What Is an Onerous Contract in Accounting? Definition and Examples

Some business agreements turn out to be more costly than beneficial. When fulfilling a contract is expected to result in unavoidable losses, companies must account for this financial burden in their books.

Accounting standards require businesses to recognize and report such contracts to reflect potential liabilities accurately.

Key Criteria

A contract is classified as onerous when the costs of fulfilling it exceed the expected economic benefits. This assessment is based on current estimates, meaning a contract that was once profitable can become a liability due to rising material costs or declining market demand.

Accounting standards such as IFRS 37 and ASC 450 provide guidance on identifying these contracts. Under IFRS, a company must determine whether the contract’s costs are unavoidable—expenses that cannot be avoided without breaching the agreement. U.S. GAAP does not explicitly define onerous contracts but requires companies to recognize losses when they become probable and estimable. As a result, different accounting frameworks may lead to varying thresholds for recognizing these losses.

Industry-specific factors also play a role. Construction firms dealing with long-term projects may face cost overruns that turn a once-profitable contract into a financial burden. Retailers locked into long-term leases may find rental costs exceeding store revenue due to declining sales. Service providers, such as IT consulting firms, may encounter onerous contracts if rising labor costs make the contract unprofitable.

Recognition and Measurement

Once a contract is identified as onerous, a company must recognize a liability and measure the expected loss based on unavoidable costs.

Liabilities

When a contract is deemed onerous, the company records a liability for the expected loss. Under IFRS 37, this is done by recognizing a provision based on the lower of the cost to fulfill the contract or the penalty for terminating it.

For example, if fulfilling a contract requires $500,000 in costs but the company can exit the agreement for a $300,000 penalty, the provision should be recorded at $300,000. While U.S. GAAP does not have a specific standard for onerous contracts, companies must recognize losses when they become probable and reasonably estimable, typically under ASC 450.

Unavoidable Costs

Unavoidable costs are those a company cannot escape without breaching the contract. These include direct costs such as materials, labor, and subcontractor expenses, as well as indirect costs like allocated overhead. Under IFRS 37, the unavoidable cost is the lower of the cost to fulfill the contract or the cost to exit it.

For instance, if a construction company has a contract requiring $1 million in materials and labor but can terminate the agreement for $750,000, the unavoidable cost is $750,000. If the expected revenue is only $600,000, the company must recognize a $150,000 loss.

Provision Adjustments

Once recorded, provisions must be reviewed periodically to ensure accuracy. If circumstances change—such as a decrease in material costs or a renegotiation of contract terms—the provision should be adjusted. IFRS 37 requires companies to reassess provisions at each reporting date.

For example, if a company initially recorded a $200,000 provision but later secures a supplier discount that reduces costs by $50,000, the provision should be adjusted to $150,000. If the contract is fulfilled at a lower cost than expected, any excess provision should be reversed, improving reported earnings.

Disclosure in Financial Reporting

Transparent reporting of onerous contracts helps stakeholders understand a company’s financial position. Accounting standards require businesses to disclose not only the existence of such contracts but also the assumptions used in estimating their financial impact. This includes details on the nature of the obligation, expected timing of outflows, and uncertainties that could affect the final cost.

IFRS 37 mandates that companies provide sufficient detail about provisions recognized for onerous contracts, including how the liability was measured and any changes in estimates from prior periods. Businesses must explain the rationale behind their cost assumptions, such as projected material expenses or labor rates, to give stakeholders insight into potential variability. If significant judgments were made—such as determining whether a contract could be renegotiated—these must be disclosed.

Auditors closely examine these disclosures to ensure compliance with accounting standards. Misstating or omitting information about onerous contracts can lead to financial misrepresentation, regulatory scrutiny, or legal consequences. Companies in industries with high exposure to long-term contracts, such as construction or energy, must be particularly diligent, as misjudging future costs can significantly distort reported earnings.

Examples

Companies across various industries encounter onerous contracts due to unforeseen economic shifts, regulatory changes, or miscalculations in project feasibility.

In the airline industry, carriers that locked into long-term fuel purchase agreements at fixed prices saw these contracts become financial burdens when oil prices collapsed. Originally intended as a hedge against rising costs, these agreements forced airlines to recognize substantial losses.

The pharmaceutical sector has faced similar challenges with drug development agreements. A company may enter a licensing deal requiring milestone payments to a research partner, anticipating future revenue from a new drug. If clinical trials fail or regulatory approval is denied, the firm remains obligated to pay under contractual terms, despite having no path to recover costs.

Real estate firms often experience onerous lease agreements, particularly in commercial property markets where demand fluctuates. A retailer securing a 10-year lease in a prime location may later struggle with declining foot traffic or industry downturns, making the fixed rental payments unsustainable. Accounting standards require recognition of the unavoidable loss once it becomes evident that projected cash inflows will not cover lease obligations.