How Executory Contract Accounting Works

An executory contract is an agreement between two parties where outstanding obligations remain to be fulfilled by both sides. Although signed, the core exchange of goods or services for payment has not yet occurred. For instance, a company signing a one-year contract for monthly cleaning services has an executory contract. Until the first month of service is performed and the client must pay, both parties have unfulfilled duties.

Another example is a purchase order for a future delivery. A manufacturer might order raw materials for delivery in three months. Once the order is accepted, an executory contract is formed. The supplier is obligated to deliver the goods, and the manufacturer is obligated to pay, but neither action has happened yet.

This concept applies to many business arrangements, from supply agreements to long-term leases. The defining characteristic is the mutual and unperformed nature of the promises. This forward-looking aspect distinguishes it from an executed contract, where obligations have already been fulfilled.

The General Accounting Principle for Executory Contracts

The primary accounting principle for executory contracts is that they are not recorded on a company’s balance sheet at inception. This off-balance-sheet treatment exists because, until one party performs its duty, no formal accounting liability or asset has been created under U.S. Generally Accepted Accounting Principles (GAAP). The agreement represents a future commitment rather than a present obligation or resource.

This principle is rooted in the idea of mutual unperformed obligations. When a contract is purely executory, the signing of the agreement is an exchange of promises, not an exchange of economic resources. For example, when a company signs a one-year lease for office space, it promises to pay rent, and the landlord promises to provide the space. On day one, no recordable transaction has occurred.

In an executory contract, the event that triggers recognition—performance—has not yet happened. The obligation to pay for a service only becomes a formal liability once the service has been rendered. Before that point, the contract is a commitment that is disclosed in the footnotes of the financial statements.

This contrasts with an executed contract. If a supplier delivers goods to a customer on credit, the supplier has performed its obligation. At that moment, the supplier has an asset (accounts receivable), and the customer has a liability (accounts payable). The transaction is no longer purely executory because one party has acted, creating a tangible financial claim that must be recorded. The off-balance-sheet nature of executory contracts persists only as long as the obligations of both parties remain unfulfilled.

Recognition and Measurement Upon Performance

The accounting for an executory contract transitions from an unrecorded commitment to a recognized financial event as soon as performance begins. When either party starts to fulfill its duties, the off-balance-sheet arrangement gives way to the recording of assets, liabilities, revenues, or expenses. The trigger for this recognition is the transfer of control of a promised good or service.

For service contracts, recognition occurs over the period the service is provided. Consider a company that pays a monthly fee for IT support. As the IT firm provides its services each month, the customer simultaneously receives and consumes the benefit. Consequently, the customer recognizes an expense for that month’s service and a corresponding liability until the invoice is paid, while the IT provider recognizes revenue under ASC 606.

In the case of purchase commitments, the accounting event is tied to the physical receipt and control of the goods. When a company issues a purchase order for inventory, no entry is made on the balance sheet. Recognition occurs only when the supplier delivers the goods and legal title transfers to the buyer. At that point, the buyer records the inventory as an asset and establishes a liability in accounts payable.

Employment agreements function similarly. An employer does not record a liability for the entire year’s salary when an employee is hired. Instead, the wage expense and the corresponding liability are recognized incrementally as the employee performs their work each pay period. This reflects the principle that the liability is incurred only as the benefit of the employee’s labor is received.

Accounting for Executory Contracts in Bankruptcy

The treatment of executory contracts changes significantly when a company files for Chapter 11 bankruptcy. Under Section 365 of the U.S. Bankruptcy Code, the debtor can decide the fate of its existing executory contracts and unexpired leases. This authority allows the company to either “assume” (continue with) or “reject” (terminate) these agreements, subject to court approval, as part of the reorganization process.

The choice to assume or reject a contract is driven by a business judgment standard, where the debtor must show a valid business reason. A debtor may assume a contract that is profitable or needed for operations, such as a supply agreement. Conversely, it may reject an agreement with unfavorable terms, like an above-market lease, to help restructure its financial affairs.

Assumption

When a debtor decides to assume an executory contract, it agrees to be bound by its terms and continue performing its obligations. To do so, the debtor must “cure” any existing defaults by paying any past-due amounts owed to the other party. This payment is known as a cure cost, and the debtor must provide “adequate assurance” that it will be paid promptly.

The debtor must also provide adequate assurance of its future performance under the contract to ensure the non-debtor party that the reorganized company can fulfill its obligations. From an accounting perspective, assuming a contract requires bringing previously unrecorded obligations onto the balance sheet. Once assumed, the contract’s obligations are treated as administrative expenses of the bankruptcy estate, giving them higher priority for payment.

Rejection

Rejecting an executory contract is a court-approved breach of the agreement, which relieves the debtor from any further performance obligations. When a contract is rejected, the non-debtor counterparty is given a claim for damages resulting from the breach. This claim, known as a rejection damages claim, is calculated based on the losses incurred by the non-debtor party due to the termination.

The accounting for a rejected contract involves removing any related liabilities from the debtor’s balance sheet and recording a new liability for the estimated rejection damages claim. The rejection is deemed to have occurred immediately before the bankruptcy petition was filed. As a result, the rejection damages claim is treated as a general unsecured pre-petition claim, placing it in a lower priority class for repayment.

Financial Statement Disclosures

Even though executory contracts are not recorded on the balance sheet at inception, companies must provide information about them in the footnotes to their financial statements. The purpose of these disclosures is to offer transparency to investors, creditors, and other stakeholders about future commitments that could impact the company’s financial position and cash flows. U.S. GAAP, under ASC 440, outlines requirements for these disclosures to ensure users are not misled by the off-balance-sheet nature of these agreements.

The disclosures must describe the general nature and term of the obligations. For example, a company might disclose that it has long-term agreements to purchase raw materials or has non-cancelable operating lease commitments for its facilities. This provides context for the quantitative information that follows. For unconditional purchase obligations and other non-cancelable agreements, companies must disclose the fixed and determinable amounts of future payments.

This schedule of future payments quantifies the company’s future cash requirements and includes:

• The aggregate amount of payments due for each of the next five fiscal years.
• A single total amount for all years thereafter.
• Any variable components of their commitments, such as pricing that varies with a market index.
• Significant penalties for cancellation or other material provisions.

These details help provide a more complete picture of the potential risks and obligations the company faces.