priced Extended Warranty and Product Maintenance Contracts

One type of transaction for which loss contract guidance exists is separately priced extended warranties and product maintenance contracts. These contracts offer warranty protection and product maintenance services separately from the original product.

To determine if a loss on one of these contracts must be recorded, companies should determine if the sum of the following items exceeds the associated unearned revenue (contract liability):

1. The future costs companies expect to incur by providing the services set forth in the contract (e.g., replacement part or labor costs).
2. The unamortized incremental costs capitalized at contract inception.

Incremental costs are defined as costs incurred from obtaining the contract that would not have been incurred if the contract had not been obtained (ASC 340-40-25-2). A sales commission is a common example of an incremental cost because the cost is incurred only if the contract is successfully obtained.

If the sum of expected costs to fulfill the contract and any unamortized incremental costs exceeds the contract's unearned revenue, the difference must be recorded as a loss at the end of the reporting period. To record the loss, the company should first derecognize the unamortized incremental costs. If the loss exceeds the unamortized incremental costs, the company must also recognize a liability for the remaining amount (ASC 605-20-25-6).

Construction-Type and Production-Type Contracts

Construction- and production-type contracts involve either of the following (ASC 605-35-05-1):

1. Construction or production of goods according to a buyer's specifications, such as a contract to construct a buyer's home according to the buyer’s specifications.
2. A related service that is essential to the construction/production of goods built to meet a buyer’s specifications, such as an engineering firm that contracts to design a tool that will later be constructed to meet buyer’s specifications.

The FASB specifies that for a construction- and production-type contract, a loss exists if the expected total costs of the contract are greater than the total consideration from the buyer. The loss is equal to the amount by which those costs exceed the total consideration and must be recognized in the period it first becomes evident (ASC 605-35-25-46).

The guidance for losses on construction- and production-type contracts allows companies to evaluate contracts for losses at one of two levels (ASC 605-35-25-47): 

Software Contracts

Software contracts that require significant production, modification, or customization should be accounted for under ASC 605-35 (ASC 605-35-15-3(f)), which is the same guidance that applies to losses on construction- and production-type contracts, as described above.

For multiple-element software arrangements, if a loss is probable for a specific performance obligation based on the transaction price allocated to that obligation, the company should apply ASC 450 Contingencies to that loss (ASC 985-605-25-7). ASC 450 requires that a loss be recognized when the loss is probable and the amount of the loss is reasonably estimable (ASC 450-20-25-2).

Insurance Contracts

Although insurance contracts are not within the scope of ASC 606, the loss guidance for insurance contracts is included here for comparison. The only guidance for loss contracts in the insurance industry is in reference to foreign property and liability reinsurance, which states that a provision for a loss should be recorded when it is probable that the loss has been incurred before an underwriting balance has closed (ASC 944-605-35-7). This can occur in situations such as:

• Catastrophic losses
• Higher-than-expected claim frequency
• Significant unanticipated adverse events
• Negative open year account

Insurance contracts can be complex, and a more thorough discussion of this guidance is beyond the scope of this article.

Federal Government Contracts

Guidance for loss contracts is available for entities that contract to provide goods or services to the federal government. If the termination of a contract for default results in a loss, the loss should be reported as a separate item in the income statement or disclosed in the notes to financial statements (ASC 912-20-45-5). The termination of a contract for default refers to the government’s right to terminate a contract for the entity’s failure to perform the obligations.

Continuing Care Retirement Community Contracts

ASC 954-440-35-1 through 35-3 explain that if the fees charged to a resident of a retirement community will be insufficient to meet the costs of providing future services and the use of facilities, then the continuing care retirement community should record a liability equal to the expected costs less the anticipated revenues. This liability should be based off of actuarial assumptions, estimates of future costs and revenue, historical experience, and other statistical data. The future net cash flows should be discounted to their present value. Contracts should be grouped by type (e.g., contracts with or without a limit on annual fee increases). This assessment of whether fees expected to be collected will be sufficient to meet expected costs should be performed annually.

Prepaid Healthcare Services Contracts

A loss for prepaid healthcare services should be recognized when the expected future health care and maintenance costs will be more than the anticipated future premiums and stop-loss insurance recoveries (i.e., reimbursement for excess costs), as stated in ASC 954-450-30-3 through 30-4. These losses should be looked at as a group of existing contracts, which should be consistent with the provider’s method of establishing premium rates. When determining whether or not a loss has been incurred, the company should include all costs—i.e.,fixed and variable, direct and allocable indirect costs (ASC 954-450-30-3).

Long-Term Power Sales Contracts

ASC 980-350-35-3 explains that the loss guidance for long-term power sales contracts only applies to contracts that are not accounted for as a derivative under ASC 815, Derivatives and Hedging. When ASC 980 applies, these contracts should be periodically reviewed to determine whether it is a loss contract, and if it is, the loss should be recognized immediately. No specific guidance is provided on how to measure the loss.

Differences in IFRS Loss Contracts Guidance

Like the FASB, the International Accounting Standards Board (IASB) refers to a different standard to address the accounting for loss contracts rather than including it in International Financial Reporting Standards (IFRS) 15, their revenue recognition standard. Guidance for loss contracts is found in International Accounting Standards (IAS) 37, Provisions, Contingent Liabilities and Contingent Assets.

In IAS 37, a loss contract is defined as a contract where unavoidable costs exceed the economic benefits expected to be received under the contract. Unavoidable costs are considered to be the lesser of 1) fulfilling the contract or 2) paying any penalties from failure to fulfill it.

If a contract is considered a loss, the present obligation under the contract should be recognized and measured as a provision. If the time value of money is material, the economic benefits and costs should be measured at their present values (IAS 37 par. 45). Any impairment losses on assets for that contract should be recognized before the loss contract is established (IAS 37 par. 69).

Conclusion

The guidance for loss contracts is not contained in ASC 606 or IFRS 15. Instead, companies should refer to legacy GAAP (indexed in ASC 605 by the FASB and IAS 37 by the IASB) when determining their policy for recognizing and disclosing loss contracts.

Resources Consulted

• ASC 605 Revenue Recognition
• KPMG, Handbook: “Revenue Recognition.” December 2019. Section 13.
• IAS 37 Provisions, Contingent Liabilities and Contingent Asset