How are losses on non-cancellable inventory purchase commitments recognized under GAAP and IFRS?
I encountered a CFA Level I question about a company that signed a contract to buy raw materials at a fixed price, but the market price dropped before delivery. The answer said the company should recognize an estimated loss immediately. This seems odd because the goods haven't even been received yet. Can someone explain the logic and journal entries?
Non-cancellable purchase commitments can create onerous contract situations when the contracted price exceeds the current market value of the goods. Both GAAP and IFRS require recognition of the expected loss before delivery.
Example:
On October 1, 2025, Pinnacle Paper Corp signs a non-cancellable contract to purchase 500 metric tons of wood pulp at $1,200/ton for delivery on March 1, 2026. Total commitment = $600,000.
By December 31, 2025 (year-end), the market price of wood pulp has fallen to $950/ton. The market value of the committed quantity is now 500 x $950 = $475,000.
Expected loss = $600,000 - $475,000 = $125,000
Under US GAAP:
If the decline in market price is deemed "other than temporary," Pinnacle must recognize the loss in the period the decline occurs:
| Account | Debit | Credit |
|---|---|---|
| Loss on Purchase Commitment | $125,000 | |
| Estimated Liability on Purchase Commitment | $125,000 |
When the goods arrive in March 2026, the inventory is recorded at the lower market value ($475,000), and the liability is reversed.
Under IFRS (IAS 37 — Provisions):
IFRS uses the onerous contract framework. If the unavoidable costs of meeting the obligation ($600,000) exceed the expected economic benefits ($475,000), a provision of $125,000 is recognized.
Why recognize the loss before receiving goods?
The conservatism principle (and the IFRS concept of faithful representation) requires that anticipated losses be recognized when they become probable and measurable. The company is legally committed to paying $600,000 for something worth $475,000 — the economic loss already exists even if cash has not yet changed hands.
What if the market price recovers before delivery?
If by March 2026 the price rebounds to $1,100/ton, the previously recognized loss would be partially reversed — but only up to the original commitment price, never creating a gain above the committed amount.
Exam tip: Purchase commitments are a favorite testing point because they bridge inventory valuation and contingent liabilities. Always check whether the commitment is cancellable — if it is, no loss provision is needed.
Practice more inventory scenarios in our CFA Level I FRA question bank.
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