What is an Onerous Contract?

Onerous Contract

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Onerous Contract

An onerous contract, in financial accounting, refers to a contract in which the costs to fulfill the obligations of the contract exceed the benefits that are to be obtained from it. In other words, an onerous contract represents a situation where the unavoidable costs of meeting the contract’s requirements exceed the economic benefits expected to be received under it.

These unavoidable costs could include direct costs, such as the cost of materials and labor needed to complete a project, as well as indirect costs or allocations of costs that directly contribute to the contract activity.

This situation might occur for a number of reasons, including changes in market conditions, inaccurate initial cost estimates, unexpected increases in costs of materials or labor, or poor management of contract execution.

International Financial Reporting Standards (IFRS), specifically IAS 37 – Provisions, Contingent Liabilities and Contingent Assets, require that an onerous contract be reported as a liability on the balance sheet. The liability is usually measured at the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfill it.

Example of an Onerous Contract

Suppose a construction company, BuildCo, has signed a contract to build a complex bridge for a client at a total contract price of $10 million. The project is estimated to last two years. At the time of signing, BuildCo estimated the total cost of completing the project to be $8 million.

However, six months into the project, several unforeseen complications arise. These include geological issues that were not detected in the initial surveys, and a significant increase in the price of steel, a key material for the project. As a result, BuildCo now estimates that the total cost of completing the project will be $12 million.

In this situation, the contract has become onerous for BuildCo because the costs to fulfill the contract ($12 million) exceed the economic benefits (the contract price of $10 million) expected to be received under it.

Under IFRS, BuildCo would need to recognize a liability on its balance sheet for the present obligation under the contract, which would be the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfill it. In this case, that would likely be the estimated loss of $2 million ($12 million cost – $10 million contract price).

Please note that this is a simplified example. In real-world scenarios, the calculation of costs and assessment of penalties or compensation could be more complex. It’s also worth noting that different accounting standards might have different rules for how and when to recognize and measure an onerous contract.

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