What is an onerous contract?
Onerous contracts are an issue that accounting teams are required to deal with on a regular basis. If your business has identified an onerous contract (a contract for which the costs of fulfilment exceed the economic benefits), youll need to take steps to mark the loss in your accounts. Learn a little more about onerous contract accounting with our comprehensive guide. Lets get started with our onerous contract definition. Onerous contract definition  An onerous contract is a contract that will cost your business more to fulfil than youll receive in return. Contracts can be onerous from the beginning, or they can become onerous after a change of circumstances that leads to a rise in expected costs or a decrease in the expected economic benefits associated with the contract. Onerous contracts can be immensely burdensome, in a financial sense, for companies, which is why you should take steps to offset the expenses on your financial statements as soon as possible. Well explain how you can do that in greater depth later in the article. Example of an onerous contract  For a better sense of how onerous contracts come to be, lets look at some onerous contract examples. A typical example of an onerous contract would be a lease on a property that is no longer necessary but cannot be sublet. This situation could occur if the company were forced to downsize while the lease was still in effect, meaning that the office space is vacant. Another onerous contract example could be a business that has entered into a contract to rent a piece of land and equipment to drill for oil. However, a decline in the price of oil means that the cost of extraction is higher than the amount that the business can expect to make from the sale. Understanding onerous contract accounting  The International Financial Reporting Standards (IFRS) have outlined the rules for how companies should handle onerous contract accounting. Per IAS 37, onerous contracts should be classified as provisions. So, if youve identified a specific contract as onerous, youre required to recognize the current obligation as a liability and list it on your companys balance sheet. This action should be taken at the first indication that a loss may be anticipated. Its also important to note that the Generally Accepted Accounting Principles (GAAP)  used in the U.S.  dont recognise onerous contracts. When it comes to onerous contract accounting, one area of potential confusion is the costs youll need to include when you estimate the total cost of fulfilling the contract. Previously, IAS 37 didnt specify which costs need to be included, which led to a number of different interpretations. However, theyve recently clarified the rules. Put simply, the costs of fulfilment are comprised entirely of the expenses that relate directly to the contract. Some examples include:  Direct labour (i.e., salaries and wages of employees who are directly involved in manufacture and delivery)  Direct materials (i.e., supplies used to fulfil the contract)  Costs that relate directly to contract activities (i.e., contract management, depreciation of tools and equipment, etc.) Costs that you only incurred because you entered into the contract (i.e., subcontractor payments)  General and administrative costs shouldnt be counted unless theyre directly chargeable under the terms of your contract. We can help  GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.