Accounting for onerous contracts

Aletta Boshoff, CA, Technical Director, Pitcher Partners

Dr Dean Ardern, Technical Director, Pitcher Partners
February 2016

Onerous contracts are a relatively more common feature of the business environment than a
survey of financial statements might suggest. In contrast to the approach required in respect
of impairment testing, entities are not specifically required to assess whether there are any
indicators that a contract might be onerous. Accordingly, entities often fail to recognise
onerous contracts in their financial statements. If an entity determines that it is a party to a
contract that, from its perspective, is onerous, pursuant to AASB 137 Provisions, Contingent
Liabilities and Contingent Assets the entity is required to recognise a provision in respect to
the onerous aspects of the contract.
This article outlines the accounting treatment of onerous contracts and provides some
examples of the requirements applicable to operating leases of property.

Onerous contracts
Contractual arrangements have the capacity to eliminate many of the risks the contracting
parties would otherwise be exposed to had they decided not to formalise their agreement.
To this end, contractual arrangements can provide the contracting parties with legally
enforceable rights. Such rights, however, are normally not costless, and generally involve
the parties also assuming obligations to each other.

Some contracts, such as purchase orders for readily resalable goods, are often cancellable
at little or no cost to either party. Accordingly, such contracts do not normally become
onerous. . However, many contracts are non-cancellable and/or impose significant financial
penalties on the contracting parties in the event that they cancel the contract or otherwise do
not fulfil their obligations under the contract. Contracts do not necessarily become onerous
as a consequence of the attaching penalties per se. Rather, the penalties often prevent the
parties to the contract from avoiding their obligations under the contract. When this occurs,
and the estimated costs of such obligations (including any penalties) exceed the benefits
available under the contract, the contract is potentially onerous.
Onerous contracts, including onerous executory contracts, are accounted for in accordance
with AASB 137: Provisions, Contingent Liabilities and Contingent Assets. 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. Typical examples
of executory contracts include:

 Operating leases of floor space (tenant has to make periodic rental

payments/landlord has to provide accommodation);

 Operating leases of equipment (lessee has to pay operating lease

instalments/lessor has to provide equipment for use by the lessee);

 Development contracts (development work required/payment required when

milestones achieved); and

 Licenses to intellectual property (licensee has right to exploit property/licensor must

provide property and refrain from competing with licensee).

Identification of Onerous Contracts

An onerous contract is a contract in which the unavoidable costs of meeting the obligations
under the contract exceed the economic benefits expected to be received under it (AASB
137 paragraph 10). As stated above, a typical example of an onerous contract is an
operating lease on a property (executory contract) that has been abandoned by the lessee
and the lessee cannot sub-let. In this situation, the contract is onerous as the entity expects
to receive no further benefits from the property (that is, use of the property) under the
contract but is still committed to pay the landlord the future rentals.

Unavoidable Economic
Contract costs of meeting benefits expected
or the obligations to be received
Executory under the under the
Contract contract contract

Unavoidable Costs Under a Contract

The unavoidable costs under a contract reflect the least net cost of exiting from the contract,
which is the lower of:

 the cost of fulfilling the contract; and

 any compensation or penalties arising from failure to fulfil the contract (that is, exit
or breach the contract).
 Cost of fulfilling the
contract
Unavoidable costs
under a contract are
the lower of:
Any compensation or
penalties arising from
failure to fulfil the
contract

The unavoidable costs under an operating lease is the lower of:

 the cost of fulfilling the remaining operating lease – for example, $1,000 per month
for the remaining 18 months of the operating lease; and

 any compensation or penalties arising from failure to fulfil the contract – for
example, a cancellation fee of $5,000.

Economic Benefits Expected to be Received

Economic benefits expected to be received include:

 direct and indirect benefits under the contract; and

 contractual and non-contractual benefits.

Indirect Contractual
benefits benefits

Non-
Direct
contractual
benefits
Economic benefits
Bnefits

Accounting Implications
If an entity has a contract that is onerous, the present obligation under the contract is
required to be recognised and measured as a provision (AASB 137 paragraph 66).
However, before a separate provision for an onerous contract is established, an entity
recognises any impairment loss that has occurred on assets dedicated to that contract
(AASB 137 paragraph 69). An asset is only dedicated to a contract if there is a contractual
requirement to use a specific asset and no other asset can be used. For the purposes of
impairment testing, identifying the cash generating unit is based on the facts and
circumstances of the particular case and the detailed requirements of AASB 136 Impairment
of Assets.

The following examples demonstrate the accounting for onerous contracts under AASB 137.
Example 1
An entity operates profitably from a factory that it leases under an operating lease. The
monthly operating lease instalments are $1,000 per month, commencing on 1 January 2014
for a period of 5 years. At 31 December 2015, the market rent for the factory is $500 per
month.

In this example the operating lease is not onerous because the economic benefits include
those that derive from the asset’s use in the entity’s continuing business.
Example 2
An entity operates profitably from a factory that it has leased under an operating lease. The
monthly lease instalments are $1,000, commencing on 1 January 2014 for a period of 5
years. At 31 December 2015, the entity relocates its operations to a new factory. The lease
on the old factory continues for the next three years, it cannot be cancelled and the factory
cannot be sub-let to another tenant.

Until the lease becomes onerous, the entity accounts for the lease under AASB 117 Leases
by recognising the lease payments as expenses on a straight-line basis over the lease term.
However, at 31 December 2015 the lease becomes onerous because the unavoidable costs
under the lease ($36,000) exceed the economic benefits expected to be received ($0).
Therefore, a provision is recognised for the present value of the best estimate of the
unavoidable lease payments.
Example 3
An entity operates profitably from a factory that it has leased under an operating lease. The
monthly lease instalments are $1,000, commencing on 1 January 2014 for a period of 5
years. At 31 December 2015, the entity relocates its operations to a new factory. The lease
on the old factory continues for the next three years. The contract stipulates a cancellation
fee of $12,000 and the factory cannot be sub-let to another tenant.
Until the lease becomes onerous, the entity accounts for the lease under AASB 117.
However, at 31 December 2015 the lease becomes onerous because the unavoidable costs
under the lease (lower of $36,000 and $12,000) exceed the economic benefits expected to
be received ($0). Therefore, a provision is recognised for the present value of the best
estimate of the unavoidable costs under the operating lease contract.
Example 4
An entity operates profitably from a factory that it has leased under an operating lease. The
monthly lease instalments are $1,000, commencing on 1 January 2014 for a period of 5
years. At 31 December 2015, the entity relocates its operations to a new factory. The lease
on the old factory continues for the next three years. The contract stipulates a cancellation
fee of $12,000 and the factory can be sub-let to another tenant. However, at 31 December
2015 the entity has not found a suitable tenant. The expected market rental income from the
factory is $750 per month.

Until the lease becomes onerous, the entity accounts for the lease under AASB 117. At 31
December 2015 the lease is onerous because under both alternatives the unavoidable costs
exceed the economic benefits expected to be received.

The lessee should determine the cheapest exit route from the onerous lease contract, which
would determine the amount of the provision. Alternative 1 is to cancel the lease and pay
the cancellation fee of $12,000. Alternative 2 is to continue with the lease at $1,000 per
month, but to sub-lease the factory to a suitable tenant at an expected $750 per month.
Alternative 2 would result in a loss of $9,000 over the remaining 3 years of the contract. The
present value of the net cost of continuing with the lease is less than the penalty for exiting
the lease. Therefore, at 31 December 2015, a provision is recognised for the present value
of $250 per month ($1,000 operating lease expense less $750 sub-lease rental income) for
the remaining 3 years of the operating lease.