What is an 'Onerous Contract'

An onerous contract is a contract where costs to fulfill the terms of the contract are higher than the financial and economic benefit that is received. The International Accounting Standards (IAS)] purports that two methods can be used to determine a provision for onerous contracts: One is the liability approach (or method), and the other is the impairment method.

BREAKING DOWN 'Onerous Contract'

The liability method deems an onerous contract as a liability for the company’s contractual responsibilities. The impairment approach sees lease-related onerous contracts as a liability and as unrecognized or invalid.

When an onerous contract is identified, the company is best served by admitting the loss and determining the net financial obligation connected to it, which it then recognizes in financial statements as an offsetting expense and accrued liability. This process should be undertaken at the first indication that loss is anticipated.

IFRS and IAS 37

Under the International Financial Reporting Standards (IFRS) falls a reporting standard, the International Accounting Standard 37 (IAS 37). IAS 37's Provisions, Contingent Liabilities and Contingent Assets provides an outline to account for provisions, which are liabilities or debts that will accrue at an uncertain time or will be an unknown amount. Provisions are measured using the best estimate of expenses in order to satisfy the current obligation.

IAS 37 views and deals with accounting, provisions and liabilities differently than the generally accepted accounting principles (GAAP) do. Under the GAAP, losses, obligations and debts on committed onerous contracts typically are not recognized or dealt with. Under IAS 37, any business or company that has a contract that becomes onerous is required to recognize the current obligation as a liability and to list the liability on its balance sheets.

Examples

In relation to the trading and sales of commodities, an onerous contract may occur if the market price of the commodity being held falls below the cost that is needed in order to obtain, uncover or produce the commodity.

Operating leases are potentially another instance where an onerous contract may arise. For example, consider a lessee with an obligation to continue making payments on an asset, per the terms of his operating lease, but who is actually no longer making use of the asset. The remaining balance of the lease payments is recognized as a loss.

Bottom Line

Because of the negative financial consequences, management executives at companies carefully scrutinize proposed capital investments and contractual obligations in order to avoid entering into an agreement that may become an onerous contract.

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