How should a company recognize a provision for a loss-making (onerous) contract, and what costs are included in the assessment?

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AcadiFi · Accepted Answer

Under IAS 37 (Provisions, Contingent Liabilities and Contingent Assets), an onerous contract exists when the unavoidable costs of meeting the contract obligations exceed the economic benefits expected to be received. The entity must recognize a provision for the net loss.

**Definition of Unavoidable Costs (Post-2022 Amendment)**

The 2022 amendments to IAS 37 clarified that unavoidable costs include:

- **Incremental costs** directly related to fulfilling the contract (e.g., direct materials, direct labor)
- **An allocation of other costs** that relate directly to fulfilling the contract (e.g., depreciation of equipment used, allocated overhead directly tied to the contract)

This is broader than the previous interpretation some entities used (incremental costs only) and narrower than full absorption costing.

**Measurement**

The provision equals the lower of:
- The cost of fulfilling the contract, OR
- The penalty/compensation for failing to fulfill it (i.e., walking away)

**Worked Example — Steelridge Construction Ltd.:**

Steelridge signed a fixed-price contract to build a data center for Halcyon Corp at $28.5 million. Updated cost estimates reveal:

| Cost Component | Original Estimate | Revised Estimate |
|---|---|---|
| Direct materials | $11.2M | $14.8M |
| Direct labor | $7.4M | $9.6M |
| Equipment depreciation (allocated) | $2.1M | $2.3M |
| Site supervision overhead (directly related) | $1.8M | $2.1M |
| **Total unavoidable costs** | **$22.5M** | **$28.8M** |

Expected economic benefit from the contract: $28.5M (the fixed price)

Net loss: $28.8M - $28.5M = **$0.3M**

Termination penalty: $4.2M

Since the cost to fulfill ($28.8M, implying a $0.3M loss) is less than the penalty for non-fulfillment ($4.2M), Steelridge recognizes a provision of **$0.3 million**.

| Journal Entry | Debit | Credit |
|---|---|---|
| Loss on Onerous Contract (P&L) | $300K | |
| Provision for Onerous Contract (Liability) | | $300K |

**Important: Before recognizing an onerous contract provision, the entity must first test assets dedicated to the contract for impairment under IAS 36.** Any impairment loss is recognized before the onerous contract provision.

**Analyst Considerations:**

1. **Timing of recognition** — The provision is recognized as soon as the contract becomes onerous, not when the loss is realized
2. **Estimate sensitivity** — Small changes in cost estimates can flip a marginally profitable contract to onerous status
3. **Disclosure quality** — Look for description of major assumptions, sensitivity to cost overruns, and expected timing of outflows
4. **Industry patterns** — Construction, defense, and long-term service contracts are most susceptible to onerous contract provisions

Explore onerous contract analysis in detail in our CFA Level II FRA course.

How should a company recognize a provision for a loss-making (onerous) contract, and what costs are included in the assessment?

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