Breach of Contract

Breach of Contract – Contracting party’s actual failure or refusal to perform (or a clear indication of its intentions to not perform) its obligations under the contract. A breach could be effected by:

1. repudiation of obligations before the beginning of the contract,
2. repudiation of obligations before its completion, or
3. a conduct that prevents the contract’s proper performance (such as interfering with the other party’s performance).

Breach of a major term (condition) of the contract (called ‘fundamental breach’) entitles the aggrieved party to:

1. treat the contract as discharged,
2. consider itself free from its own obligations under the contract, and
3. sue the offending party for damages arising from the breach.

Breach of a minor term (warranty) allows for suing for damages arising from the breach but does not allow any party to treat the contract as discharged except were terms of the contract override this implied legal-provision. In contrast to ‘rescission of a contract,’ a breach of contract does not operate retrospectively.

Another way to put it:

When a party fails to live up to its obligations under the contract, that party is said to have breached the agreement or to be in breach of contract. The party harmed by this breach may sue to recover damages.

Courts generally refer to some basic principles in determining what sort of damages a party may recover.

• First, courts prefer that damages be monetary rather than to order specific performance, or force a party to go through with its contractual obligations.
• Second, judicial relief is intended to compensate the promise, putting the party back in the position he would have been if the breach had not occurred and the contract had been fulfilled.

In addition, contract law is primarily intended to provide relief to the party harmed by the breach, not to punish the breaching party. Thus, punitive damages, or damages intended to deter certain types of behavior through additional monetary penalties, are not usually recoverable in a contract dispute. Sometimes, a party can prove a breach of contract, but cannot prove damages with any reasonable degree of certainty. In such cases, a court may grant nominal damages, such as EUR1, in recognition of the harm caused by the breach.

The exact type of damages granted by a court depends on the situation. Contract damages normally fall within three basic categories:

1. Expectation damages. A party can recover expectation damages if he is worse off by reason of the breach than he would have been if the contract had been performed. Expectation damages are designed to place the promise in the position he would have been in if the promise had been performed. For example, Party A contracts to sell 100 pounds of coffee beans to Party B for EUR 200. Party B has a buyer who will pay him EUR 300. Party A breaches. The measure of Party B’s expectation damages is EUR100, or the EUR 300 Party B would have received in sale minus the EUR200 he would have paid for the goods.
2. Reliance damages. A party may recover reliance damages if the breach of contract has left him worse off than he would have been if the promise had never been made—for example, where a party has relied on a promise and suffered reasonably foreseeable expenses as a result of the promise. Reliance damages are generally limited to out-of-pocket expenses incurred, but opportunity costs may also be recoverable. Suppose that in the example above, Party B had informed Party A that he was building a storage unit for the coffee beans at a cost of EUR 100. He also passed up an opportunity to purchase similar goods at a slightly higher price. Party B may be able to recover the cost of building the storage unit as reliance damages; furthermore, he may be able to recover the opportunity cost of procuring similar goods from another source.
3. Restitution damages. Where a party has conferred a benefit on the breaching promisor, he may recover the reasonable value of the benefit provided. Returning to our coffee merchants, suppose that Party B paid Party A EUR100 up front. This advance payment would be recoverable as restitution damages.

In certain limited cases, a court may order specific performance; that is, the court may order the breaching party to carry out fully its contractual obligations. This type of remedy is usually only available when the item involved is unique, such as real estate, or where monetary damages would be impossible to determine.

Accounting for a breach of contract

Accounting for a breach of contract depends what the role of the subject reporting company is:

1. the entity providing services or goods is ‘accused’ of a breach of the contract with a customer, or
2. a customer receiving services of goods is ‘accused’ of a breach of the contract with a supplier of these services or goods.

1. Provider’s breach of contract is many times a type of accounting for warranties, and is part of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Depending on a magnitude of reasons such a claim by a customer is settled with more or less negotiations based on ‘normal’ business behavior. Such a claim will either be clear and  easy to resolve, as a result of which accounting is also many times easy. However, such a claim can also develop from being a very remote price concession, to becoming a very remote liability, to becoming a contingent liability and finally to becoming an obligating event (or ending anywhere in between with both parties agreeing on an action). Depending on the significance of such a breach of contract it is accounted for against a warranty provision, or expensed if and when it has become an obligating event obligation for which the supplier has no other realistic alternative than settling that obligation.

2. Customer’s breach of contract is many times part of accounting for impairments of trade receivables, contract assets or complete construction contracts. But as with the other breach of contract under 1, it is a claim by a supplier that is settled with more or less negotiations based on ‘normal’ business behavior. Such a claim will either be clear and  easy to resolve, as a result of which accounting is also many times easy. However, such a claim can also develop from being a very remote price discount, to becoming a contingent asset and finally to becoming a claim receivable.

Breach of Contract