Onerous contracts under IAS 37 vs US GAAP: when a loss provision is required
A contract is onerous under IAS 37 Provisions, Contingent Liabilities and Contingent Assets when the unavoidable costs of meeting its obligations exceed the economic benefits expected under it, and IFRS then requires the entity to recognize the expected loss as a provision immediately. US GAAP has no equivalent general rule. A US reporter books a loss before it is incurred only when a specific Topic requires it, most often the loss provision for construction-type and production-type contracts in Subtopic 605-35, which the FASB kept in place when it issued Topic 606.
The gap produces real reporting differences. The same fixed-price supply contract can carry a provision on the IFRS balance sheet and none under US GAAP, or carry provisions of different amounts, depending on the type of contract and on which costs the entity counts. Since 2022 IAS 37 has also defined the cost of fulfilling a contract to include an allocation of other directly related costs, such as depreciation of equipment used on the contract, and that single definition decides whether many contracts are onerous at all.
The question tends to arise at year-end, when input costs have risen faster than fixed contract prices, when a long-term supply agreement has been priced below cost to win a customer, or when a lease of equipment or a service commitment continues after the activity it supported has stopped. Controllers in groups that report under both frameworks meet it whenever a subsidiary closes under one framework and consolidates under the other.
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HOW IAS 37 IDENTIFIES AN ONEROUS CONTRACT.
IAS 37 starts from executory contracts, where neither party has performed or both have partly performed to an equal extent. Executory contracts that are not onerous fall outside the Standard. Many routine purchase orders can be cancelled without compensation and create no obligation at all. A contract that establishes rights and obligations for both parties falls within IAS 37 once events make it onerous, and paragraph 66 then requires the present obligation under the contract to be recognized and measured as a provision.
The test compares two amounts. The first is the economic benefits expected under the contract, normally the remaining consideration. The second is the unavoidable cost, which IAS 37 describes as the least net cost of exiting the contract: the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. In practice the comparison is made on a net basis, so the entity compares the net loss of performing (cost of fulfilling less remaining benefits) with the penalty for walking away, and provides for the smaller figure.
IAS 37 applies to contracts with customers as well, because IFRS 15 Revenue from Contracts with Customers contains no specific requirements for contracts that are or have become onerous. The provision therefore sits alongside the IFRS 15 revenue accounting and does not change the transaction price or the timing of revenue. The general recognition and measurement framework for provisions, including best estimate and discounting, is covered in our article on how provisions and contingent liabilities are recognized and measured under IAS 37 and ASC 450.
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COST OF FULFILLING A CONTRACT UNDER THE 2020 IAS 37 AMENDMENT.
Before 2022 IAS 37 did not say which costs count as costs of fulfilling a contract, and practice split between an incremental cost approach and a broader directly related cost approach. The IASB settled the point with the amendment Onerous Contracts: Cost of Fulfilling a Contract, effective for annual reporting periods beginning on or after 1 January 2022. Paragraph 68A now states that the cost of fulfilling a contract comprises the costs that relate directly to the contract, which consist of both the incremental costs of fulfilling that contract, such as direct labour and materials, and an allocation of other costs that relate directly to fulfilling contracts, such as an allocation of the depreciation charge for an item of property, plant and equipment used in fulfilling that contract among others.
Costs that do not relate directly to fulfilling contracts, such as general administrative or selling costs, are not part of the measure. Shared costs enter the test only through an allocation of costs that relate directly to fulfilling contracts, with depreciation of production equipment as the example the Standard itself gives. A contract that looked profitable on an incremental basis can therefore be onerous on the directly related cost basis, and the worked example below has that profile.
The transition rules required entities to apply the amendment to contracts for which they had not yet fulfilled all their obligations at the beginning of the annual period of first application, with the cumulative effect taken to opening retained earnings and no restatement of comparatives.
Paragraph 69 adds a sequencing rule. Before a separate onerous contract provision is established, the entity recognizes any impairment loss on assets used in fulfilling the contract under IAS 36 Impairment of Assets. A dedicated machine used only for a loss-making contract may absorb part or all of the expected loss through impairment, leaving a smaller provision or none. IAS 37 also prohibits provisions for future operating losses: an unprofitable business line produces no provision unless a specific contract within it is onerous.
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LOSS CONTRACTS UNDER US GAAP: SUBTOPIC 605-35 AND OTHER SPECIFIC GUIDANCE.
US GAAP does not contain a general onerous contract model. When the FASB issued Topic 606 it decided not to include specific guidance on onerous contracts, and for that reason it retained the guidance on provisions for losses in Subtopic 605-35, Revenue Recognition: Construction-Type and Production-Type Contracts. ASU 2016-20 later clarified how that guidance operates alongside Topic 606.
Under Subtopic 605-35, for a contract on which a loss is anticipated, the entity recognizes the entire anticipated loss as soon as the loss becomes evident. The provision is determined at least at the contract level, with contracts combined under Topic 606 treated as a single unit, and ASU 2016-20 permits an accounting policy election to determine the provision at the performance obligation level, applied consistently to similar types of contracts. Estimated consideration for the test follows the Topic 606 transaction price principles, without applying the constraint on variable consideration and adjusted for customer credit risk. The "entire anticipated loss" is a total-contract figure, so any margin already recognized on completed work is reversed through the provision, and contract costs for this purpose include allocable indirect costs as well as direct costs.
Outside Subtopic 605-35, a US reporter looks for a Topic that addresses the specific arrangement. Topic 330 requires net losses on firm, noncancelable and unhedged commitments to purchase inventory to be measured in the same way as inventory losses and recognized in the period they arise. Topic 420 covers costs to terminate a contract and costs that continue under a contract without economic benefit to the entity once an exit activity begins. Topic 340-40 requires an impairment of capitalized contract costs when their carrying amount exceeds the remaining consideration less the costs that relate directly to providing the goods or services, a test explained in our article on contract costs under IFRS 15 and ASC 340-40. Where none of these applies, a loss on a service contract or a supply contract for standard products is recognized as the costs are incurred, and the expected future loss appears only in disclosures and in any impairment testing of related long-lived assets.
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ONEROUS CONTRACTS: IFRS VS US GAAP COMPARISON.
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Issue | IFRS (IAS 37) | US GAAP |
General model | Yes, for all onerous contracts in scope | No general model |
Main source | IAS 37 paragraphs 66-69 | Subtopic 605-35, Topics 330, 420, 340-40 |
Contracts with customers | Covered, IFRS 15 has no onerous rules | Only if in 605-35 or another Topic |
Costs counted | Incremental plus allocated directly related costs | 605-35: direct and allocable indirect costs |
Exit option | Lower of net cost to fulfil and penalty | Not part of the 605-35 loss measure |
Unit of account | The contract | Contract level, or performance obligation by election |
Asset impairment first | Yes, IAS 36 before the provision | Long-lived assets tested under Topic 360 |
Future operating losses | Prohibited | Not recognized |
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WORKED EXAMPLE: ONEROUS CONTRACT PROVISION AND JOURNAL ENTRIES.
The figures are illustrative. A manufacturer signed a fixed-price contract to produce and deliver 10,000 units of a component made to the customer's specifications at $50 per unit, total consideration $500,000. Revenue is recognized at a point in time on delivery. By December 31, 2026, the entity has delivered 4,000 units, recognizing revenue of $200,000 against costs of $196,000. Material prices then rose sharply. The remaining 6,000 units will now cost $47 per unit in materials and direct labour, and the production line, which the entity also uses for other contracts, carries depreciation that allocates $5 per unit to this contract. If the entity breaks the contract it must pay the customer a penalty of $25,000. The line is not impaired, because its other contracts recover its carrying amount, and the effect of discounting is immaterial because delivery is completed within 2027.
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Measure at December 31, 2026 | Amount (USD) |
Remaining consideration (6,000 x $50) | 300,000 |
Incremental costs (6,000 x $47) | 282,000 |
Allocated depreciation (6,000 x $5) | 30,000 |
Cost of fulfilling under IAS 37.68A | 312,000 |
Net cost of fulfilling | 12,000 |
Penalty for non-performance | 25,000 |
IAS 37 provision (lower of 12,000 and 25,000) | 12,000 |
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On an incremental cost basis alone the remaining work would earn $18,000 ($300,000 less $282,000) and the contract would not be onerous. The 2020 amendment requires the allocated depreciation to be included, so the contract is onerous and the provision is $12,000. If the penalty had been $8,000 instead of $25,000, the least net cost of exiting would be the penalty and the IFRS provision would be $8,000.
Under US GAAP, the contract is a production-type contract for goods made to the buyer's specifications, so the Subtopic 605-35 loss provision applies. Total consideration is $500,000 and total estimated cost is $508,000 ($196,000 incurred plus $312,000 to complete), an anticipated loss of $8,000. Because $4,000 of margin has already been recognized on the delivered units, the provision needed to bring the cumulative result to the full $8,000 loss is $12,000. Both frameworks reach the same charge in this case. Had the contract been a supply of standard catalogue products outside Subtopic 605-35, the US GAAP charge at December 31, 2026 would have been zero, and the $12,000 loss would have emerged in 2027 as the units were delivered.
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Date and entry | Account | Debit (USD) | Credit (USD) |
Dec 31, 2026: recognize loss | Loss on onerous contract (cost of sales) | 12,000 | |
Provision for onerous contract | 12,000 | ||
2027: deliver remaining units | Trade receivables | 300,000 | |
Revenue | 300,000 | ||
2027: costs of remaining units | Cost of sales | 312,000 | |
Cash and trade payables | 282,000 | ||
Accumulated depreciation | 30,000 | ||
2027: use the provision | Provision for onerous contract | 12,000 | |
Cost of sales | 12,000 | ||
Totals | 636,000 | 636,000 |
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The 2027 deliveries generate revenue of $300,000 and costs of $312,000, and the release of the $12,000 provision leaves a margin of zero in 2027. The whole loss sits in 2026, the period in which the contract became onerous. A US GAAP reporter applying Subtopic 605-35 records the same entries, typically labelling the credit as an accrued loss on contracts.
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PRESENTATION AND DISCLOSURE OF ONEROUS CONTRACT PROVISIONS.
Under IFRS the provision is presented within provisions, split between current and non-current according to the expected timing of the outflow. IAS 37 paragraph 84 requires a reconciliation for each class of provision showing the opening and closing carrying amounts, additional provisions, amounts used, unused amounts reversed and the unwinding of any discount. Paragraph 85 requires a description of the obligation and the expected timing of outflows, an indication of the uncertainties and major assumptions, and any expected reimbursement. Onerous contract provisions are usually a separate class when they are material.
Under US GAAP a 605-35 loss provision is commonly presented as an accrued liability, or as a reduction of a related contract asset where the entity's policy does so, and the critical estimates behind it are discussed in the notes and, for SEC registrants, in the critical accounting estimates section of MD&A. The income statement line is a matter of policy under both frameworks; most entities include the charge in cost of sales because it relates to fulfilling the contract. Where the timing of revenue matters to the analysis, our article on over-time vs point-in-time revenue recognition under IFRS 15 and ASC 606 explains how progress measures interact with expected losses on long-term contracts.
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COMMON ERRORS IN ONEROUS CONTRACT ACCOUNTING.
The most frequent IFRS error is applying the incremental cost approach that some entities used before 2022, which understates the cost of fulfilling and leaves onerous contracts unprovided. The opposite error also occurs: loading general overheads, head office costs or selling costs into the cost of fulfilling, which IAS 37 excludes because they do not relate directly to the contract.
A second group of errors concerns sequencing and the unit of account. Entities book a provision without first testing the dedicated assets for impairment under IAS 36, or they assess a portfolio of contracts or a whole business line, which turns the test into a forbidden provision for future operating losses. The exit route is also often ignored: if a penalty is lower than the net cost of performing, IAS 37 measures the provision at the penalty, whether or not management intends to pay it.
In US GAAP reporting, the most common error is importing the IFRS approach and recognizing loss accruals for contracts that no Topic covers, which overstates liabilities. The reverse error is missing the contracts that do fall within Subtopic 605-35, such as production of goods to customer specifications, because the entity treats all Topic 606 contracts as outside the loss guidance. Dual reporters need a reconciling item whenever one framework provides and the other does not.
Judgement remains in estimating remaining costs, in deciding which costs relate directly to the contract, in determining expected benefits when consideration is variable, and in the US GAAP decision whether a contract is construction-type or production-type. Each of these should be documented with the evidence used at the reporting date.
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ONEROUS CONTRACTS UNDER IAS 37 AND US GAAP: CLOSING CHECKLIST.
IAS 37 gives IFRS reporters a general, contract-by-contract test with a defined cost measure, an exit alternative and a required impairment step. US GAAP gives no general test and relies on Subtopic 605-35 for construction-type and production-type contracts, plus targeted rules for purchase commitments, exit costs and capitalized contract costs. The same contract can therefore produce the same charge, a different charge or no charge, and the difference can be explained only by scope.
A practical year-end review covers the following points: list fixed-price customer and supplier contracts with remaining obligations; estimate the remaining consideration and the remaining directly related costs, including allocated depreciation; compare the net cost of performing with any termination penalty; test dedicated assets for impairment before measuring the provision; under US GAAP confirm whether each contract falls within Subtopic 605-35 or another Topic before accruing anything; and reconcile the movements and assumptions required by IAS 37 paragraphs 84 and 85 or by the entity's US GAAP disclosure policy.
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