Could your company be managing an onerous contract? If so, it will have a significant effect on your businesses and financial reporting obligations.
Onerous contracts have significant obligations for businesses and financial reporting. The terms of these contracts can leave a business exposed to unexpected costs, legal disputes and even reputational damage. It remains essential to identify and manage onerous’ contracts at an early stage. This will ensure accurate accounting and disclosure, while also allowing the opportunity to convey a positive message to stakeholders.
What is an onerous contract?
According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, an onerous contract is one in which the unavoidable costs of fulfilling the contractual obligations exceed the economic benefits expected to be derived from it. The standard clarifies these unavoidable costs as the lower of the cost of fulfilling the contract and any compensation or penalties that would arise from failing to fulfil it.
In other words, a contract is considered ‘onerous’ when a company cannot meet its obligations without incurring a loss.
When can a contract be labelled onerous?
Types of contracts that often become onerous include leases, supply agreements, and revenue/service contracts. A contract may be onerous from the outset due to factors such as unrealistic delivery timelines (where the liability rests with the contracting party), excessive fees, hidden penalties, or ambiguous terms – to name a few. In such cases, the agreement may place the full legal burden on one party and be difficult or costly to terminate.
Sometimes companies enter into revenue-generating contracts during the early stages of market entry or product development, without fully assessing the associated costs. As a result, they may set pricing that fails to cover expenses, let alone generate profit.
Under IAS 37, a contract is only classified as onerous if the costs of meeting its obligations outweigh the benefits. It’s important to note that a contract may contain unfavorable terms – such as strict deadlines, high penalties, or ambiguous clauses –, without necessarily being onerous.
Similarly, a contract that underperforms or fails to meet expectations is not automatically considered onerous. The key criterion is whether fulfilling the contract results in a net loss.
Interaction between IAS 37, IFRS 15 and IAS 2
As we’ve said, a contract may be onerous from the very start or it may become onerous over time due to changing circumstances. These changes can stem from shifts in the company’s internal strategy. Alternatively, they may be caused by external factors such as market conditions, regulatory developments, natural disasters, or supply chain disruptions.
In order to determine if a contract is loss-making or onerous, the assessment has to look at the totality of the contract (or the totality of the remaining contract term in the case of an ongoing contract), rather than on a ‘loss-making’ year within an overall profitable multi-year contract or on a performance-obligation basis.
Similarly, an entity may have a portfolio of similar contracts with different customers (for example, multiple customers are receiving similar goods or services). In this case, an onerous contract a provision should be recognised for loss-making contracts within that portfolio – regardless of the existence of other profitable contracts.
When to combine contracts
It’s important to note that IFRS 15 allows companies to combine two or more contracts entered into at (or around) the same time with the same customer, or related parties, and account for them as a single contract. But one or more of these criteria must be met:
- The contracts are negotiated as a package with a single commercial objective
- The consideration in one contract depends on the price or performance of the other
- The goods or services promised in the contracts represent a single performance obligation.
In such cases, the total contract price is determined by combining the contracts, and the assessment of whether the contract is onerous is based on that combined arrangement.
It’s also important to consider the value of inventory held in relation to fulfilling a loss-making contract. According to IAS 2, [JR9] this may need to be written down to reflect its net realisable value.
For example:
Company A has entered into two revenue contracts with Customer B. The first involves the manufacture and delivery of a water-powered car at a sales price of £100m, with an estimated cost of £250m. The second grants Customer B the rights and licensed intellectual property to manufacture the car independently, priced at £400m. Payments under the second contract begin only after the first car has been delivered and has operated for at least a month.
Given that the second contract is contingent on the successful execution of the first, it is reasonable to conclude that both contracts were negotiated as a package with a single commercial objective. This satisfies criterion (a) above, which allows for the combination of contracts for accounting purposes.
So to assess whether the arrangement is onerous, the combined contract price of £500m should be considered. This approach concludes that the overall contract is not onerous.
How can we help?
Although onerous contracts are common, they involve a lot of judgement and can be challenging. It’s essential to maintain accurate and timely tracking of contracts, their recognition and their disclosure.
While the accounting standards provide extensive guidance, they strike a balance between prescriptive rules and areas requiring professional interpretation. IFRS, in particular, is clear on certain matters but leaves room for interpretation in others. So sound judgement is critical.
We recognise that some contracts can be complex, and PKF is here to support you in navigating the associated challenges, uncertainties, and assessments with confidence and clarity.
If you would like further guidance on any issues raised in this article, please contact Nick Joel or Pamela Ntandane.
