An onerous contract is a contract in which the unavoidable costs of meeting the obligations exceed the economic benefits expected to be received. Once a contract meets this definition under IAS 37, the entity must recognise a provision for the net loss immediately — not when the loss is actually incurred, but at the point the contract becomes onerous. The principle is the same as for all provisions: probable losses should be recognised as soon as they can be reliably estimated, not deferred until cash leaves the entity.
What “Unavoidable Costs” Means — and the 2022 Amendment
The definition of “unavoidable costs” is the most important and most contested element of onerous contract accounting. IAS 37.68 defines unavoidable costs as the lower of:
- The cost of fulfilling the contract, and
- Any compensation or penalties arising from failure to fulfil it
A 2020 amendment to IAS 37 (effective for annual periods beginning on or after 1 January 2022) clarified what “costs of fulfilling a contract” includes. Before the amendment, practice diverged: some entities included only the direct costs attributable to the specific contract; others included an allocation of fixed overheads. The amendment confirmed that costs of fulfilling a contract comprise both:
- Incremental costs — costs that would not be incurred if the entity did not have the contract (direct materials, direct labour, contract-specific subcontractors)
- An allocation of other costs that relate directly to fulfilling contracts — indirect costs that are attributable to contract activity generally, but not general overheads unrelated to contract performance
💡 What the amendment does NOT include: General and administrative overheads that would be incurred regardless of whether the contract exists are excluded from the cost of fulfilment. If a factory supervisor manages multiple product lines, their salary allocated to the specific contract is included; the CFO’s salary is not. The boundary is costs that “relate directly to fulfilling contracts” — not all costs of running the business.
The Lower-Of Test — Worked Example
To measure the onerous contract provision, the entity takes the lower of the cost to fulfil and the cost to exit. This reflects the economic reality that a rational entity would exit the contract if the exit cost is lower than the ongoing fulfilment cost.
Fixed-price supply contract — lower-of calculation A manufacturer signed a 3-year fixed-price contract to supply components at $80 per unit, for 10,000 units per year. At the end of Year 1, raw material costs increased significantly.
Remaining obligation: 2 years × 10,000 units = 20,000 units
Cost to fulfil: $105 per unit × 20,000 = $2,100,000
Expected revenue: $80 per unit × 20,000 = $1,600,000
Loss on fulfilment: $500,000
Cost to exit (contract termination penalty): $350,000
Lower of fulfilment loss ($500,000) and exit cost ($350,000) = $350,000
Provision recognised: $350,000 — reflecting the lower-cost route to extinguish the obligation.
Note: if the entity intends to fulfil rather than exit, the provision is still measured at the exit cost ($350,000) because that is the minimum unavoidable loss. The entity’s intention to fulfil does not change the measurement.
Impairment Test Before the Provision
IAS 37.69 requires that before recognising a provision for an onerous contract, the entity shall recognise any impairment loss on assets dedicated to the contract. This sequencing matters because assets already used for the contract may themselves be impaired — their recoverable amount is reduced because the contract they are supporting generates a loss.
The logic: impairment of the dedicated assets reduces the carrying amount of those assets first. The provision covers any remaining expected loss that isn’t addressed by the impairment. Recognising a provision without first testing dedicated assets for impairment could result in double-counting the same loss.
Common Onerous Contract Scenarios
Long-term purchase commitments
A company commits to purchase materials at a fixed price over three years. The market price subsequently falls well below the committed price. The purchase commitment is onerous: the unavoidable cost (the committed purchase price) exceeds the benefit (the lower market value of what is received). A provision is recognised for the net loss over the remaining commitment period.
Unused leased space
A company leases office space under a non-cancellable operating lease and subsequently vacates the premises following a headcount reduction. The lease continues to require monthly payments but generates no economic benefit. If the cost to sublet or exit is lower than the remaining lease payments, a provision is recognised at the lower amount. (Under IFRS 16, this interaction also involves the right-of-use asset — the ROU asset should first be assessed for impairment before the IAS 37 provision is recognised.)
Fixed-price construction contracts
A contractor bids a fixed-price contract and subsequently faces cost overruns that exceed the contract price. Once the contract is expected to generate a net loss, the entire expected loss is recognised immediately — not over the remaining contract period. This is one of the most common areas of onerous contract accounting in construction and infrastructure.
Interaction with IFRS 15 for Revenue Contracts
Where a contract with a customer is both within the scope of IFRS 15 (revenue recognition) and becomes onerous, the two standards interact. IFRS 15 governs how revenue is recognised; IAS 37 governs the onerous contract provision.
Where a customer has prepaid for goods or services and the entity expects to fulfil the contract at a loss, the prepayment sits in contract liability (deferred revenue) under IFRS 15. The IAS 37 onerous contract provision covers the additional loss — the amount by which the cost to fulfil exceeds the total consideration (including the prepayment already received). The provision does not duplicate the deferred revenue; it covers only the excess loss.
IFRS 15 / IAS 37 interaction Customer prepays $200,000 for services to be delivered over 12 months. Cost to fulfil: $280,000.
IFRS 15: $200,000 contract liability recognised at inception (deferred revenue).
IAS 37: Onerous contract provision = $280,000 − $200,000 = $80,000 (the loss beyond the revenue already received).
Total balance sheet impact: $200,000 contract liability + $80,000 provision = $280,000 obligation. Matches the expected cost to fulfil.
Reversal and Disclosure
If circumstances change and the contract is no longer onerous — for example, if raw material costs fall back below the contract price, or if a renegotiation reduces the commitment — the provision is reversed in the period the change occurs. Reversals go through the income statement as a credit, offsetting the expense recognised when the provision was initially raised.
IAS 37 requires disclosure of onerous contract provisions including: the nature of the obligation, the expected timing of any resulting outflows, and any major uncertainties about the amount or timing. Where the provision is material, the disclosure should give readers sufficient context to understand the contract and the basis for the loss estimate.
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