Onerous contract definition
/What is an Onerous Contract?
An onerous contract is a contract in which the aggregate cost required to fulfill the agreement is higher than the economic benefit to be obtained from it. Such a contract can represent a major financial burden for an organization. These contracts may be considered onerous as soon as they come into existence, but it is more common for them to be considered onerous due to a change in circumstances that either increases their costs or reduces their benefits.
Accounting for an Onerous Contract
An onerous contract exists when the unavoidable costs of meeting the contract exceed the economic benefits expected from it. In that situation, the entity recognizes a liability and related loss for the present obligation, measured based on the lower of the cost to fulfill the contract or any compensation or penalties arising from failure to fulfill it. Before recording the onerous contract loss, the entity should first test any assets dedicated to the contract for impairment. After recognition, the liability is reviewed at each reporting date and adjusted if the expected costs or benefits change. This accounting ensures that expected losses are recognized when they become evident, rather than being deferred until the contract is completed.
Types of Onerous Contracts
There are a number of situations in which onerous contracts can arise, including the following:
Commodity sales. An onerous contract may arise in relation to the sale of commodities, when the market price declines below the cost required to obtain, mine, or produce a commodity.
Construction contract. An onerous construction contract is one in which the revenue from a fixed-price or lump-sum arrangement is lower than the total costs incurred. This situation usually arises when there are unforeseen expenses or project delays.
Lease contract. An onerous contract can occur when a lessee is still obligated to make payments under the terms of an operating lease, but is no longer using the related asset. The amount of the remaining lease payments, less any offsetting sublease income, is considered the amount of the obligation to be recognized as a loss.
Service contract. An onerous service contract is one in which the ongoing costs to meet obligations are higher than the fees received.
Example of an Onerous Contract
As an example of an onerous contract, a company enters into a 20-year lease for a new corporate headquarters, for $2 million in lease payments per year. Shortly thereafter, it sheds most of its divisions during a major downsizing and no longer needs about 90% of the floor space in the headquarters building. Despite not needing it, the company is obligated to continue making lease payments through the end of the lease term. This can reasonably be considered an onerous contract.
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Onerous Contract FAQs
Can provisions for onerous contracts be reversed?
Provisions for onerous contracts can be reversed if the contract no longer meets the criteria for being onerous. This may happen if estimated costs decrease or expected economic benefits increase, eliminating the net loss. The reversal is recognized in the income statement, improving reported earnings in the period of the change.