An onerous contract is a type of contract in which the costs of the contract exceed the economic benefits that are expected to be received. This means that the contract will result in a financial loss rather than a profit for the entity that is bound by the terms of the agreement.
Characteristics of an Onerous Contract:
The unavoidable costs of meeting the obligations under the contract are higher than the expected benefits.
When the entity has an obligation to deliver goods or services in the future, which will incur higher costs than expected revenues.
Example of an Onerous Contract:
A construction company enters into a fixed-price contract to build a commercial building for $1,000,000. After starting the project, the company discovers unexpected problems, such as unstable soil conditions. This significantly increase the costs of construction. The company now estimates that the total costs to complete the project will be $1,200,000.
Since the costs to complete the contract ($1,200,000) exceed the contract revenue ($1,000,000), the contract is considered onerous. The construction company will incur a loss of $200,000 by fulfilling this contract.
Accounting for the Onerous Contract:
According to Accounting Standards (e.g., IAS 37 – Provisions, Contingent Liabilities and Contingent Assets), the company should recognize a provision for the expected loss as soon as it identifies the contract as onerous.
Debit: Loss on Onerous Contract $200,000
Credit: Provision for Onerous Contract $200,000
This entry ensures that the expected loss is reflected in the financial statements, providing a more accurate picture of the company’s financial position.
Impact on Financial Statements:
Income Statement: Recognizes a loss of $200,000, reducing net income for the period.
Balance Sheet: Includes a provision for onerous contracts of $200,000 under liabilities.