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), you’ll need to take steps to mark the loss in your accounts. But how do you do that? Learn a little more about onerous contract accounting with our comprehensive guide. Let’s 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 you’ll 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. We’ll 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, let’s 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 you’ve identified a specific contract as onerous, you’re required to recognize the current obligation as a liability and list it on your company’s balance sheet. This action should be taken at the first indication that a loss may be anticipated. It’s also important to note that the Generally Accepted Accounting Principles (GAAP) – used in the U.S. – don’t recognise onerous contracts.
What are the costs of fulfilling an onerous contract?
When it comes to onerous contract accounting, one area of potential confusion is the costs you’ll need to include when you estimate the total cost of fulfilling the contract. Previously, IAS 37 didn’t specify which costs need to be included, which led to a number of different interpretations. However, they’ve 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 shouldn’t be counted unless they’re directly chargeable under the terms of your contract.
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