What is an expensive contract?
An expensive contract is an accounting term for a contract that will cost a business more than it receives in return.
Understanding expensive contracts
International Accounting Standards (IAS) define an expensive contract as “a contract in which the inevitable costs of complying with contractual obligations exceed the economic benefits which should result from it”.
The term “unavoidable costs” also has special meaning for accounting purposes. The IAS defines it as “the lesser of the cost of performing the contract and any indemnity or penalty resulting from its non-performance”.
An example of a costly contract could be an agreement to lease property that is no longer needed or that can no longer be used profitably. For example, suppose a business signs a multi-year agreement to rent office space, then moves or shrinks while the agreement is still in effect, leaving the office space it no longer needs vacant. Or consider a mining company that has signed a lease to mine coal or another product on land, but at some point during the term of the contract, the price of that product drops to a level that makes mining and putting in the unprofitable market.
Key points to remember
- The onerous contract is an accounting term defined by international financial reporting standards (IFRS), used in many countries around the world.
- Companies that comply with these standards are required to declare in their balance sheets all the expensive contracts to which they are committed.
- In the United States, companies generally follow a different set of accounting standards and generally do not have to account for their expensive contracts.
The rules governing how onerous contracts should be treated in a company’s financial statements are part of international financial reporting standards (IFRS), for which the IAS Board is the independent standard-setting body. The governing body, the IFRS Foundation, is a non-profit organization based in London.
International Accounting Standard 37 (IAS 37), “Provisions, Contingent Liabilities and Contingent Assets”, classifies onerous contracts as “provisions”, that is, liabilities or debts that will accumulate at an uncertain time or for an unknown amount. Provisions are valued using the best estimate of the expenses necessary to meet the current obligation.
Under IAS 37, any business or company that identifies a contract as onerous is required to recognize the current obligation as a liability and to record that liability on its balance sheet. This process is supposed to be undertaken at the first indication that the company expects a loss of the contract.
IFRS and IASB are used by companies in many countries around the world, but not in the United States. In the United States, companies must follow another set of standards known as generally accepted accounting principles, or GAAP, as defined by the United States Financial Accounting Standards Board. Under GAAP, losses, obligations and debts on expensive contracts entered into are generally not recognized or treated. However, the FASB is working with the IASB to establish compatible standards worldwide, which may change one day.