An onerous contract is an agreement that offers more costs than benefits to one party. For example, a contractor might agree to build a home at a set price, only to have a spike in raw materials pricing drive the cost of construction past the expected earnings from the project. In accounting statements, onerous contracts need to be included as liabilities for a business, as they reflect expenses that must be met. These statements may include notes to discuss the type of contract and the situation, providing context for readers.
When contracts are established, both parties usually take steps to make sure they receive fair consideration from the deal. This may include a variety of forms of compensation including not just cash and assets, but also things like reputation; for example, someone might buy a florist in order to retain the name, along with getting the facility and all the equipment. Subsequent events can create an onerous contract, where one party has an excessive obligation.
Increases in raw material prices and changes to market conditions are examples. The obligated party needs to keep fulfilling the contract, even at personal cost. Examples can be seen in manufacturing, where companies may end up producing products and receiving less than they cost to make, or business, where companies might be stuck with a lease they cannot use. It would be too expensive to exit the contract, and activities like bankruptcy may not necessarily clear the obligation. Someone making installment payments on a business, for example, still needs to repay the seller if the company fails.
For accounting purposes, the handling of an onerous contract can vary, depending on the specifics of the situation. It may be considered a direct liability, as it involves an expense unavoidably incurred due to prior obligations. In the case of a lease, a company may be able to use asset impairment, arguing that the value of the lease has declined because the company can no longer use it, and thus it should be counted differently on financial statements.
Opinions from accounting authorities are available for companies deciding how to handle an onerous contract. Consistent handling is critical; accountants use decisions made by a single authority in order to prepare statements to ensure their accuracy and reliability. Once they decide how to handle an onerous contract, they need to continue to handle it in the same way, unless circumstances radically change.
