Note on Onerous Contract

 What is an Onerous Contract?

Indian Accounting Standard (Ind As) 37 defines an onerous contract as a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. 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 it and any compensation or penalties arising from failure to fulfil it.

In simple words, if the cost to complete a contract is more than its sale proceeds than the Contract is an Onerous Contract.

A Contract can become an Onerous Contract at any time. At the time of taking up a Contract, the contract might be profitable but due to certain factors it subsequently becomes a loss making one, thereby it becomes an Onerous Contract.

Accounting for Onerous Contract

If a contract is onerous, the present obligation i.e. the difference between the revenue and unavoidable cost under the contract shall be recognized and measured as a provision. Many contracts (for example, some routine purchase orders) can be cancelled without paying compensation to the other party, and therefore there is no obligation. Other contracts establish both rights and obligations for each of the contracting parties. Where events make such a contract onerous, the contract falls within the scope of Ind AS 37 and a liability exists which is recognized. Executory contracts that are not onerous fall outside the scope of said Standard.

Before a separate provision for an onerous contract is established, an entity recognizes any impairment loss that has occurred on assets dedicated to that contract (Ind AS 36).

Illustrations

i.         There is a contract to purchase one million units of gas at 20p per unit, giving a contract price of Rs 2,00,000. The current market price for a similar contract is 13p per unit, giving a price of Rs 1,30,000. The gas will be used to generate electricity, which will be sold at a profit. The economic benefits from the contract include the benefits to the entity of using the gas in its business and, because the electricity will be sold at a profit, the contract is not onerous.

 

ii.         in the example (i), if the electricity is sold at a loss, and an overall operating loss is made. All of the gas purchased is used to generate electricity using dedicated assets. First consider whether the assets used to generate electricity are impaired. To the extent that there is still a loss after the assets have been written down, a provision for an onerous contract should be recorded.

 

iii.         In the example (i), if the gas under contract is sold, which it no longer needs, to a third party for 15p per unit (5p below cost). It is determined that it will have to pay Rs 55,000 to exit the purchase contract. The only economic benefit from the purchase contract costing Rs 2,00,000 are the proceeds from the sales contract, which are Rs.1,50,000. Therefore, a provision should be made for the onerous element of Rs. 50,000, being the lower of the cost of fulfilling the contract and the penalty cost of cancellation (Rs 55,000).

 

iv.         In the period ended 31-Dec-2022, an entity has a contract with a third-party supplier. The entity wishes to terminate this contract in 2022-23 because it can enter into a cheaper contract with a new supplier, even though it will still have two years to run. It will incur a charge for terminating the contract. In that case, a provision should be recognized only if the contract is onerous. If the goods received under the supply contract are sold at a profit, the contract is not onerous and provision should not be made in 2021-2022. The termination cost should be recognized as incurred in 2022-2023. 

Tax Implication on Onerous Contract Expense

Onerous Contract expense is a provision created to safeguard against anticipated future losses. The Provision is created based on estimates of expected future revenue and the cost to be incurred for earning such revenue hence the provision so created is allowable as an expenditure.

This has been confirmed and upheld by the Court in various rulings details given below:

·       Rotork Controls India P. Ltd. (2009) 314 ITR 62 (SC)

·       ACIT v. LG Electronics India P. Ltd, 24 ITR 634 (Delhi ITAT)