Onerous contract

A contract for the exchange of assets or services in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits or service potential expected to be received under it.

So these a loss-making contracts.

Such a contract can represent a main financial burden for an entity. Here is an example of onerous contract.Onerous contracts

Celestron enters into a supply agreement with Meade on 1 January 2014. The agreement states that Celestron must supply Meade with 100 Telescopes at a price of $150 per Telescope. The agreement also states that if Celestron cannot deliver the Telescopes on time and under the terms of the contract it must pay Meade a penalty of $12 000. The delivery date is 31 March 2014. Celestron commences manufacturing the Telescopes on 1 March and experiences a series of production problems that result in the cost to produce each Telescope totaling $200 as at 31 March 2014.

As at 31 March, Celestron identifies an onerous contract in accordance with IAS 37 because the costs of fulfilling the contract (100 × $200 = $20 000) exceed the agreed amount to be received (100 × $150 = $15 000). The cost of the Telescopes is recognized as inventory as at 31 March 2014. Assuming the end of Celestron’s reporting period is 31 March, it must first recognize an impairment loss on the inventory. This would be calculated and recorded as $5000 (lower of cost and net realizable value (ignoring costs of disposal) under IAS 2 Inventories.

Once this impairment loss has been recognized, there is no amount to be recorded as a provision under the onerous contract. However, if Celestron had not yet recorded any costs as inventory it would need to determine what amount to recognize as a provision for the onerous contract. This would be the lesser of the penalty required to be paid to Meade ($12 000) and the cost of fulfilling the contract (assume that $20 000 if the costs have not yet been recognized). Thus, Celestron would record a provision of $12 000, but only if Celestron is going to use the penalty option. In many cases a manufacturing entity will deliver the Telescopes at the (higher) loss of $5,000 because, for example, additional sales are expected.

General model of measurement of insurance contracts

Onerous contract

Onerous contract

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