What is an onerous contract under IAS 37, and how is the provision calculated when a company is locked into a loss-making agreement?

An onerous contract is one where the unavoidable costs of meeting the obligations exceed the economic benefits expected to be received under the contract. Under IAS 37, when a contract becomes onerous, the entity must recognize a provision for the present obligation.

Key Definition:

Unavoidable costs = the lower of:

• Cost of fulfilling the contract, OR
• Penalties/compensation for failing to fulfill it (i.e., termination costs)

Example:

Vertex Analytics leased a 10,000 sq ft office for $25,000/month on a non-cancellable 8-year lease starting January 2022. In January 2026, Vertex relocates entirely to a new building and cannot sublease the old space. The remaining lease term is 4 years (48 months). Early termination penalty = $800,000. Discount rate = 5%.

Option A: Fulfill the contract

Remaining lease payments = 48 x $25,000 = $1,200,000 (undiscounted)

PV of remaining payments = $25,000 x PVIFA(5%/12, 48) = $25,000 x 43.42 = $1,085,500

Option B: Terminate early

Termination penalty = $800,000

Unavoidable cost = lower of $1,085,500 and $800,000 = $800,000

Since economic benefits from the contract are zero (the space is vacant and cannot be subleased), the onerous contract provision = $800,000.

What if partial benefits exist?

Suppose Vertex could sublease half the space for $10,000/month. The economic benefit would be PV of $10,000 x 48 months = approximately $434,200.

Fulfillment cost net of benefits = $1,085,500 - $434,200 = $651,300

Termination penalty = $800,000

Unavoidable cost = lower of $651,300 and $800,000 = $651,300

The provision would be reduced to $651,300.

Timing of recognition:

The provision is recognized as soon as the contract becomes onerous — which is when Vertex made the decision to vacate and determined that the space cannot generate economic benefits. You do not wait until the lease expires.

Subsequent measurement:

The provision is reviewed at each reporting date. If market conditions change (e.g., sublease becomes possible), the provision is adjusted through profit or loss.

Important note on IFRS 16 interaction: Since IFRS 16 now requires most leases to be recognized as right-of-use assets, the onerous contract provision for leases has been largely replaced by impairment testing of the right-of-use asset under IAS 36. However, the IAS 37 onerous contract framework still applies to non-lease executory contracts (supply agreements, service contracts, etc.).

For more on provisions and onerous contracts, check our CFA Level I FRA course.