Onerous Contract – Definition


Definition of onerous contract:
An agreement which commits a business to obligations which will generate losses.

What is a onerous contract?

No business wishes to be party to an onerous contract.

An onerous contract is essentially a loss-making contract which cannot be cancelled or mitigated in a way that would allow the business to escape the loss.

If a business has an onerous contract, then it is effectively ‘locked in’ to incurring that loss.

Onerous Contract - Definition
The definition of onerous contracts is an accounting concept

Examples of onerous contracts

A catering company signs a contract to provide 200 lobster dinners for a fixed price. But before the wedding week arrives, the lobster price triples. This means that the caterer has to pay more to produce the lobster dishes than they can recover from the venue.

A gym signs a non-cancellable 5-year lease on a property which it wishes to refurbish and turn into a new gym location. Due to planning permission issues and the discovery of asbestos, the company decides it is no longer economical to pursue the project. Despite being obliged to pay rent for 5 years, the company will generate no revenues from the location.

A construction firm bids to build a housing project for £5m. Due to complications and a union-led wage rise for its labourers, it now estimates that it will make a small loss on the project after factoring in all direct and indirect costs.

Two partners agree to form a joint venture to collaborate on a large project for 3 years. A clause in the joint venture agreement states that if the assets reported on the balance sheet of the joint venture fall below a certain level, that each partner commits to providing additional cash. The joint venture falls behind budget and requires capital injections. The partners are now committed future cash contributions each of the next two years into a cash sinkhole.

What these four examples have in common is that the business feels they have no sensible way to further mitigate the losses – the best result they envisage in the most common scenario is still a loss.

This isn’t to say that profit is impossible. Contracts which are labelled as onerous could later be turned around by unforeseen fortuitous events.

For example, the counterparty to a lease could eventually allow them to exit without penalty after a new tenant is found. Or a customer may agree to compensate a builder for additional costs incurred to deliver a fixed price project.

How are onerous contracts accounted for?

IFRS and local GAAP requirements expect that a company will recognise all future losses on an onerous contract upfront, at the point they label the contract as onerous.

The appropriate journal entry is to recognise a liability of sufficient size to bridge the current loss shown in the income statement for this contract, up to the total loss anticipated.

Over time, as costs are incurred and losses are crystalised, the size of the manual adjustment required should reduce as the actual position converges to the long term expected loss.

How is the phrase onerous contract used in a sentence?

“Since the increase in whole sale lobster prices, the gross margin on each cover become negative. With negative gross profits, no amount of overhead cuts could rescue this onerous contract.”

What else you should know about onerous contracts?

Onerous contracts are more common than you’d think. For companies who engage in thousands of projects per year, it’s enevitable that some will perform disasterously.

For companies who trade heavily on their brand, there’s a sound financial reason to honour an onerous contract with grace, rather than attempting to renege on obligations.

Particularly if onerous contracts are a small proportion of the total, companies accept that sometimes things go wrong and that they won’t be able to make a profit from every deal.

How does the definition of onerous contracts relate to investing?

Onerous contracts are a red flag in large project-based companies. These should be disclosed in the financial statements.

In the pursuit of revenue growth, contractors may take on unprofitable or low margin contracts. When this happens, the number and value of onerous contracts will increase.

Low-margin contracts may help to keep their staff utilised, but they add a lot of risk to the bottom line, as recent history has shown.

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