What is an onerous contact?

Contracts are written or spoken agreements that are binding on the signing parties. They are carried out for some consideration or value to the parties involved.

However, some contracts end up doing more harm than good over a period of time. Onerous contracts, as the name suggests, involve straining obligations.

An onerous contract is an accounting term defined by the International Accounting Standards Board (IASB). An onerous contract refers to a contract in which the unavoidable costs of meeting the obligations exceed the economic benefits expected to be received under it. 

The IASB further defines the ‘unavoidable costs’ to be the lower of the cost of fulfilling the contract, and any compensation or penalties arising from a failure to fulfil it. In layman’s terms, an onerous contract provides lesser economic benefits compared to the costs incurred to keep it in force.

For stock investors, an onerous contract may show up when studying a company’s financial report or a balance sheet. According to the International Financial Reporting Standards (IFRS), an onerous contract is categorised as ‘provisions’, which inherently mean debt obligations that will accrue in an uncertain time or in an unknown amount. 

Companies that follow IFRS are required to recognise the onerous contract as a liability and list it on its balance sheet to account for an expected loss through this contract.

Onerous contracts are officially recognised by all countries that follow IFRS. Whereas under the US’s Generally Accepted Accounting Principles (GAAP), there is no general requirement for companies to recognise a loss in advance of performance for onerous contracts.

Onerous contract example

Multi-year office leaseholds could be an example of an onerous contract relevant to this day and age.

When Covid-19 hit the global economy, companies around the world were forced to shut offices and move to the work-from-home model. 

A lot of firms that had lease agreements for their office spaces suffered as these became useless during the lockdowns. Yet due to the existing agreements in force, companies had to continue paying the rent without having any employees going to the office premises.