Onerous contract

An onerous contract is one the firm is locked into where finishing it now costs more than it will ever earn back, forcing the company to recognise a provision for the expected net loss immediately.

FrameworkIAS 37

What it is

See it move

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A supply contract with 2 years left forces €400,000 of unavoidable purchases, but the goods can only be resold for €310,000, a net cost of €400,000 − €310,000 = €90,000 to continue. A cancellation clause allows exit for €70,000. Since €70,000 is cheaper than €90,000, the provision recognised is the lower figure, €70,000.

The formula

LaTeX

P = \min\left(C_{fulfil} - B_{recoverable},\; C_{exit}\right)

Variables

$C_{f u l f i l}$: Unavoidable cost of fulfilling the contract (€)
$B_{r eco v er ab l e}$: Expected recoverable benefit (e.g. resale value) (€)
$C_{e x i t}$: Cost of exiting the contract (e.g. cancellation penalty) (€)

Measures the provision as whichever is cheaper: absorbing the net cost of seeing the contract through, or paying to cancel it.