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Onerous Contract: Definition, Example and Related Terms

What is an Onerous Contract ?

An onerous contract is essentially a contract where the costs required to fulfill the obligations outweigh the benefits that the parties expect to receive from it. This means the contract results in a financial burden rather than a benefit for the party concerned. In legal and financial terms, it represents an obligation that is disadvantageous for the party committed to fulfilling it, often leading to a financial loss.

For example, consider a situation where a construction company enters into a contract to build a structure for a fixed price. If the costs of materials skyrocket unexpectedly and the cost of completing the project exceeds the fixed price agreed upon, the contract becomes onerous for the construction company.

Recognizing an onerous contract is critical for businesses to accurately manage financial risks and make informed decisions about continuing or renegotiating contract terms. Understanding the concept of onerous contracts can help in assessing potential liabilities and ensuring sound financial planning.

In accounting, onerous contracts are acknowledged as liabilities on balance sheets under the International Financial Reporting Standards (IFRS), since they are expected to result in future economic outflows or a loss.

Example(s)

  • Scenario Description
    A catering company agrees to provide services for a large event at a fixed price. Due to unforeseen circumstances such as a rise in food prices and delivery logistics, the costs of providing the services exceed the revenue received, rendering the contract onerous for the company.
    A manufacturing firm enters a long-term supply agreement with a fixed price clause. When raw material costs spike unexpectedly, fulfilling the contract results in a loss, hence the contract is considered onerous.