Onerous Contract

Onerous Contract
See also

Onerous contract is a contract in which the unavoidable costs of the contract outweigh the economic benefits that the reporting entity will receive under it[1]. A typical example of an onerous contract is a loss recognised on unfavorable non-cancelable purchase commitments related to inventory items[2].

Onerous contract cause

If the entity has entered a contract to sell the assets at a future date, the price fixed in the contract does not necessarily dictate the fair value since the contract price reflects an estimate of the future fair value and therefore includes a time value factor. In addition, the locked in contract price may be higher or lower than the fair value at any point in time, including at the date of delivery. This is due to changing market conditions and expectations. Where an entity has locked into a price to sell the assets at a price less than the current fair value, this would be reflected in the statements as an onerous contract[3].

Example of onerous contract

Company A Limited occupies two properties. One of the properties is owned by Company A and the other property is occupied under an operating lease and is owned by an unconnected third party. The provisions in the lease state that Company A Limited will pay the landlord monthly rentals amounting to £1,000 per month from 1 April 2015 to 31 March 2019. However, due to a reduction in trade, Company A has been forced to downsize and has abandoned the property it occupied under an operating lease from 1 April 2016. Company A has vacated a property it held under an operating lease but the contract is onerous as Company A is still committed to pay the landlord future rents until 31 March 2019. Therefore, the present obligation under the contract is recognised and measured as a provision in Company A's financial statements[4].

Onerous contract termination

An onerous contract is an agreement that an entity cannot get out of legally even though it has signed another parallel agreement under which it is able to undertake the same activities at a better price. As it is locked into the existing agreement, it would need to incur costs under both contracts but derive economic benefits from only one of them[5]. Early termination of an onerous contract may lead to financial consequences - an additional fee or penalty, described as early termination fee. The standard mandates that unavoidable costs under a contract represent the least net costs of exiting from the contract. Such unavoidable costs should be measured at the lower of[6]:

  • the cost of fulfilling the contract or any compensation,
  • penalties arising from failure to fulfill the contract.

Termination example

Company C Limited has a contract with a supplier and this contract is onerous. The provisions in the contract stipulate that Company C will enter into the contract on 1 January 2016 and it will run for three years until 1 January 2019. Company C wishes to terminate the contract in 2017 because a competing supplier has offered more favourable terms. Early termination incurs an early termination fee to terminate the contract by the existing supplier[7].

References

Footnotes

  1. Collings S., 2015, p347
  2. Kieso, D. E., Weygandt, J. J., Warfield, T. D., 2011, p687
  3. Wiecek, I. M., Young, N. M., 2010, p86
  4. Collings S., 2015, p347
  5. Mirza, A. A., Holt, G. J., Orrell, M., 2008, p320
  6. Epstein, B. J., Jermakowicz, E. K., 2010, p603
  7. Collings S., 2015, p347

Author: Gabriela Sambór