What Is an Onerous Contract?

What Is an Onerous Contract?

Let me explain what an onerous contract is—it's an accounting term for a contract that will end up costing your company more to fulfill than what you'll get back in return.

You'll find this term used in many countries around the world, where international regulators require that such contracts be accounted for on balance sheets. In the United States, though, we have a different approach based on generally accepted accounting principles, or GAAP, as established by the U.S.-based Financial Accounting Standards Board.

Key Takeaways

Remember, an onerous contract is defined under the International Financial Reporting Standards (IFRS), which are used in many countries globally.

If your company follows those standards, you must report any onerous contracts you're committed to on your balance sheets.

Here in the United States, companies usually follow GAAP and generally don't have to account for their onerous contracts.

Understanding Onerous Contracts

The International Accounting Standards (IAS) defines an onerous contract as one where the unavoidable costs of meeting the obligations exceed the economic benefits you expect to receive from it.

Unavoidable costs have a precise meaning in accounting: it's the lower of the cost to fulfill the contract or any compensation or penalties from failing to fulfill it.

Onerous Contract Example

Consider this example: you might have an agreement to rent a property that's no longer needed or can't be used profitably.

For instance, if your company signs a multiyear lease for office space, then moves or downsizes, leaving the space vacant while the agreement is still active. Or think of a mining company with a lease to extract coal or another commodity, but during the contract term, the commodity's price drops so low that mining and selling it becomes unprofitable.

Special Considerations

The rules for handling onerous contracts in financial statements are part of the International Financial Reporting Standards (IFRS), with the IAS Board as the independent standard-setting body. The overseeing organization, the IFRS Foundation, is a not-for-profit based in London.

Under International Accounting Standard 37 (IAS 37), 'Provisions, Contingent Liabilities, and Contingent Assets,' onerous contracts are classified as provisions—meaning liabilities or debts that will occur at an uncertain time or amount. You measure these provisions using the best estimate of the expenses needed to satisfy the obligation.

According to IAS 37, if your business identifies a contract as onerous, you must recognize the current obligation as a liability and list it on your balance sheet. Do this at the first indication that you expect a loss from the contract.

IFRS and IASB standards apply to companies in many countries worldwide, but not in the United States. U.S. companies follow GAAP, where losses, obligations, and debts from onerous contracts typically aren't recognized or addressed. However, the FASB is collaborating with the IASB to develop compatible standards globally.