Onerous contracts: when a contract becomes a liability
When a client's contract turns onerous under IAS 37, which costs count after the 2020 amendment, and how to recognise the expected loss at once.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
A building contractor wins a fixed-price tender for a school extension. Halfway through, steel and cement prices jump, a subcontractor fails, and the revised budget shows the job will cost more to finish than the contract will pay. The contractor has not lost the money yet; most of the overrun lies in next year's work. The question for the year-end file is whether that future loss belongs in this year's statements.
Usually the answer to "can we provide for future losses?" is no. Onerous contracts are the exception, and they matter well beyond construction: a cleaning company locked into a fixed-rate contract after a wage increase, a caterer whose menu prices were set before food inflation, a lessee committed to service charges on premises it no longer uses. This article covers when a contract becomes onerous, which costs count, and how to record the loss.
IAS 37: an onerous contract gives rise to a provision
IAS 37 sets a firm limit: a provision cannot be recognised for future operating losses, because there is no obligation at the end of the reporting period. A business expecting a bad year next year has nothing to record this year.
The same standard makes an exception for contracts. IAS 37 states that an onerous contract gives rise to a provision. The difference is the obligation: a signed contract binds the client to perform, so the loss on performing it is not merely expected trading but a consequence of an obligation that already exists at year end.
In plain terms, a contract becomes onerous when meeting its obligations will cost more than the benefits it will bring. IAS 37's own definition sets the precise test and should be read before concluding, because a contract the client can leave cheaply may be judged differently from one it cannot.
The May 2020 clarification on the cost of fulfilling
For years, preparers disagreed about which costs to compare with the contract's benefits. Some counted only the extra costs the contract caused; others included a share of overheads. A May 2020 amendment to IAS 37 clarified the point: in assessing whether a contract is onerous, the cost of fulfilling it includes both the incremental costs and an allocation of other costs that relate directly to fulfilling contracts.
For the contractor, that means:
- Incremental costs, such as materials for the school extension, site labour hired for the job, and the replacement subcontractor's fee.
- An allocation of other costs that relate directly to fulfilling contracts, such as a share of the depreciation of plant used on the site or of the site supervisor's cost, where those relate directly to contract work.
General head office costs that do not relate directly to fulfilling contracts stay out. The allocation should follow a reasonable, documented basis, and the same basis should be used for every contract tested. Including directly related costs makes the test stricter than an incremental-only view, so more contracts may now qualify as onerous.
Long contracts: when estimates turn into an expected loss
For contracts where revenue is recognised over time, ACCA explains that the stage of completion is needed to calculate revenue to date, but that IFRS 15 does not require the estimated profit or loss on the whole contract to be calculated, except to determine whether the contract is onerous. That exception is the link between revenue and provisions: the onerous test is the one place the standards make the whole-contract forecast compulsory.
So for each long contract at year end, ask the client for a current forecast of total revenue and total cost to complete. Compare them. Where costs exceed revenue, test the contract against IAS 37. Build the forecast from current information: latest supplier prices, the revised programme, known claims and variations. Construction contracts more generally are covered in construction contracts after IAS 11.
Recognising the loss in the period it becomes known
AccountingTools states that when revised estimates show an overall loss on a construction contract, the contractor recognises the entire expected loss immediately. Investopedia, quoting the accounting policies of the engineering group Fluor, notes that changes to total estimated contract costs or losses are recognised in the period in which the company determines them.
The practical message is the same in both: the loss belongs to the year in which it becomes known, not spread over the remaining life of the contract and not deferred until the final invoice. A contractor that discovers in the final quarter that its school extension will lose money records that loss in this year's statements.
Measurement then follows the general rules for provisions, discussed in measuring a provision at year end: the amount the client would rationally pay, reflecting risks and uncertainties, discounted where the timing makes that matter.
Note wording and the adjusting entry
A worked example in words. The contractor's forecast shows total costs to complete, including directly related plant depreciation and supervision, above the remaining contract revenue. Revenue and costs to date have been recognised as the work progressed. The preparer records a provision for the remaining expected loss, with the charge in profit or loss, and keeps the forecast, the cost allocation basis and the supplier quotations in the working papers.
In Achekam's Studio, the provision is posted as a year-end adjusting entry against the client's trial balance. If an entry later proves wrong, it is reversed with a record of who did it and why, rather than deleted. Notes take their figures from the mapped trial balance, and facts the trial balance does not hold are left as "[to be completed]"; a description of the contract, why it became onerous and the main uncertainties are such facts, written by the preparer. The Studio's standard policy wording is based on IFRS for SMEs and is labelled for review before issue; staff can write a specific policy on onerous contracts for clients that have them.
The IFRS Foundation's IAS 37 page summarises how provisions are defined and accounted for, and records the 2020 clarification on the cost of fulfilling a contract. Ask every client with fixed-price contracts for its latest forecasts before the year-end meeting; the onerous test cannot be done without them.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
