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Onerous Contracts
Introduction
Even in the business world and accountancy, though it may not have entered everyday discussion, a highly significant term does exist. Such terms are known as "onerous contract," which the accounting standard defined as a contract whose expected economic benefits are lower than its costs to fulfill obligations from such contracts. These contracts usually arise due to unforeseen circumstances, economic downturns, or changes in the market, and they have a financial cost on the parties involved. This article will explore the concept of an onerous contract, accounting treatment required, and give examples of when and why a contract may be considered an onerous contract.
What is an Onerous Contract?
An onerous contract is one that imposes a higher cost to fulfill the contractual obligations as compared to the perceived benefits of the said contract. It makes the contract burdensome to one of the parties involved in it, particularly to the party expected to deliver the goods or service. In this sense, "onerous" connotes being burdensome or unfavorable. The point is that fulfilling the contract might lead to some loss on the party's side because they have obligated themselves according to the agreement.
Onerous contracts are typically found where costs are not anticipated with long-term projects or where leases were signed under better conditions and no longer apply. Example: A company signed a lease when rental rates were below market. Market conditions now are such that the company is paying more than the current market rate for the same space. If the company cannot sublease or otherwise mitigate its duties, then the lease might be considered onerous.
Characteristics of an Onerous Contract
To understand what an onerous contract is, several key characteristics can be identified:
Cost Overrun:
The costs of performing the contract (for example, production costs, labor, raw materials) exceed the forecasted income or the contractual price. Thi