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Onerous Contracts - Ind AS 37

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.

Recognition and measurement rules

If an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision.Many contracts (forexample, 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 recognised. 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 recognises any impairment loss that has occurred on assets dedicated to that contract (see Ind AS 36).

Illustrations

(1) An entity has entered into a contract to purchase one milliion 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 1,60,000. 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 the entity makes an overall operating loss. All of the gas purchased by the entity is used to generate electricity using dedicated assets. The entity first considers 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 entity sells the gas under contract, which it no longer needs, to a third party for 15p per unit (5p below cost). The entity determines that it would 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 ` 1,50,000. Therefore, a provision should be made for the onerous element of ` 50,000, being the lower of the cost of fulfilling the contract and the penalty cost of cancellation (Rs 55,000).

(iv) In the year ended 31 December 2021, an entity has a contract with a third party supplier. The entity wishes to terminate this contract in 2022 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 recognised 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 recognised as incurred in 2022-2023. 

Significant differences in Ind AS 37 and AS 29

 

Ind AS 37

AS 29

  • Ind AS 37 makes it clear that before a separate provision for an onerous contract is established, an entity should recognise any impairment loss that has occurred on assets dedicated to that contract in accordance with Ind AS 36.
  • There is no such specific provision in the AS 29.

 


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TaxGyata Team

TaxGyata Team