Key points
- An onerous contract exists when the unavoidable costs of fulfilling it exceed the economic benefits expected from the contract.
- Since the 2022 amendment to IAS 37 , unavoidable costs include both incremental costs and an allocation of other costs that relate directly to fulfilling the contract.
- The provision equals the lower of the cost of fulfilling the contract and the cost of terminating it (penalties, damages, foregone deposits, or compensation to the counterparty).
- Missing an onerous contract assessment can understate liabilities by the full expected loss, distorting both the balance sheet and the income statement.
What is an onerous contract?
A client signs a three-year fixed-price supply contract when input costs are stable. Eighteen months later, energy prices spike, raw-material markets tighten, and the contract that once carried a 12% margin is now losing money on every delivery. The finance team knows the numbers have turned. The question is whether anyone has run the IAS 37.66 test and booked the provision. Half the time, nobody has.
IAS 37.66 defines an onerous contract as one where the unavoidable costs of meeting the obligations exceed the economic benefits expected to be received. Before recognising anything, the entity must first test the underlying asset(s) for impairment under IAS 36 ( IAS 37.69 ). Only after that step does the entity recognise a provision for the remaining net loss.
What counts as "unavoidable costs" changed with the January 2022 amendment. IAS 37 .68A now clarifies that these include both incremental costs of fulfilling the contract (direct labour, materials) and an allocation of other costs that relate directly to fulfilling it (depreciation of equipment used exclusively for the contract, for instance). This closed a gap that previously allowed entities to argue only incremental costs were relevant, which systematically understated the loss.
Measurement is binary. Compare two numbers: the cost of fulfilling the contract and the cost of exiting it (penalties, damages, lost deposits). Whichever is lower becomes the provision ( IAS 37.68 ). Under ISA 540.13 (a), the auditor evaluates whether the cost projections and the exit-cost estimate are supported by contract terms, supplier confirmations, management's historical accuracy on similar estimates, or independent market data.
Worked example: Bergstrom Skog AB
Client: Swedish forestry and paper company, FY2025, revenue €75M, IFRS reporter. In March 2024, Bergstrom entered a three-year fixed-price supply contract to deliver 40,000 tonnes of bleached pulp annually to a German packaging manufacturer at €680 per tonne (total contract value €81.6M over three years). By late 2025, input costs have risen sharply due to energy price increases and a shortage of certified sustainable timber.
Step 1: identify the contract and assess remaining obligations
As at 31 December 2025, Bergstrom has delivered Year 1 volumes and is committed to two further years (80,000 tonnes at €680/tonne, generating expected revenue of €54.4M).
Step 2: estimate the cost of fulfilling the remaining contract
Bergstrom's finance team projects fulfilment costs for the remaining two years at €62.1M, comprising direct materials (€41.2M), direct labour (€8.9M), energy directly attributable to pulp production (€7.4M), and depreciation of the dedicated production line (€4.6M). All four cost categories relate directly to fulfilling the contract under IAS 37 .68A.
Step 3: estimate the cost of exiting the contract
The contract includes an early-termination clause requiring Bergstrom to pay liquidated damages of €6.5M plus reimbursement of the buyer's cover-purchase premium, estimated at €2.8M. Total exit cost: €9.3M.
Step 4: measure the provision
Cost of fulfilling exceeds expected revenue by €7.7M (€62.1M less €54.4M). Cost of exiting is €9.3M. The lower amount is €7.7M (fulfilling), so Bergstrom recognises a provision of €7.7M.
This €7.7M provision is defensible because the cost projections include directly attributable allocated costs per the 2022 amendment and the exit-cost alternative is documented from contractual terms. The IAS 36 impairment test was also performed before recognition, satisfying the sequencing requirement in IAS 37.69 .
Why it matters in practice
Teams frequently calculate unavoidable costs using only incremental costs (materials and direct labour), omitting allocated costs that relate directly to contract fulfilment. Since the 2022 amendment to IAS 37 .68A, this approach understates the loss. On a contract where dedicated equipment depreciation or directly attributable energy costs are material, the difference between an incremental-only calculation and the correct calculation can exceed 15% of the provision amount. In our experience, teams often roll the prior-year working paper forward without checking whether the cost base has changed. SALY does not work here because the inputs shift every period.
A second common error is skipping the IAS 36 impairment test on underlying assets before recognising the onerous contract provision. IAS 37.69 requires this sequencing. Recognising the provision first and testing for impairment afterwards (or not at all) risks double-counting the loss, because the impairment charge and the onerous contract provision may overlap if the same asset serves the contract. Nobody enjoys running two separate impairment models for what feels like the same economic event, but getting the sequence wrong is how review findings multiply.
The file should tell a story: management identified a contract turning negative, tested the underlying assets for impairment first, then measured the onerous contract provision as the lower of fulfilling or exiting. If the working papers (WPs) do not show that sequence clearly, the reviewer will send it back.
Onerous contract vs. restructuring provision
| Dimension | Onerous contract provision | Restructuring provision |
|---|---|---|
| Trigger | Unavoidable costs of a specific contract exceed economic benefits | Board-approved plan to change the scope or manner of a business activity |
| Recognition gate | The contract must be identified as onerous under IAS 37.66 ; no announcement or communication required | Requires both a detailed formal plan and a valid expectation in those affected ( IAS 37.72 ) |
| Measurement basis | Lower of cost of fulfilling and cost of exiting the contract ( IAS 37.68 ) | Direct expenditures arising from the restructuring that are both necessarily entailed and not associated with ongoing activities ( IAS 37.80 ) |
| Scope | Single contract, measured contract by contract | Can span multiple contracts, locations, and employee groups |
| Sequencing | IAS 36 impairment test on underlying assets must precede the provision | No mandatory impairment sequencing, though IAS 36 may apply separately if assets are affected |
Overlap arises when a restructuring plan involves exiting onerous contracts. Each onerous contract provision is measured individually under IAS 37.66 –68, and the broader restructuring provision is measured under IAS 37.80 . These provisions are not netted: costs already included in the onerous contract provision must be excluded from the restructuring provision to avoid double-counting.
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Frequently asked questions
How do I identify onerous contracts during the audit?
Start with the entity's contract register and focus on fixed-price contracts where input costs have moved against the entity since inception. ISA 540.13(a) requires the auditor to evaluate the method used to identify onerous contracts. Ask management whether they have a process for flagging contracts where margins have turned negative, and test a sample of contracts with declining gross margins against the IAS 37.66 criteria.
Does the onerous contract provision cover the full contract loss or just the current year?
The provision covers the entire remaining loss over the contract's life, not just the loss attributable to the current reporting period. IAS 37.66 requires recognition of the present obligation, which is the total net loss from the date of assessment through to contract completion. The entity remeasures the provision at each reporting date under IAS 37.59, adjusting for changes in cost estimates or contract terms.
Can a profitable contract become onerous mid-way through?
Yes. A contract that was profitable at inception can become onerous if input costs rise, expected volumes drop, the entity's cost structure shifts, or contractual terms are renegotiated unfavourably. IAS 37.66 does not distinguish between contracts that were always loss-making and those that became loss-making. The assessment applies at each reporting date. The auditor tests whether management has reassessed all material fixed-price contracts in light of current cost data.