Onerous contract

Essentially, it’s a contract whose aggregate cost required to fulfill the agreement is higher than the economic benefit to be obtained from it.

Onerous contracts are an official accounting term defined by the International Financial Reporting Standards (IFRS), therefore they need to be accounted for on the company’s balance sheet. 

Typically onerous contracts refer to assets that no longer perform or create the same economic value it did in the past. A typical example refers to extraction companies and land.

Let’s assume an oil producer owns a plot of land from which it has extracted oil. At one point the site has exhausted its oil reserves, but the company still owns the plot of land. It becomes an onerous contract, because the company may have to pay real estate taxes on it and incur other expenses associated with owning the land.

What causes onerous contracts?

While there may be multiple reasons that may account for the emergence of onerous contracts on a company’s balance sheet, these are some of the most common cases:

• Extraction of natural resources
• Changes in the market price of a commodity that makes it cheaper than the cost of obtaining the commodity
• A situation when a lessee is still obligated to make payments under the terms of an operating lease, but is no longer using the asset.