Executory contracts are contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent. Hence an executory contract contains a combined right and obligation constituting a single asset or liability. The entity has an asset if the terms of the exchange are favorable; otherwise, it has a liability.
Examples of executory contracts (and some common reasons why they might be executory) include:
- Real estate leases (tenant has to pay rent/landlord has to provide space) Executory contracts
- Equipment leases (lessee has to pay rent/lessor has to provide equipment)
- Development contracts (development work required/payment required on milestones), and
- Licenses to intellectual property (licensee can use only within scope of license/licensor must refrain from suing for licensed uses).
Reference is made to the treatment of executory contracts in bankruptcies to clear this type of contracts.
The question now is why executory contracts seem to matter so much in bankruptcy. (in some countries the debtor even has to list them separately in its bankruptcy schedules.)
The short answer is that they are treated differently from general unsecured claims in three important ways.
- First, a debtor (or a bankruptcy trustee) gets to decide whether to agree to perform or refuse to perform its obligations under an executory contract. In bankruptcy parlance, agreeing to perform translates to “assumption” of the contract and refusing to perform translates to “rejection” of the contract.
- Second, while the debtor is thinking about what to do, you – the non-debtor party to an executory contract – have to keep on performing as if no bankruptcy had been filed. (You do have some options if this puts a burden on your business but you will need an attorney to help you sort them out). Third, if the debtor assumes the executory contract – here’s the good news — the debtor has to pay (“cure”) in full any payment or other defaults and show that it can actually perform in the future too. If the debtor wants to assume and assign the executory contract to someone else, commonly a buyer of its assets, at a minimum the debtor has to cure any defaults and the buyer has to show that it can actually perform under the contract in the future.
Executory versus executed contracts
An executed contract is a contract that is fully legal immediately after all parties involved have signed, and the terms must be fulfilled immediately. With an executory contract, the terms are set to be fulfilled at a future date. Both contracts however, are considered executed agreements once the parties sign. This means that both parties are legally obliged to follow the terms as and when defined within the agreement.
Example of Executory Contract
John has been looking at a TV he wants to purchase. After some debate, he finally decides to go lease it instead. John enters the electronics store, signs a lease agreement that states the he will pay $100 per month until the purchase price has been paid in full. Until John makes the final payment, the contract has not been fulfilled.
Example of Executed Contract Executory contracts
John has been looking at a TV he wants to purchase. After deciding to go forward with the purchase, John walks into the electronics store and pays for the TV in cash. John walks out of the store with the TV and the store has the full payment. This contract is considered executed since the TV was paid for in full and all terms of the contract were met.
The Conceptual Framework explains ‘executory contracts‘ along some essential features captured in the following subjects:
1. Definition of executory contract Executory contracts
An executory contract is a contract, or a portion of a contract, that is equally unperformed—neither party has fulfilled any of its obligations, or both parties have partially fulfilled their obligations to an equal extent.
When a contract is priced on arm’s length terms, the initial measurement of that contract would typically be zero, because the rights of one party have the same value as its obligations to the other party. Accordingly, usually neither party recognises a net asset or a net liability at contract inception. After contract inception, one or both parties may need to recognise its asset or liability, depending on the measurement basis applied.
2. Combined right and obligation to exchange economic resources
An executory contract establishes a combined right and obligation to exchange economic resources. The right and obligation are interdependent and cannot be separated. Hence, the combined right and obligation constitute a single asset or liability. The entity has an asset if the terms of the exchange are currently favourable; it has a liability if the terms of the exchange are currently unfavourable. Whether such an asset or liability is included in the financial statements depends on both the recognition criteria and the measurement basis selected for the asset or liability, including, if applicable, any test for whether the contract is onerous.
An entity’s rights and obligations under an executory contract are highly interdependent:
- the entity’s right to receive one resource is conditional on it fulfilling its obligation to transfer the other resource, and its obligation to transfer the other resource is conditional on it receiving the first resource.
- when the parties perform their obligations, there is only a net inflow or outflow of resources: each party transfers one resource but receives another resource in exchange. This is the case even if the parties perform their obligations at different times: when the first party transfers one resource (the first underlying resource), it simultaneously receives another resource (a right to receive the second underlying resource from the second party).
3. Rights and obligations of each separate party Executory contracts
To the extent that either party fulfils its obligations under the contract, the contract is no longer executory. If the reporting entity performs first under the contract, that performance is the event that changes the reporting entity’s right and obligation to exchange economic resources into a right to receive an economic resource. That right is an asset. If the other party performs first, that performance is the event that changes the reporting entity’s right and obligation to exchange economic resources into an obligation to transfer an economic resource. That obligation is a liability.
If and when one party has done its part of the right or obligation, the zero offsetting of the right and obligation changes and the executory contract changes to a contract for a right or obligation of the part not yet performed.
Executory contracts include numerous forms of arrangements for both buyers and sellers of products and services. One example is a product purchase order in which one party’s performance obligations are limited to accepting delivery and making agreed-upon payments. Other examples include, but are not necessarily limited to, employment contracts, lease arrangements, service contracts, certain derivative contracts, purchase and sales commitments, insurance contracts, franchise agreements and compensation arrangements. Executory contracts
The contract acquired or assumed in a business combination is recognized at its fair value. The fair value of the contract may consist of one or both of the following components: any off-market element of the contract and any inherent fair value (i.e., the price a market participant is willing to pay for an at-market contract). Executory contracts
Off-market element of fair value in executory contracts Executory contracts
To the extent that terms of acquired or assumed executory contracts contain terms that are not equivalent to market terms (based on a current transaction with a market participant) on the date of acquisition (i.e., the off-market element of fair value), an asset or liability is recognized in the business combination. Assets and liabilities recognized in a business combination that relate to the off-market element of fair value in an executory contract typically are amortized over the term of the contract.
Conceptually, that amortization, plus or minus the actual effect on the acquirer resulting from performing under the contract after acquisition, results in a net (or aggregate) effect on results of operations in future periods during which the contract is completed as if the executory contract were consummated at market on the acquisition date. Executory contracts
In-process revenue contracts are examples of executory contracts that should be recognized as unfavorable contract liabilities to the extent that the terms of the contracts are less favorable than the terms that could be realized in current market transactions. Conversely, an in-process revenue contract with terms that are favorable to the acquirer on the acquisition date should be recognized as an asset in a business combination. Executory contracts
Inherent fair value in executory contracts Executory contracts
Fair value in an acquired or assumed executory contract might also include an inherent value element (i.e., the price a market participant is willing to pay for an at-market contract). “At-market” contracts are bought and sold in exchange transactions (e.g., airport gates (operating leases) in the airline industry and customer contracts in the home security industry are bought and sold for valuable consideration even when the terms of the underlying and respective contracts are “at-market”).
Those transactions provide evidence that a contract may have value for reasons other than its terms relative to the current market and, therefore, concluded that the amount by which the terms of a contract are favorable or unfavorable does not necessarily represent the full fair value of a contract. Executory contracts
At-market contracts generally are profitable and often costly to obtain. The at-market or inherent value of a contract from a market participant’s perspective relates to the cost, time and effort required to obtain an at-market contract that is avoided by acquiring a target’s preexisting contracts in a business combination. Further, as there is no uncertainty associated with whether a preexisting target company contract will be executed (because by definition it already has been executed), at-market value might also reflect avoided uncertainty.
The following sections discuss unique aspects of certain common types of executory contracts. Executory contracts
A lease agreement conveys the right to use an identified asset (i.e., property, plant or equipment) for a period of time in exchange for consideration. Under a lease, the party obtaining the right to use the leased property is referred to as a lessee and the party conveying the right to use the property is referred to as a lessor.
The acquirer separately recognizes identifiable intangible assets associated with the inherent value of the lease (i.e., the price market participants are willing to pay for an at-market lease). The inherent value may relate to the economic benefit of acquiring an asset with an in-place lease versus one that is not leased. Executory contracts
Leases with a remaining lease term of 12 months or less Executory contracts
If the acquiree is a lessee, the acquirer can elect to apply the same accounting policy election by class of underlying asset for all business combinations to not recognize assets and liabilities for leases that at the acquisition date have a remaining lease term of 12 months or less. Such an election includes not recognizing an intangible asset if the terms of a lease are favorable relative to market terms or a liability if the terms are unfavorable relative to market terms. Executory contracts
When the acquiree in a business combination is a lessee, the acquirer initially measures the lease liability and right-of-use asset for acquired finance and operating leases as if the leases are new at the acquisition date. Measuring the acquired lease as if it were a new lease includes assessing the following:
- The lease term Executory contracts
- Any lessee options to purchase the underlying asset Executory contracts
- Lease payments Executory contracts
- The discount rate for the lease Executory contracts
The lease liability is initially measured at the present value of the remaining lease payments using the lease term, lease payments and discount rate as of the acquisition date. The right-of-use asset is initially measured at an amount equal to the lease liability, adjusted for favorable or unfavorable terms of the lease (including favorable and unfavorable purchase or renewal options) when compared with market terms. Therefore, the acquirer does not separately recognize an intangible asset or liability for favorable or unfavorable lease terms relative to market terms.
An acquirer does not recognize (separately or as part of the lease liability and right-of-use asset) any prepaid or accrued rent previously recognized by the acquired entity for the lease payments that are uneven throughout the lease term because the acquiree’s prepaid or accrued rent does not meet the definition of an asset or liability.
However, the acquirer separately recognizes, at fair value, any other identifiable intangible assets associated with the lease, which may be evidenced by market participants’ willingness to pay for the lease even if it is at market terms. For example, a lease of gates at an airport or a lease of retail space in a prime shopping area might provide entry into a market or other future economic benefits that qualify as an identifiable intangible asset. An intangible asset is identifiable if it meets either the separability criterion or the contractual-legal criterion.
The acquirer also recognizes leasehold improvements acquired in a business combination at fair value and amortizes the assets over the shorter of the useful life of the assets or the remaining lease term at the date of acquisition. However, if the lease transfers ownership of the underlying asset to the lessee, or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee amortizes the leasehold improvements to the end of their useful life.
Considerations for valuing in-place leases Executory contracts
When assets are acquired with in-place leases, some lease contracts may have value for reasons other than terms that are favorable relative to market prices. In valuing in-place leases, various methods may be used to determine the fair value of the lease. These include the income method, the cost method and the market method. However, when valuing in-place leases, the following components should be considered in the valuation.
- Direct costs associated with obtaining a new lessee — The value of an in-place lease would include the direct costs that are avoided by acquiring the lease instead of originating the lease. For example, these costs could include commissions, tenant improvements and other direct costs associated with obtaining a new lessee.
- Opportunity costs associated with lost rentals — In general, obtaining a new lessee will take some period of time, and during that period of time the asset owner may not be receiving lease payments. This period, often referred to as the absorption period, represents an opportunity cost to the owner that is avoided if the asset is acquired with an in-place lease.
Consideration also should be given as to whether the lease arrangements create a customer relationship asset under IFRS 3 Business combinations. Examples of customer relationship assets might include the value, as a result of a current lease arrangement, associated with the expected renewal of the lease or the increased likelihood of obtaining the lessee as a lessee for other locations owned by the lessor.
In-place leases acquired with an asset (e.g., tenant leases associated with an acquired building) would also meet the recognition criteria under IFRS 3 Business combinations; therefore they must be recognized apart from the acquired asset. As the useful life of an in-place lease is normally shorter than the remaining life of the underlying asset, separate recognition and amortization will affect the net earnings of the acquiring entity.
Acquired leasehold improvement
A leasehold improvement acquired in a business combination should be amortized over the shorter of the useful life or the lease term (determined at the date the business combination is recorded) that includes renewals that are reasonably certain to be exercised. However, if the lease transfers ownership of the underlying asset to the lessee, or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee will amortize the leasehold improvements to the end of their useful life.
Lease of property from a third party entered into as part of a business combination
In certain business combinations, a third party unrelated to the acquiree or acquirer is inserted into the transaction to acquire certain assets of the business directly from the acquiree that will in turn be leased by the third party to the acquirer of the business. The question has arisen as to whether such transactions should be accounted for as the acquisition, sale and leaseback of the assets or simply as a lease transaction by the acquirer.
In our view, although the transaction may in form be a lease of assets, it is in substance a sale-leaseback and should be accounted for as such if the assets to be leased are acquired by the third party in contemplation of, or contingent upon, the acquisition of a business by the acquirer-lessee.
Sale and leaseback transactions of the acquiree
A sale and leaseback transaction involves the sale of an asset by an entity (the seller-lessee) to another entity (the buyer-lessor) and the leaseback of the same asset by the seller-lessee. In cases where the transfer of an asset is not a sale (i.e., sale and leaseback), the seller-lessee and the buyer-lessor account for the transaction as a financing transaction. The seller-lessee retains the asset subject to the sale and leaseback transaction on its balance sheet and accounts for amounts received as a financial liability in accordance with IFRS 16.
If the seller-lessee or buyer-lessor is subsequently acquired in a business combination, the acquisition is not a triggering event to reevaluate whether the accounting for the transaction is now a sale and leaseback transaction. Rather, the acquirer should carry forward the acquiree’s accounting as a failed sale and leaseback transaction and continue to follow IFRS 16’s sale and leaseback guidance to determine if and when a sale occurs.
Derivative contracts that are acquired or assumed in a business combination are recognized at fair value in the business combination based on the principles and requirements outlined in IFRS 3. Prior classifications or designations of derivative instruments are reconsidered in connection with their remeasurement in a business combination. To qualify for hedge accounting, the acquirer must designate those derivatives as hedges on or after the date of the business combination. The redesignation requirement extends to all acquired derivative contracts. For example, contracts that qualified for the normal purchases and sales exception or the short-cut method may no longer qualify for these exceptions on the date of the acquisition.
– Employment contracts
Employment contracts, including collective bargaining agreements and those between individual employees and employers, generally meet the contractual-legal criterion and are recognized apart from goodwill as an intangible asset (or potentially as a liability). The value of acquired/assumed employment contracts should be evaluated the same as any other acquired lease or contract agreement; however, measurement of that value might be difficult and affected by the fact that many employees are “at-will” employees (even if subject to collective bargaining arrangements or individual employment contracts).
The value of an employment contract should be considered separately from the value of non-competition agreements. However, a non-competition agreement will not have significant value for continuing employees as the employee’s decision on whether or not to compete is influenced by the terms of the existing employment agreement as well as many other factors. Further, as a matter of law non-competition agreements may be unenforceable in certain jurisdictions.
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