Onerous contracts: compare fulfilment and exit costs
A contract becomes onerous through its unavoidable remaining economics, not simply because the business expects a bad year. Compare the cost of fulfilling the obligation with the cost of exiting it, using a consistent scope. Then distinguish an existing contractual loss from future discretionary operating losses.
Establish the present obligation
IAS 37 distinguishes onerous-contract provisions from unprovided future operating losses. The Foundation’s 2020 amendment project addresses the cost of fulfilling a contract. Historical IFRS-aligned detail is accessible in AASB 137, December 2022, paragraphs 66–69; its own local applicability dates must be respected.
This article concerns an ordinary IFRS executory supply contract. Insurance contracts, employee obligations and other arrangements can fall under different requirements. Identify remaining enforceable deliveries, consideration, cancellation rights, penalties and assets used to fulfill the contract before selecting the relevant accounting route.
Hypothetical fulfillment versus exit
Assume a fixed-price contract has 100 thousand of remaining consideration. Incremental materials and labor will cost 108. Another 12 of costs directly related to fulfilling this contract must be allocated to it. Assume these are appropriate fulfillment costs and exclude unrelated headquarters spending. Total fulfillment cost is 120, leaving a fulfillment loss of 20.
The contract can instead be exited by paying compensation of 15, with no additional remaining obligations. Under these simplified assumptions, the lower unavoidable net cost is 15, not 20. An incremental-cost-only calculation would show a loss of 8 and miss the directly related allocated cost.
| Hypothetical route | Remaining cost | Remaining benefit | Net unavoidable cost |
|---|---|---|---|
| Fulfill | 120 | 100 | 20 |
| Exit under assumed enforceable terms | 15 | 0 | 15 |
| Lower-cost route | 15 |
If exit compensation were 30 instead, the lower route would be fulfillment at a net loss of 20. The provision is not the sum of both routes. They are alternative ways of meeting or ending the same obligation, so adding 20 and 15 would count incompatible outcomes together.
Check related asset impairment first
Before recording a separate onerous-contract provision, examine impairment of assets used in fulfilling the contract under the applicable requirements. Do not book a full contract loss and separately write down the same recovery shortfall without checking for double counting. This article’s numerical case assumes no separate asset impairment is required.
A dedicated tool may have salvage value or alternative use that changes the analysis. Conversely, a cancellation option may exist only with customer consent that has not been obtained. Preserve the distinction between a contractual exit right and management’s hope to negotiate one.
Build the unavoidable-cost worksheet
Use fields for remaining contract quantity, price, incremental costs, directly related allocation, excluded general costs, exit clauses, penalties, expected benefits and asset impairment review. Attach a cost basis and date to each input. Costs already incurred are not automatically remaining fulfillment costs; avoid importing historical project losses into the forward obligation twice.
Compare the worksheet with procurement changes, new labor rates, revised production plans and customer claims. A temporary shortage can raise fulfillment cost, but an unenforceable forecast order may not create the same present obligation as a signed supply commitment. Contract boundaries matter more than a broad forecast that the segment will lose money.
Observable review triggers include a fixed selling price combined with rising inputs, loss of an alternative use, adverse penalty rulings and negotiated releases. A provision release after cancellation requires evidence of the obligation’s changed status, not merely management’s decision to stop production.
Public disclosures may aggregate contracts or omit cancellation terms. State what cannot be reproduced. The final memo should show the two alternative routes, the supported cost population and the remaining obligation, without converting an illustrative loss calculation into a confirmed legal claim or an automatic forecast of cash paid next year.
FAQ
Can expected future operating losses alone create this provision?
No. Identify the existing obligation and relevant contract rather than a general loss forecast.
Should fulfillment loss and exit compensation be added?
Not when they are alternatives for the same obligation. Compare the supported routes under the applicable requirements.