Onerous Contracts Bite Back

First off, we should really start with where these honors contracts sit in the bigger scheme of things.

The accounting standard covering honors contracts fall under IAS 37, which is provisions, contingent liabilities, and contingent assets.

So, before we're even talking about honors contracts specifically, we're inside the wider world of provisions, situations where a company has an obligation that isn't paid yet.

but is real enough to recognize now.

An onerous contract is really just one specific trigger for a provision under that same standard.

I've actually got an episode covering IAS 37 in full detail, so I'll link it up in the show notes if you want a broader picture of that accounting standard and you can check it out.

With that context set, let's start with the definition of an onerous contract.

An honoris contract under IAS 37 is one in which the unavoidable costs of meeting the obligation under that contract exceeds the economic benefits expected to be received under it.

So, say that a few times because there are two things to notice there.

First, unavoidable costs.

Not costs you might incur, not costs if things go badly.

Unavoidable.

That means costs you can't escape from, either because you fulfill the contract or because you pay to get out of it.

Second, economic benefits expected.

This is forward-looking.

We're not asking, did this contract lose money last year? We're asking, going forward, is this going to cost us more than it brings in? That's the real question here.

So, when do you recognize a provision? Here's where it gets practical.

IAS 37 says that if you have an honoris contract, you recognize a provision for the present obligation under that contract.

And we'll talk about measurement in the next section, but this is where the normal trip-up happens.

You don't provide for every contract that's simply loss-making in a general sense.

Now, what do I mean by that? It has to meet the recognition criteria for a provision under IAS 37.

There needs to be a present obligation from a past event, probable outflow of resources, and a reliable estimate.

For an onerous contract, the past event is the signing of the contract, and the obligation crystallizes once the unavoidable cost test is met.

It's really a big thing to be able to distinguish an honors contract from a contract that's merely expected to be less profitable.

Less profitable, of course, is not the same as loss on unavoidable costs.