Key Takeaways
- Costs exceed benefits; contract becomes onerous.
- Recognize loss provision immediately under IAS 37.
- Includes unavoidable and allocated contract costs.
What is Onerous Contract?
An onerous contract is an agreement where the unavoidable costs to fulfill its obligations exceed the expected economic benefits gained from it. Under accounting standards like IAS 37, companies must recognize a loss immediately when such contracts are identified.
This situation often arises due to changes in market conditions, cost increases, or declining revenues, requiring careful assessment of contract terms and expected outcomes.
Key Characteristics
Onerous contracts possess specific traits that distinguish them from regular agreements:
- Unavoidable Costs: Costs that a company must incur regardless of contract termination, including direct and allocated costs.
- Economic Benefits: Expected returns or revenue from the contract that fail to cover fulfillment costs.
- Recognition Requirement: Accounting standards demand immediate loss recognition via provisions when costs exceed benefits.
- Scope: Applies mainly to contracts outside revenue recognition standards like IFRS 15, often involving service or supply contracts.
- Measurement: Losses are measured at the lower of unavoidable fulfillment costs or penalties for non-fulfillment.
How It Works
When you identify a contract as onerous, you must calculate the unavoidable costs to fulfill it, including incremental and allocated overhead expenses. If these costs are higher than the economic benefits, recognize a provision on your balance sheet to reflect the expected loss.
This process requires continuous monitoring, especially in industries with fluctuating costs or revenues. Understanding fair value concepts and applying consistent measurement principles is critical to accurate reporting and compliance.
Examples and Use Cases
Onerous contracts can appear in various sectors, often requiring companies to reassess their obligations under changing circumstances:
- Airlines: Delta and American Airlines may face onerous contracts when fuel price spikes increase operating expenses beyond ticket revenues.
- Energy Sector: Companies in the best energy stocks category may encounter contracts for drilling or supply that become uneconomical due to commodity price drops.
- Large-Cap Corporations: Firms included in the best large-cap stocks often manage complex contracts where assessing onerous status is essential for accurate financial disclosures.
Important Considerations
Regularly review your contractual obligations for potential onerous status, especially during volatile market conditions. Failure to recognize such contracts can misstate your financial position and mislead stakeholders.
Implementing risk management strategies and understanding operating leverage can help mitigate the impact of rising costs on contract profitability and aid in early identification of onerous contracts.
Final Words
Onerous contracts require prompt recognition of losses when costs outweigh benefits, impacting your financial statements. Review your existing agreements regularly to identify potential onerous contracts and adjust provisions accordingly.
Frequently Asked Questions
An onerous contract is one where the unavoidable costs of fulfilling the contract exceed the expected economic benefits from it. This means the contract results in a loss that must be recognized in financial statements.
Under IAS 37, a contract is onerous if the lower of the unavoidable costs of fulfilling it or penalties from not fulfilling it exceed the economic benefits expected. Unavoidable costs include both incremental and allocated costs directly related to the contract.
Yes, a contract may become onerous after signing due to changes like increased costs or reduced benefits. Once this occurs, the loss must be recognized immediately in the financial statements.
Onerous contracts can include service agreements, leases (before IFRS 16), and supply contracts where costs exceed benefits. However, contracts governed by IFRS 15 (revenue) or IFRS 17 (insurance) are excluded and handled differently.
IFRS requires recognizing a provision for onerous contracts as a liability on the balance sheet, measured at the lower of unavoidable costs of fulfillment or penalties for termination. This provision must be updated if estimates change.
An example is an oil drilling lease where falling oil prices cause extraction costs to exceed expected sales revenue, resulting in a loss that must be recognized as an onerous contract.
Both IFRS and U.S. GAAP require recognizing losses when contracts become onerous, but IFRS focuses on provisions under IAS 37, while U.S. GAAP has specific guidance for certain contract types. The measurement and timing of recognition may also differ.
