How to test a provision for onerous purchase commitments

Testing a provision for onerous purchase commitments means identifying firm, non-cancellable purchase orders or forward purchase contracts where the unavoidable cost of meeting the obligation exceeds the economic benefit expected to be received from it, and then measuring the provision at the lower of the cost of fulfilling the contract and the cost of exiting it, including any compensation or penalty payable. This procedure covers committed purchase orders for goods at a fixed price, which is a distinct contract type from the service and supply contracts covered in the general onerous contract provision procedure, because the economic benefit the entity receives and the exit mechanics are both different.

Why committed purchase orders need a separate lens

A long-term service or supply contract usually generates its own revenue stream, so the test compares the contract's costs to the revenue it brings in. A purchase commitment for raw material or stock has no revenue stream of its own — the economic benefit it brings is whatever the entity can do with what it buys, which means the comparison runs through the realisable value of the inventory it will receive, not through a contract-level margin calculation.

The testing sequence

1. 01Identify all firm, non-cancellable purchase commitments outstanding at the reporting dateOpen purchase orders with fixed quantities and fixed or formula-based prices that cannot be cancelled without penalty, forward purchase contracts for commodities, and take-or-pay arrangements with suppliers.
2. 02Confirm the commitment is genuinely unavoidableA purchase order that can be cancelled without penalty, or amended on notice, is not an unavoidable obligation and does not meet the threshold for a provision — it may still need disclosure as a commitment, which is a separate question.
3. 03Obtain the current market price for the same goods as at the reporting dateFrom the entity's own recent purchase transactions at market rates, published commodity prices, or quotations obtained independently, rather than relying solely on management's assertion that the committed price is above market.
4. 04Trace the economic benefit side through to realisable value, not just to the purchase price gapWhere the goods purchased will be processed and sold, the relevant comparison is the net realisable value of the end product against the full cost of production including the committed purchase price, consistent with how inventory is tested for net realisable value — a raw material price above current market does not make the commitment onerous if the finished product it goes into still sells at a profit.
5. 05Recompute the lower of the cost of fulfilling and the cost of exitingObtain the supplier contract's cancellation or exit terms — penalty clauses, minimum take provisions, liquidated damages — and compare that exit cost to the net unavoidable cost of simply fulfilling the commitment.
6. 06Quantify the provision at the lower of the two and test the measurement dateThe provision is for the full remaining term of the firm commitment as at the reporting date, not just the following period, unless the commitment itself is shorter.
7. 07Test for partial fulfilment and double-counting against inventory already receivedGoods already received and recorded as inventory under the commitment are tested through the normal inventory net realisable value procedure; the onerous commitment provision should cover only the remaining, unfulfilled portion, to avoid providing twice for the same loss.