How to Account for Onerous Contracts Under IAS 37

A contract becomes onerous under IAS 37 when the unavoidable costs of meeting your obligations exceed the economic benefits you expect to receive, and the standard requires you to recognize that expected loss as a provision the moment the test is met. Accounting for onerous contracts under IAS 37 comes down to four steps: confirm the contract meets the definition, measure the loss as the lower of fulfillment cost or exit cost, impair any dedicated assets first, then record what remains as a provision and revisit it every reporting period.¹

When a Contract Qualifies as Onerous

One condition triggers the standard: the costs you cannot escape must outweigh the total economic benefit the contract will deliver over its remaining life. Economic benefits include revenue, cost savings, or any other measurable value the arrangement provides. The comparison is forward-looking across the full remaining term, not a snapshot of a bad quarter.¹

The word “unavoidable” does the heavy lifting. These are costs the entity cannot sidestep without breaching or exiting the contract. If a company is losing money on a supply agreement because its own factory runs inefficiently, that loss comes from internal operations, not the contract’s terms. The contract becomes onerous only when external market forces or the built-in pricing structure guarantee a loss regardless of how well the company runs its operations.

The contract must also be enforceable and binding. If you can walk away without penalty, there is no unavoidable cost, and the arrangement fails the test. Where an exit penalty exists but costs less than the projected loss from performing, the agreement still qualifies as onerous, because you face a guaranteed loss either way. The penalty becomes part of the measurement rather than a reason to exclude the contract.

Measuring the Loss

Measurement means finding the “least net cost”: the lower of the cost of fulfilling the contract or the cost of getting out of it. Whichever path is cheaper defines the liability you must record.²

Cost of Fulfilling

Following the amendment to IAS 37 that took effect for reporting periods beginning on or after January 1, 2022, fulfillment costs include both incremental expenses and an allocation of other costs directly tied to the contract’s activities. Incremental costs are straightforward: subcontracting fees, raw materials purchased specifically for the contract, direct labor hours. They would not exist if the contract did not exist.²

The allocated costs are where companies historically got tripped up. Before the 2022 amendment, some entities argued that only pure incremental costs mattered, which conveniently kept many contracts from tripping the onerous threshold. The amendment settled the debate. You must also include a share of costs like equipment depreciation and maintenance expenses for machinery used on the contract. General administrative overhead with no direct connection to contract performance stays out.

Cost of Exiting

The alternative figure is what it would cost to walk away. This typically includes contractual termination penalties, liquidated damages, and any compensation owed to the other party. Amounts vary widely by contract and industry, and the contract itself usually specifies them. Companies often discover that negotiating a mutual termination is cheaper than either the contractual penalty or continued performance, but any negotiated settlement still represents a real cost that must be measured.

Discounting

When expected cash outflows stretch over a long period, IAS 37 requires discounting the provision to present value using a rate that reflects the time value of money and the risks specific to the liability. For multi-year contracts, the difference between nominal and discounted amounts can be significant.³

Impair Dedicated Assets First

Before you establish the provision, you must test any assets dedicated to the contract for impairment under IAS 36. If specialized equipment or custom software used to fulfill the contract has lost value, write those assets down first. Only then do you calculate whether a remaining shortfall exists that requires a separate provision.¹

Skip this step and your auditor will send you back to redo the analysis. Impairment reduces the carrying value of the assets, which changes the net cost calculation. Recording the provision first would overstate the liability.

Recording and Reviewing the Provision

Once the contract meets the test and dedicated assets have been tested, record the expected loss as a provision: a liability on the balance sheet with a matching expense on the income statement. Recognition happens the moment the criteria are met, not when cash actually leaves the building.¹

The provision is not a one-time entry. IAS 37 requires a review at the end of each reporting period, with the provision adjusted to reflect the current best estimate of the unavoidable cost. A provision that turns out too small must be increased. If commodity prices recover, a customer renegotiates terms, or market conditions improve enough that the contract is no longer loss-making, the standard is explicit: if it is no longer probable that an outflow of resources will be required, the provision must be reversed.¹

For contracts spanning several years, these adjustments can swing quarterly earnings meaningfully, so finance teams tend to build monitoring processes around their largest onerous contracts.

Leases Sit Outside the Provision Route

Leases recognized as right-of-use assets under IFRS 16 do not get an IAS 37 onerous contract provision. The lessee tests the right-of-use asset for impairment under IAS 36 instead.⁴ Before IFRS 16 took effect, operating leases were off-balance-sheet and companies recorded onerous lease provisions under IAS 37 directly. Now that leases sit on the balance sheet as assets and liabilities, the impairment route applies.

Where U.S. GAAP Diverges

If your company also reports under U.S. GAAP, the term “onerous contract” does not appear as a standalone concept. U.S. GAAP has no general requirement to recognize a loss in advance of performance for executory contracts. You look instead to whichever specific topic in the FASB Codification governs the type of contract involved.⁵

Long-term construction contracts have their own loss recognition rules under the guidance that preceded and now supplements Topic 606. Extended warranty contracts, certain software arrangements, and reinsurance contracts each follow separate codification subtopics. If your loss-making contract does not fall under any of these categories, U.S. GAAP may not require a provision at all, even where the same contract would clearly be onerous under IFRS. Burdensome leases follow the long-lived asset impairment rules in ASC 360 rather than an onerous provision route, and after impairment the expense pattern shifts from straight-line to a front-loaded profile resembling a finance lease.

Two measurement differences regularly catch dual reporters. Where a range of equally likely outcomes exists, U.S. GAAP uses the minimum amount in the range while IFRS uses the midpoint. For a provision that could run anywhere from $2 million to $8 million, that is the difference between recording $2 million and $5 million. IFRS also requires discounting provisions to present value in all cases where the time value of money is material, while U.S. GAAP generally does not require discounting loss contingencies.

The Provision Is Not a Tax Deduction

Booking the provision on your financial statements does not deliver a matching tax deduction. Under U.S. tax law, a liability is not considered “incurred” until economic performance occurs, even if you have already booked the expense for accounting purposes.⁶

Economic performance works differently depending on the obligation. If someone is providing services or property to you, economic performance happens as they deliver. If you owe services or property to someone else, it happens as you provide them. For most onerous contracts, this means the tax deduction arrives in installments as you actually perform or pay, not all at once when you book the provision. The gap between accounting recognition and tax deductibility creates a temporary difference that shows up as a deferred tax asset on the balance sheet.

1
IFRS Foundation. IAS 37 Provisions, Contingent Liabilities and Contingent Assets
2
IFRS Foundation. In Brief – Onerous Contracts
3
IFRS Foundation. IAS 37 Provisions, Contingent Liabilities and Contingent Assets
4
IFRS Foundation. IFRS 16 Leases
5
Financial Accounting Standards Board (FASB). Accounting Standards Update No. 2014-09 – Revenue from Contracts with Customers (Topic 606)
6
Office of the Law Revision Counsel. 26 U.S. Code 461 – General Rule for Taxable Year of Deduction