A contract become onerous if the unavoidable costs related to the contract exceed the expected benefits expected to be received from that contract. Unavoidable costs are the lower of the following:
- Costs required for performance of remaining obligations under a contract, OR
- Costs of termination of a contract such as penalties.
For instance, a company has acquired a machinery on one-year rental to produce certain products. However, due to adverse market conditions, the company decides to stop the production of that product after 6 months. That machinery is now of no use to the company and rent agreement does not allow early termination without payment of remaining rentals. So, we can say that the rent agreement becomes onerous after 6 months.
Let’s recall the definition of provision. A provision is a liability of uncertain timing or amount. Whereas liability is a present obligation as a result of past events, the settlement of which is expected to result in outflow of resources embodying economic benefits. So, when a contract becomes onerous, the unavoidable costs in excess of the expected benefits from a contract (expected loss) is a present obligation which arose as a result of signing the agreement in the past.
As the costs are related to future and if there is significant time between actual payment of such costs, the effect of discounting becomes material. So, we can say that both the timing and the amount of these costs are uncertain. Therefore, a provision is recorded for onerous contracts.
Provision is calculated by determining the present value of the expected losses (amount of unavoidable costs exceeding the expected benefits). The expected losses of an onerous contract are discounted if the effect of discounting is material.
Provision is recorded in the income statement in the period in which the contract becomes onerous. In subsequent periods, unwinding of discount will increase the provision, whereas actual payment of costs will reduce the provision.
Let’s see an example of provision for onerous contract.
Example – Provision for onerous contract
A construction company is engaged in the construction of a building. During the year, the company noticed that actual costs are more than what it expected, and it is believed that it has quoted lesser contract price to its customer. However, the company cannot abandon the project as doing so will harm its reputation in the market. Following is the calculation of a provision for onerous contract.