Auditing restructuring and onerous contract provisions
The evidence an auditor needs before accepting a restructuring or onerous contract provision under IAS 37, and the timing games to watch for.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
A new managing director arrives in the final quarter. By year end the board has approved a plan to close two branches, the old results have been called "disappointing", and the draft statements carry a large restructuring provision. Next year, under new leadership, profits recover. Some of that recovery will be real. Some of it may be costs that were charged to the year the old team is blamed for.
Restructuring and onerous contract provisions are where the accounting rules are strict and the incentives to stretch them are strong. This article covers the evidence an auditor should obtain before accepting either provision, and the signs that the timing has been chosen for effect.
When a restructuring provision may be recognised
IAS 37, as the IFRS Foundation summarises it, defines a provision as a liability of uncertain timing or amount, which may be a legal obligation or a constructive obligation. A constructive obligation arises from the entity's own actions, through which it has shown others it will accept certain responsibilities and so created an expectation that it will meet them.
For restructuring, IAS 37 recognises a provision only when the entity has a constructive obligation because the main features of the detailed restructuring plan have been announced to those affected by it.
Two conditions sit in that sentence, and the auditor needs evidence for both:
- A detailed plan. Not an intention or a strategy paper, but a plan that identifies what is being restructured, where, who is affected and roughly what it will cost.
- An announcement to those affected, before year end. A board decision kept inside the boardroom does not create an expectation in anyone outside it.
The announcement as key evidence
ACCA's article on examining evidence states that, for a restructuring provision, the auditor should expect to see a copy of the announcement, which has to be made before the year end for a provision to be recognised.
Ask for it, and test it:
- Date. Agree the date to when it was actually issued: e-mail headers, notice board records, union correspondence, minutes of staff meetings.
- Audience. Was it made to the employees, customers or suppliers actually affected, or only to senior management?
- Content. Does it describe the main features of the plan, or only an intention to "review operations"?
- Consistency. Does it match the plan used to calculate the provision?
Where staff are affected, look for the consultation steps employment law requires in the country concerned; their start is often good evidence of when the plan became public. Our article on provisions and contingent liabilities covers the general recognition tests.
Onerous contracts and the costs to include
IAS 37 also states that an onerous contract gives rise to a provision. The IFRS Foundation notes that a May 2020 amendment clarified that, in assessing whether a contract is onerous, the cost of fulfilling it includes both the incremental costs and an allocation of other costs that relate directly to fulfilling contracts.
Typical onerous contracts in clients' books include a fixed-price supply agreement where input costs have risen, a commitment to buy goods the client can no longer sell at a profit, or a service contract priced below cost to win the work. For each:
- read the contract and identify the remaining obligations;
- recompute the cost to fulfil, including directly related costs allocated in line with the amendment, not only the incremental ones;
- compare with the economic benefits still to be received;
- check whether exiting the contract would cost less than fulfilling it.
No provisions for future operating losses
IAS 37 states plainly that a provision cannot be recognised for future operating losses, because there is no obligation at the end of the reporting period.
This is the line clients most often cross. A restructuring provision that includes the losses the business expects to make while it winds down is, in part, a provision for future operating losses. Go through the provision line by line and ask, for each cost: is this a cost of the restructuring itself, or a cost of running or improving the business that remains? Then check each answer against what IAS 37 allows a restructuring provision to include.
Recording procedures and adjustments in Achekam
In Achekam, the work item for provisions lists the procedures to perform and the documents required, and a step is complete only when it has a written response and its documents, or has been set aside with a reason; steps are never deleted. For a restructuring provision, that keeps the announcement, the plan and the line-by-line cost review as distinct steps, each with its evidence.
The provision line in the lead schedules is built from the engagement's trial balance and traces to its lines. If the team concludes that part of the provision covers future operating losses, or that the announcement came after year end, staff record an audit adjustment on the line with a reason and raise a finding from the working paper, later closed or withdrawn.
Scepticism about management's timing
The IAASB states that ISA 540 (Revised) fosters a more independent and challenging sceptical mindset when auditing accounting estimates. Restructuring provisions call for it, because the timing and size of the charge can be chosen. Warning signs:
- a change of management, ownership or strategy close to year end;
- an announcement dated in the last days of the year with little sign of being acted on;
- a provision much larger than the costs actually incurred after year end;
- provisions released to profit in the following year as "no longer required";
- a charge that conveniently brings results down to, or back up to, a target.
Look at how last year's provisions were used. A history of large releases suggests a habit of over-providing. Our guide to auditing accounting estimates sets out how to evaluate management's point estimate.
The IFRS Foundation's summary of IAS 37 covers the definition of a provision, restructuring, onerous contracts and the ban on providing for future operating losses, and is the reference to check the client's policy against.
When a client proposes a restructuring provision, ask for the announcement before the calculation. If the announcement does not stand up, the calculation does not matter.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
