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. A typical example of an onerous contract is a loss recognised on unfavorable non-cancelable purchase commitments related to inventory items.
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.
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.
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. 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:
- the cost of fulfilling the contract or any compensation,
- penalties arising from failure to fulfill the contract.
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.
Advantages of Onerous Contract
Onerous contracts can bring a number of advantages to the reporting entity. These include:
- Greater certainty and assurance to the reporting entity, as the contract is legally binding and all parties involved have agreed to its terms. This can provide a sense of security and help to ensure that all parties will adhere to the agreed upon obligations.
- Increased leverage for the reporting entity. As onerous contracts are legally binding, they can be used to protect the interests of the reporting entity in the event of any disputes. This can give the reporting entity greater control over the situation and help to ensure that their rights are respected.
- Reduced risk of financial losses. By entering into an onerous contract, the reporting entity can limit their exposure to potential losses as any risks associated with the contract are shared among all parties involved. This can help to minimize the potential for unexpected losses.
- Improved cash flow. Onerous contracts can provide the reporting entity with a reliable source of income and can help to ensure that payments are received on time. This can improve the reporting entity's overall cash flow, helping them to better manage their finances.
Limitations of Onerous Contract
A onerous contract can present a number of limitations that can greatly impact the financial stability of a business. These limitations include:
- Unpredictable Expenses: A major limitation of an onerous contract is that it can result in unpredictable expenses for the reporting entity, as the unavoidable costs can be hard to estimate. This can be especially difficult for small businesses who may not have the resources to properly estimate the potential costs.
- Lack of Flexibility: Another limitation of an onerous contract is that it can be inflexible, meaning the reporting entity may not be able to make changes or renegotiate terms after the contract has been initially signed. This can be a major problem if the business’s circumstances change, as the contract may no longer be beneficial.
- Limited Profits: Lastly, an onerous contract can limit profits that the reporting entity can potentially make from the contract. This can be especially troublesome in the long-term, as the business may not be able to take advantage of any opportunities that may arise.
An 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. There are several other approaches to Onerous Contracts which can be used to evaluate the economic value of these contracts:
- Fair Value Approach: This approach is used to determine the fair value of a contract and assess whether it is onerous or not. The fair value of a contract is the amount that the contract would be worth if it were sold in the market. If the fair value of the contract is lower than its carrying value (the amount that the contract is recorded in the financial statements) then the contract is considered to be onerous.
- Comparative Approach: This approach is used to compare the estimated costs of fulfilling a contract with the estimated economic benefits that the contract will generate. If the costs of fulfilling the contract are greater than the estimated economic benefits, then the contract is considered to be onerous.
- Incremental Approach: This approach is used to compare the estimated costs of fulfilling a contract with the estimated benefits that the contract will generate for each incremental period. If the costs of fulfilling the contract are greater than the estimated benefits for each period, then the contract is considered to be onerous.
In summary, an 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. There are several approaches to assessing whether a contract is onerous or not, including the Fair Value Approach, Comparative Approach, and Incremental Approach.
|Onerous Contract — recommended articles
|Restricted Cash — Dissenters right — Risk transfer — Current portion of long-term debt — Shareholder loan — Asset sales — Contingent consideration — Warranty bond — Translation Risk
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- Wiecek, I. M., Young, N. M., 2010, p86
- Collings S., 2015, p347
- Mirza, A. A., Holt, G. J., Orrell, M., 2008, p320
- Epstein, B. J., Jermakowicz, E. K., 2010, p603
- Collings S., 2015, p347
Author: Gabriela Sambór