What Is an Onerous Contract?
An onerous contract is a financial term referring to a contract where the unavoidable costs of meeting the contractual obligations exceed the economic benefits expected to be received.
Many countries incorporate the concept of onerous contracts within their financial reporting standards. These countries typically demand that businesses acknowledge such contracts in their balance sheets based on the International Financial Reporting Standards (IFRS).
Key Points to Remember
- Defined under IFRS: An onerous contract is a specific term under the IFRS, affecting millions of companies globally.
- Reporting Necessity: Companies adhering to IFRS must document any recognized onerous contracts on their fiscal reports.
- U.S. Practices: While firms in the United States adhere to GAAP and usually do not have the same obligation, joint efforts are underway for standardization.
Grasping the Concept of Onerous Contracts
The International Accounting Standards (IAS) clarify the definition of an onerous contract as one where the unavoidable costs of meeting the obligations exceed the anticipated economic benefits from the contract.
‘Unavoidable costs’ are defined within IAS as the lesser of the two: the fulfillment cost of the contract or any penalties resulting from non-fulfillment.
Real-World Example of an Onerous Contract
Consider a company that leases office space under a multi-year agreement. If the company downsizes or relocates before the contract expires and the remaining leased space is no longer needed, this lease becomes onerous. Another example could be a mining company with a contract to extract minerals like coal. If market prices drop drastically, leading to unprofitable extraction, the previously agreed-upon lease turns into an onerous contract.
Important Considerations
The principles outlining how onerous contracts should be recorded are part of the International Financial Reporting Standards, espoused and maintained by the IFRS Foundation—a global non-profit organization based in London.
International Accounting Standard 37 (IAS 37) delves into “Provisions, Contingent Liabilities, and Contingent Assets,” where onerous contracts are deemed provisions. Provisions denote liabilities or obligations predicted to accrue at uncertain moments or known amounts.
IAS 37 mandates that recognitions of onerous contracts be categorized as current liabilities in the financial report and flagged at the first signs of anticipated losses.
Though the IFRS guidelines are accepted globally, they do not apply in America, where GAAP rules dominate. Unlike IFRS, GAAP often overlooks committed onerous contracts’ losses or obligations. However, efforts from the FASB are aligning with the IASB aiming toward global accounting standardization.
Related Terms: Provisions, Contingent Liabilities, IFRS, IAS 37, GAAP, Financial Accounting Standards Board, contractual obligations.
References
- IFRS Foundation. “Onerous Contracts”, Page 1.
- IFRS Foundation. “About Us”.
- IFRS Foundation. “IAS 37 Provisions, Contingent Liabilities and Contingent Assets”.
