Onerous contracts

[TERM] – Onerous contracts

Hidden LINK_POOL:

• Internal Links:
  • Provision
  • Balance sheet
  • Financial statements
  • Accounting standards
  • Impairment
  • International Accounting Standards Board (IASB)
  • Generally Accepted Accounting Principles (GAAP)
  • Future economic benefits
  • Obligation
  • Liabilities
  • Revenue recognition
  • Expenditure
  • Contract law
  • Financial performance
  • Contingent liabilities
• External Links:
  • IFRS Foundation - IAS 37: https://www.ifrs.org/issued-standards/list-of-standards/ias-37-provisions-contingent-liabilities-and-contingent-assets/
  • American Bar Association - Contract Law: https://www.americanbar.org/groups/public_education/resources/law_explained/contracts/
  • Reuters - Siemens Energy turbine losses: https://www.reuters.com/markets/companies/siemens-energy-losses-deepen-turbine-troubles-mount-2023-08-07/
  • Journal of Accountancy - IFRS vs. GAAP provisions: https://www.journalofaccountancy.com/news/2021/oct/cpa-exam-differences-ifrs-us-gaap-provisions.html

What Are Onerous Contracts?

Onerous contracts are contracts in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received from it. In the realm of accounting standards and financial reporting, specifically under International Financial Reporting Standards (IFRS), a company is required to recognize a provision for these anticipated losses. This means that even if a contract is still active, if it's determined to be onerous, the expected future loss must be recorded on the balance sheet as a liability. The purpose is to ensure that a company's financial statements accurately reflect its true financial position and anticipated future expenditure.

History and Origin

The concept of onerous contracts, particularly their accounting treatment, has evolved with the development of international accounting standards. A significant milestone was the issuance of International Accounting Standard (IAS) 37, titled "Provisions, Contingent Liabilities and Contingent Assets," by the International Accounting Standards Board (IASB). This standard, originally issued in September 1998, replaced parts of IAS 10 and provides specific guidance on the recognition and measurement of provisions, including those arising from onerous contracts. IAS 37 defines an onerous contract as one where the unavoidable costs of fulfilling the contract outweigh the expected economic benefits. I²², ²³, ²⁴n May 2020, the IASB further clarified which costs should be included when determining if a contract is onerous, specifying that both incremental costs and an allocation of other direct costs related to fulfilling the contract must be considered. T²⁰, ²¹his clarification aimed to address differing views and ensure more consistent financial reporting globally.

¹⁹## Key Takeaways

• Onerous contracts occur when the costs of fulfilling a contractual obligation outweigh the benefits expected from it.
• Under IFRS, companies must recognize a provision for the anticipated losses from onerous contracts on their balance sheet.
• The recognition of an onerous contract impacts a company's financial performance by immediately reflecting future losses.
• Before recognizing a provision for an onerous contract, any impairment losses on assets used in fulfilling the contract must be recognized first.
• The concept ensures a more prudent and realistic depiction of a company's financial health, particularly regarding its contractual commitments.

Interpreting Onerous Contracts

When a contract is deemed an onerous contract, it signifies that the entity has a present obligation under that contract, and the unavoidable costs of meeting this obligation are expected to exceed the future economic benefits that will be received from it. The interpretation involves a careful assessment of both the costs and benefits. Costs typically include direct costs such as labor and materials, as well as an allocation of other costs directly related to the contract. Benefits refer to the revenue or other inflows expected from fulfilling the contract. If this assessment reveals a net loss, a provision is established. This accounting treatment directly impacts a company's reported profit or loss, reflecting the burden of the contract immediately, rather than spreading the loss over the contract's term. It highlights situations where existing commitments will negatively affect future profitability.

Hypothetical Example

Consider "Alpha Construction Co." which signed a fixed-price contract to build a specialized facility for a client, "Beta Corp." The initial contract value was $10 million, with expected construction costs of $8 million, anticipating a $2 million profit. However, halfway through the project, due to unforeseen and significant increases in raw material prices and labor costs, Alpha Construction Co. re-estimates its total costs for completing the project at $12 million.

At this point, Alpha Construction Co. determines that the unavoidable costs of completing the facility ($12 million) now exceed the economic benefits (the fixed contract price of $10 million). This constitutes an onerous contract.

Alpha Construction Co. must recognize a provision for the expected loss. The estimated loss is $2 million ($10 million revenue - $12 million costs). This $2 million loss is recognized immediately on Alpha's financial statements, even though the work is not yet complete and the cash outflow has not fully occurred. This accounting entry reduces Alpha Construction Co.'s current period profit and increases its liabilities.

Practical Applications

Onerous contracts appear in various sectors where long-term or complex agreements are common, particularly in industries susceptible to volatile input costs, unforeseen delays, or significant market shifts. For instance, in manufacturing, a company with fixed-price supply agreements might find these agreements becoming onerous if raw material prices surge unexpectedly, making the cost of production higher than the agreed sales price. Similarly, in construction or engineering, a project originally contracted at a fixed price could become an onerous contract if labor, equipment, or material costs escalate beyond projections.

A notable example of companies facing substantial contractual losses can be seen in the wind turbine sector. For instance, in August 2023, Siemens Energy reported deepening losses, with its wind turbine division facing significant charges due to quality issues in newer models. The company anticipated that these issues would cost at least €1 billion to fix, illustrating how contractual commitments for products can become extremely burdensome when unforeseen problems arise and the costs of rectification outweigh the original contractual benefits. Suc¹⁷, ¹⁸h situations highlight the importance of recognizing the potential for future losses from these agreements, requiring companies to establish a provision as an obligation on their balance sheet.

Limitations and Criticisms

While the accounting for onerous contracts under IFRS promotes financial prudence by requiring early recognition of expected losses, it also presents certain complexities and areas of criticism. One significant limitation is the subjective nature of estimating both the unavoidable costs and the expected future economic benefits of a contract. Management's judgments and assumptions about future costs (e.g., inflation, labor rates, material prices) and expected revenue recognition can heavily influence the amount of the provision recognized. This subjectivity can potentially lead to inconsistencies in application across different entities or industries.

Furthermore, there is a divergence in how various accounting standards approach such situations. Unlike IFRS, which explicitly defines and requires the recognition of provisions for onerous contracts under IAS 37, U.S. Generally Accepted Accounting Principles (GAAP) does not have a single, direct equivalent standard. Instead, under GAAP, losses on firm purchase commitments are generally recognized when they are probable and can be reasonably estimated, often relying on broader impairment or loss contingency rules rather than a specific "onerous contracts" framework. This difference can lead to variations in financial performance reporting between companies adhering to IFRS and those following GAAP, potentially affecting comparability for international investors. Cri¹⁴, ¹⁵, ¹⁶tics argue that the lack of a specific, harmonized standard can reduce transparency and consistency in situations involving burdensome contractual commitments.

Onerous Contracts vs. Executory Contracts

Onerous contracts are often discussed in contrast to executory contracts. The key distinction lies in their financial viability from the perspective of one of the parties.

An executory contract is a contract law term referring to an agreement where both parties still have significant obligations to perform. Most contracts start as executory. However, an onerous contract is a specific type of executory contract that has become unprofitable. While all onerous contracts are, by nature, executory until fully performed, not all executory contracts are onerous. A typical executory contract is expected to be profitable or at least break even, whereas an onerous contract is explicitly expected to result in a loss.

FAQs

What triggers the recognition of an onerous contract?

The recognition of an onerous contract is triggered when it becomes probable that the unavoidable costs of meeting the obligation under the contract will exceed the future economic benefits expected to be received from it. This assessment requires continuous monitoring of contracts.

How does an onerous contract affect a company's financial statements?

When an onerous contract is identified, a provision for the estimated loss is immediately recognized on the company's balance sheet as a liability. Simultaneously, an expense is recognized in the income statement, reducing current period profit. This ensures that the anticipated future losses are accounted for promptly, providing a more accurate view of the company's financial health.

Can an onerous contract cease to be onerous?

Yes, theoretically. If the expected costs to fulfill the contract decrease significantly, or the expected economic benefits (e.g., through price renegotiation or increased demand) increase to the point where they exceed the costs, the contract would no longer be considered onerous. However, once a provision has been recognized, it can only be reversed if the conditions that led to its recognition no longer exist or have changed materially.¹, ²³, ⁴, ⁵⁶, ⁷⁸⁹, ¹⁰¹¹, ¹², ¹³