What are Constructive Obligations and Onerous Contracts?
A constructive obligation arises not from a contract or law, but from a company's own established practices, published policies, or specific statements that create a valid expectation in others that it will meet certain responsibilities. An onerous contract is one where the unavoidable costs of meeting its obligations exceed the economic benefits expected from it.
Under IAS 37, a constructive obligation exists when past practice, published policy or a specific current statement creates a valid expectation that the entity will act in a certain way; an onerous contract triggers a provision equal to the lowest net cost of exiting it.
- •Arises from a contract, legislation or other operation of law
- •Enforceable through the courts
- •Example: a signed loan agreement or a tax law
- •Arises from established past practice, published policies or a specific current statement
- •Creates a valid expectation in other parties, though not legally enforceable
- •Example: a company that has always paid customers goodwill refunds beyond its legal warranty
Step-by-step worked examples
A retailer has no legal obligation to refund goods after 30 days, but has always done so for years and widely advertises this practice. A customer returns an item after 45 days. Should a provision be recognized?
Assess whether a valid expectation has been created by consistent past practice and public communication Conclude yes — this is a constructive obligation under IAS 37 Recognize a provision for the estimated cost of expected returns/refunds beyond the legal period
A company signs a 5-year warehouse lease for $120,000/year. After 2 years it stops using the warehouse; it cannot sublet it and the remaining lease payments total $360,000 with no further economic benefit. Should a provision be recognized?
Compare the unavoidable costs of the remaining lease to any expected economic benefit (here, zero benefit since it can't be used or sublet) Since unavoidable costs exceed benefits, this is an onerous contract under IAS 37 Recognize a provision for the lower of the cost of fulfilling the contract and the cost of exiting it — here, $360,000 (or any lower exit penalty if one exists)
A company announces a detailed restructuring plan and communicates it to affected employees before year end, creating a valid expectation that the restructuring will happen. Estimated exit costs are $500,000. Should a provision be recognized?
Confirm a detailed formal plan exists and has been announced to those affected This creates a constructive obligation to carry out the restructuring Recognize a provision of $500,000 for the direct costs of restructuring, excluding costs of ongoing activities
Flashcards
Quick quiz
Q1.What creates a constructive obligation?
Q2.An onerous contract exists when...
Q3.How is the provision for an onerous contract measured?
Q4.Which of these is an example of a constructive obligation?
The full card deck, worked steps and AI-tutor support for “What are Constructive Obligations and Onerous Contracts?” are in Notek — study by hand before your exam.
Common mistakes
Assuming an obligation must be legally enforceable to require a provision. — Correct: A constructive obligation, created by past practice or public policy, can also require a provision under IAS 37.
Measuring an onerous contract provision at the full remaining contract value. — Correct: Measure it at the lower of the cost to fulfill the contract and the cost to exit it.
Recognizing a restructuring provision just because management has decided internally. — Correct: A constructive obligation for restructuring requires a detailed formal plan communicated to those affected.
Ignoring future losses on a contract because no cash has been paid yet. — Correct: Onerous contracts are recognized when unavoidable future costs exceed benefits, regardless of cash timing.
FAQ
What is a constructive obligation?
An obligation that isn't legally required but arises from an entity's own past practice, published policy, or a specific statement creating a valid expectation.
What is the formula for an onerous contract provision?
There's no numeric formula — the provision equals the lower of the cost of fulfilling the contract and the cost of exiting it.
What are examples of constructive obligations and onerous contracts?
A store's long-standing goodwill refund policy (constructive obligation) and an unused warehouse lease with no sublet value (onerous contract).
How do you calculate the provision for an onerous contract?
Compare the cost of fulfilling the remaining contract to the cost of exiting it, and provide for whichever is lower.