What is an Onerous Contract?

An onerous contract is a contract in which the aggregate cost required to fulfill the agreement is higher than the economic benefit to be obtained from it. Such a contract can represent a major financial burden for an organization. These contracts may be considered onerous as soon as they come into existence, but it is more common for them to be considered onerous due to a change in circumstances that either increases their costs or reduces their benefits.

Accounting for an Onerous Contract

When an onerous contract is identified, an organization should recognize the net obligation associated with it as an accrued liability and offsetting expense in the financial statements. This should be done as soon as the loss is anticipated.

Types of Onerous Contracts

There are a number of situations in which onerous contracts can arise, including the following:

Commodity sales. An onerous contract may arise in relation to the sale of commodities, when the market price declines below the cost required to obtain, mine, or produce a commodity.
Construction contract. An onerous construction contract is one in which the revenue from a fixed-price or lump-sum arrangement is lower than the total costs incurred. This situation usually arises when there are unforeseen expenses or project delays.
Lease contract. An onerous contract can occur when a lessee is still obligated to make payments under the terms of an operating lease, but is no longer using the related asset. The amount of the remaining lease payments, less any offsetting sublease income, is considered the amount of the obligation to be recognized as a loss.
Service contract. An onerous service contract is one in which the ongoing costs to meet obligations are higher than the fees received.

Example of an Onerous Contract

As an example of an onerous contract, a company enters into a 20-year lease for a new corporate headquarters, for $2 million in lease payments per year. Shortly thereafter, it sheds most of its divisions during a major downsizing and no longer needs about 90% of the floor space in the headquarters building. Despite not needing it, the company is obligated to continue making lease payments through the end of the lease term. This can reasonably be considered an onerous contract.