Onerous commodity and raw-material purchase commitments

Commodity price volatility is common in manufacturing input costs (resins, metals, agricultural inputs), so failing to recognize an onerous take-or-pay or fixed-price commitment understates liabilities and overstates profit until losses actually crystallize in future periods' cost of sales, distorting current-period results and hiding forward margin pressure from investors and lenders relying on covenant and liquidity forecasts.

Is the purchase commitment genuinely unavoidable (firm, non-cancellable or cancellable only with penalty) for a fixed volume of raw material or commodity? Has the contract been screened for embedded derivative features (net settlement, ability to resell in a trading pattern) that would move it out of IAS 37 and into IFRS 9? Has the unavoidable loss been measured as the lower of the cost to fulfil and the cost to exit, for the full remaining committed volume?

1. Confirm the purchase commitment is unavoidable - i.e., it is a firm, non-cancellable (or cancellable only with a penalty) obligation for a fixed volume of raw material or commodity, such as a take-or-pay or fixed-price forward purchase contract.
2. Confirm the contract is an executory contract for own-use purchase (not a financial instrument); if it contains features of a derivative not clearly for normal purchase, use, or sale in the ordinary course, first assess whether it falls under IFRS 9 as an embedded derivative instead of IAS 37. 3. Compare the current market price (or expected net realizable value of the output made using the input) to the committed contract price for the remaining committed volume. 4. If the unavoidable cost of fulfilling the commitment exceeds the economic benefit expected from it, and the entity cannot exit without penalty, recognize a provision for the excess - do not anticipate losses on contracts that are merely out-of-the-money but not yet onerous (i.e., avoidable without penalty). 5. Measure the provision as the lower of the cost of fulfilling the contract (net of expected benefit) and any cost of exiting the contract (penalty), whichever the entity would rationally choose. 6. Reassess the provision at each reporting date as market prices, remaining committed volumes, and exit terms change, releasing the provision as volumes are delivered against or the market price recovers.

Measurement basis: the provision equals the unavoidable excess of the contracted purchase cost over the current economic benefit obtainable (current market price of the input, or expected net realizable value of the output made from it), for the remaining committed volume, measured at the lower of the cost to fulfil and the cost to exit. Included: the full remaining committed volume under the unavoidable contract term, discounted to present value if the time value of money effect is material given the remaining contract duration. Excluded: volumes already delivered and expensed/inventoried at actual cost, and any volume the entity can avoid without penalty. Remeasurement trigger: reassess at each reporting date for movements in market/forward prices, changes in remaining committed volume as deliveries occur, and any renegotiation of contract or exit terms; release the provision as the contract is fulfilled or the market price recovers above the contract price.

Disclose: (1) the nature of the onerous purchase commitment (commodity, take-or-pay structure, remaining term and volume); (2) the amount of the provision and its movement during the period (additions, utilization, releases); (3) key assumptions used to measure it (forward price curves or spot price used, contract terms, discount rate if the timing effect is material); (4) the total remaining committed purchase value versus current market value, if material to understanding exposure; (5) any related embedded-derivative assessment performed under IFRS 9, if relevant.

• Ignoring a fixed-price commodity contract that has moved out-of-the-money simply because no delivery has yet occurred and no loss has been realized in cash terms
• recognizing a provision for a contract that remains avoidable without penalty (e.g., can be cancelled with notice and no material exit cost), when IAS 37 does not permit anticipating losses on such executory contracts
• failing to distinguish an onerous purchase contract to be assessed under IAS 37 from a contract containing an embedded derivative that should instead be assessed under IFRS 9
• measuring the provision using a spot price snapshot without considering the full remaining committed volume and term, or ignoring available exit penalties that would produce a lower loss
• not releasing/reducing the provision as committed volumes are delivered against or as market prices recover, leaving a stale provision on the balance sheet.