Executory contracts are contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent. Hence an executory contract contains a combined right and obligation constituting a single asset or liability. The entity has an asset if the terms of the exchange are favorable; otherwise, it has a liability.
Examples of executory contracts (and some common reasons why they might be executory) include:
- Real estate leases (tenant has to pay rent/landlord has to provide space)
- Equipment leases (lessee has to pay rent/lessor has to provide equipment)
- Development contracts (development work required/payment required on milestones), and
- Licenses to intellectual property (licensee can use only within scope of license/licensor must refrain from suing for licensed uses).
Reference is made to the treatment of executory contract in bankruptcies to clear this type of contracts.
The question now is why executory contracts seem to matter so much in bankruptcy. (in some countries the debtor even has to list them separately in its bankruptcy schedules.)
The short answer is that they are treated differently from general unsecured claims in three important ways.
- First, a debtor (or a bankruptcy trustee) gets to decide whether to agree to perform or refuse to perform its obligations under an executory contract. In bankruptcy parlance, agreeing to perform translates to “assumption” of the contract and refusing to perform translates to “rejection” of the contract.
- Second, while the debtor is thinking about what to do, you – the non-debtor party to an executory contract – have to keep on performing as if no bankruptcy had been filed. (You do have some options if this puts a burden on your business but you will need an attorney to help you sort them out).
- Third, if the debtor assumes the executory contract – here’s the good news — the debtor has to pay (“cure”) in full any payment or other defaults and show that it can actually perform in the future too. If the debtor wants to assume and assign the executory contract to someone else, commonly a buyer of its assets, at a minimum the debtor has to cure any defaults and the buyer has to show that it can actually perform under the contract in the future.
Executory versus executed contracts
An executed contract is a contract that is fully legal immediately after all parties involved have signed, and the terms must be fulfilled immediately. With an executory contract, the terms are set to be fulfilled at a future date. Both contracts however, are considered executed agreements once the parties sign. This means that both parties are legally obliged to follow the terms as and when defined within the agreement.
Example of Executory Contract
John has been looking at a TV he wants to purchase. After some debate, he finally decides to go lease it instead. John enters the electronics store, signs a lease agreement that states the he will pay $100 per month until the purchase price has been paid in full. Until John makes the final payment, the contract has not been fulfilled.
Example of Executed Contract
John has been looking at a TV he wants to purchase. After deciding to go forward with the purchase, John walks into the electronics store and pays for the TV in cash. John walks out of the store with the TV and the store has the full payment. This contract is considered executed since the TV was paid for in full and all terms of the contract were met.
The Conceptual Framework explains ‘executory contracts‘ along some essential features captured in the following subjects:
1. Definition of executory contract Executory contracts
An executory contract is a contract, or a portion of a contract, that is equally unperformed—neither party has fulfilled any of its obligations, or both parties have partially fulfilled their obligations to an equal extent.
When a contract is priced on arm’s length terms, the initial measurement of that contract would typically be zero, because the rights of one party have the same value as its obligations to the other party. Accordingly, usually neither party recognises a net asset or a net liability at contract inception. After contract inception, one or both parties may need to recognise its asset or liability, depending on the measurement basis applied.
2. Combined right and obligation to exchange economic resources
An executory contract establishes a combined right and obligation to exchange economic resources. The right and obligation are interdependent and cannot be separated. Hence, the combined right and obligation constitute a single asset or liability. The entity has an asset if the terms of the exchange are currently favourable; it has a liability if the terms of the exchange are currently unfavourable. Whether such an asset or liability is included in the financial statements depends on both the recognition criteria and the measurement basis selected for the asset or liability, including, if applicable, any test for whether the contract is onerous.
An entity’s rights and obligations under an executory contract are highly interdependent:
- the entity’s right to receive one resource is conditional on it fulfilling its obligation to transfer the other resource, and its obligation to transfer the other resource is conditional on it receiving the first resource.
- when the parties perform their obligations, there is only a net inflow or outflow of resources: each party transfers one resource but receives another resource in exchange. This is the case even if the parties perform their obligations at different times: when the first party transfers one resource (the first underlying resource), it simultaneously receives another resource (a right to receive the second underlying resource from the second party).
3. Rights and obligations of each separate party Executory contracts
To the extent that either party fulfils its obligations under the contract, the contract is no longer executory. If the reporting entity performs first under the contract, that performance is the event that changes the reporting entity’s right and obligation to exchange economic resources into a right to receive an economic resource. That right is an asset. If the other party performs first, that performance is the event that changes the reporting entity’s right and obligation to exchange economic resources into an obligation to transfer an economic resource. That obligation is a liability.
If and when one party has done its part of the right or obligation, the zero offsetting of the right and obligation changes and the executory contract changes to a contract for a right or obligation of the part not yet performed.