Understanding Onerous Contracts

An onerous contract is an agreement whose unavoidable costs to fulfill exceed the economic benefits expected from it. When a contract becomes onerous, it creates a financial burden that companies must address in their financial statements under International Financial Reporting Standards (IFRS).

How onerous contracts arise — examples

• Long-term property leases that remain payable after a business relocates or downsizes.
• Resource extraction or supply contracts that become unprofitable when market prices fall.
• Service agreements where the cost of performance rises unexpectedly (e.g., due to input-cost increases or regulatory changes).

Key accounting principles (IFRS)

IFRS treats onerous contracts under International Accounting Standard 37 (IAS 37), “Provisions, Contingent Liabilities and Contingent Assets.” Key points:
* Classification: Onerous contracts are recognized as provisions — liabilities for present obligations with uncertain timing or amount.
Recognition: A provision must be recognized when the company identifies that meeting the contract obligations will generate a loss. Recognition should occur at the first indication that a loss is expected.
Measurement: The provision is measured at the best estimate of the expenditure required to settle the obligation. IAS guidance defines “unavoidable costs” as the lower of:
* the cost of fulfilling the contract; and
* any compensation or penalties for failing to fulfill it.

IFRS vs. U.S. GAAP

• IFRS (IAS 37) requires recognition of onerous-contract provisions and presentation of the liability on the balance sheet.
• U.S. GAAP does not have an equivalent specific requirement to recognize onerous-contract losses in the same way; treatment of such losses depends on applicable GAAP guidance. Differences in standards can lead to divergent reporting between IFRS-reporting and GAAP-reporting companies.

Identifying indications of an onerous contract

Companies should monitor contracts for signs that costs will exceed benefits, including:
* Significant and sustained declines in revenue related to the contract.
Cost increases (materials, labor, compliance) that cannot be passed on.
Contract performance becoming impracticable or subject to penalties.
* Strategic changes (e.g., closures, relocations) that leave contractual obligations unused.

Practical steps for companies

• Regularly review long-term and material contracts for onerous indicators.
• Estimate the best possible cost to fulfill or the minimum cost of terminating (including penalties).
• Recognize provisions promptly under IAS 37 when loss is expected.
• Disclose material onerous-contract provisions and the assumptions used to measure them to ensure transparency.

Summary

Onerous contracts arise when contractual costs exceed expected benefits. Under IFRS, companies must recognize and measure these losses as provisions (IAS 37) and report them on the balance sheet. U.S. GAAP does not require identical treatment, so reporting can differ by jurisdiction. Prompt identification, careful measurement, and clear disclosure are essential for accurate financial reporting and risk management.