The purpose of this article is to evaluate whether a contract should be recognised as an onerous contract.

The main accounting requirements for an onerous contract can be found in IAS37 Provisions, Contingent Liabilities and Contingent Assets.

IAS 37.10 defines an onerous contract as, “A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.”

There are no explicit requirements for entities to 'search' for onerous contracts as per IAS37.  It is nonetheless implicit in the onerous contract principles that reasonable steps should be taken to identify them.

IAS37 unfortunately also has no detailed guidance to assist in the identification process of onerous contracts. Accordingly, it is derived that entities should apply the onerous contract definition by comparing the unavoidable costs of a contract and the expected economic benefits to be received on a case-by-case basis.

Therefore if an onerous contract is identified, a provision must be recognised for the best suitable estimate of the unavoidable cost. IAS37 goes further in paragraph 63 and defines the unavoidable costs under a contract as, “the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation and penalties arising from failure to fulfil it”.

The onerous contract should be measured by determining the present value of the unavoidable costs, net of the expected benefits under the contract. In terms of IAS37, where the effects of the time value of money are material, the amount of the provision should be the present value of the expected expenditure required to settle the obligation. The discount rate should be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability.  The discount rate should not reflect risks for which future cash flow estimates have been adjusted.

This net approach is not specifically stated in IAS37 but is consistent with the definition of unavoidable costs.

The requirements of an onerous contract must be considered along with IAS37.63's prohibition on providing for future operating losses. It is therefore important to distinguish between unavoidable costs under an onerous contract, and future operating losses. Key differences between future operating losses and onerous contracts are that future operating losses:

(i)  are not independent of the entity's future actions; and

(ii) do not stem from an obligation arising from a past event. However, the distinction is not always clear and judgment may be required.

Examples of potential onerous contracts include, but are not limited to the following:

  • excess vacant lease space because of project cancellations or restructuring/downsizing exercises
  • original suppliers going out of business and thus forcing the client to source products from alternative suppliers at higher prices
  • being locked into unfavourable sales contracts when production is based overseas
  • being forced to enter into very competitive tendering bids

In conclusion, it is necessary to always consider whether a contract meets the definition of an onerous contract. The importance of this test is highlighted by the current economic crisis, since a lot of companies may find themselves to have onerous contracts due to the fact that the company has a commitment to make future payments that are in excess of the benefits that will be derived from those payments.

Jorene Cox

Audit Supervisor