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Thursday, March 24, 2016

Onerous Contracts And Its Treatment Under IND AS 37

Onerous Contract is a contract in which the costs of meeting the obligations under the contract exceeds the economic benefits that are expected to be received from it. 

A Contract, which can be cancelled without paying compensation to the other party, involves no performance obligation and hence can never be an onerous contract.

The following is an example of an onerous contract. 

On 1st October 2016, Organisation A enters into a contract with organisation B to supply 100 Kgs of wheat at Rs 35 per kg. The wheat is to be supplied on 31st October, 2016.

Organisation A has no stock of wheat on hand. However, it expects to receive a consignment of wheat on 15th October, 2016 at Rs 30 per Kg.

On 15th of October, due to an acute supply constraint, the consignment does not arrive. Now, in order to meet the obligations under the contract, Organisation A has to procure the wheat from the open Market. The cost of procurement for organisation A on that date is Rs 40 per Kg.

Thus, on 15th of October, the contract for Organisation A takes the shape of an onerous contract. This is because the cost of meeting the obligations under the contract i.e procure 100 kg of wheat from the open market at Rs. 40 per kg exceeds the benefits (selling price of Rs. 35 per Kg) expected to received from the contract.

Accounting treatment of an onerous contract. 

As per IND AS 37 - Provisions, Contingent Liabilities and Contingent Assets, "If an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision."

The provision is to be recognised at the "least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfill it."

Continuing with the above example, let us assume that the contract had a penalty provision under which the party failing to fulfill its obligations under the contract has to pay to the other party, a fixed penalty of Rs 250. 

IND AS 37 states that if an entity has a contract that is onerous it must recognise a liability, at the lower of the following amounts: 

A) The net cost of fulfilling the contract. 
B) Any compensation or penalties arising from failure to fulfill it. 

In the present case, the net cost of fulfilling the contract can be computed as follows: 
(Rs. 40 Less Rs. 35) multiplied by 100 Kgs.
= Rs. 5 X 500
= Rs. 500

However, the fixed compensation for any failure to fulfill the obligations under the contract is Rs. 250. 

Therefore, Organisation A will recognise a liability at the lower of the two amounts i.e Rs. 250 in its books. 

Note that the liability has to be recognised on 15th of October i.e on the date the contract turns onerous. 

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