How are onerous contracts recognised and measured under IAS 37?

Under IAS 37, when a contract becomes onerous, the present obligation under that contract must be recognised and measured as a provision (IAS 37.66). A contract is onerous when the unavoidable costs of meeting its obligations exceed the economic benefits expected to be received under it (IAS 37.68). Recognition is mandatory — there is no optionality once the threshold is met. - Definition of an onerous contract: The unavoidable costs under a contract reflect the least net cost of exiting from it — specifically, the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfil it (IAS 37.68). This "least net cost of exit" concept is the foundation of both identification and measurement. - Recognition trigger: A provision is recognised when the entity has a present obligation, it is probable that an outflow of economic benefits will be required to settle it, and a reliable estimate can be made (IAS 37.14). For onerous contracts, these conditions are typically met at the point the contract turns onerous. - Sequencing with impairment: Before establishing a separate onerous contract provision, the entity must first recognise any impairment loss on assets used in fulfilling the contract under IAS 36 (IAS 37.69). Assets are impaired first; only then is the residual contractual obligation assessed and provisioned.

How does the 2020 amendment to IAS 37 paragraph 68A clarify which costs are included in 'cost of fulfilling a contract', and what changed in practice?

- Measurement — best estimate: The provision is measured at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period (IAS 37.36). This is the amount an entity would rationally pay to settle or transfer the obligation. Measurement uses the least net cost of exit: either fulfil at a net cost or exit by paying penalties — whichever is lower. - Cost of fulfilling a contract (2020 amendment): The 2020 amendments, effective for annual periods beginning on or after 1 January 2022, clarified what costs are included when determining whether a contract is onerous (IAS 37.105). The amendments added paragraph 68A to address directly attributable costs versus allocated overheads. Entities apply the amendments to contracts not yet fully fulfilled at the date of initial application and do not restate comparatives (IAS 37.94A). - Tax and measurement: The provision is measured before tax; the tax consequences are dealt with separately under IAS 12 (IAS 37.41). - Disclosure: For each class of provision, entities disclose a description of the nature of the obligation, the expected timing of outflows, and an indication of the uncertainties about the amount or timing of those outflows (IAS 37.85).

When a long-term lease becomes onerous under IFRS 16, should the lessee recognise an IAS 37 onerous contract provision in addition to any right-of-use asset impairment?

- Forgetting the impairment-first sequence. Many preparers jump straight to provisioning without first testing dedicated contract assets for impairment under IAS 36. IAS 37.69 is explicit: impair assets first, then provision the residual. - Using the wrong cost base. The measurement is based on the least net cost of exit, not the total cost to fulfil. If penalties for exiting are lower than the net cost of completion, the provision is measured at the penalty amount. - Ignoring the 2020 amendments. The clarification on directly attributable costs (effective 1 January 2022) changed practice for many entities. Applying a broad overhead allocation when assessing whether a contract is onerous overstates the provision. - Misclassifying expected future operating losses. An expectation of future operating losses does not itself give rise to an onerous contract provision, though it may indicate assets are impaired and should be tested under IAS 36.

How should an entity account for the unwinding of discount on an onerous contract provision recognised at present value — and where does it appear in the income statement?

- Netting against related assets. The onerous contract provision is a liability and must not be offset against any related asset on the face of the statement of financial position. - IAS 37.14 — Sets out the three recognition criteria for all provisions: present obligation, probable outflow, and reliable estimate. - IAS 37.36 — Requires the provision to be measured at the best estimate of expenditure to settle the present obligation at the reporting date. - IAS 37.66 — Core rule: a present obligation under an onerous contract shall be recognised and measured as a provision. - IAS 37.68 — Defines an onerous contract and establishes the least-net-cost-of-exit measurement principle. - IAS 37.69 — Requires impairment of contract assets under IAS 36 before a separate onerous contract provision is established. - IAS 37.85 — Specifies disclosure requirements for each class of provision, including nature, timing, and uncertainties of outflows.

IAS 37 Onerous Contracts

IAS 37 Onerous Contracts — Core Rule

Under IAS 37, when a contract becomes onerous, the present obligation under that contract must be recognised and measured as a provision (IAS 37.66). A contract is onerous when the unavoidable costs of meeting its obligations exceed the economic benefits expected to be received under it (IAS 37.68). Recognition is mandatory — there is no optionality once the threshold is met.

How IAS 37 Onerous Contracts Works

Definition of an onerous contract: The unavoidable costs under a contract reflect the least net cost of exiting from it — specifically, the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfil it (IAS 37.68). This "least net cost of exit" concept is the foundation of both identification and measurement.

Recognition trigger: A provision is recognised when the entity has a present obligation, it is probable that an outflow of economic benefits will be required to settle it, and a reliable estimate can be made (IAS 37.14). For onerous contracts, these conditions are typically met at the point the contract turns onerous.

Sequencing with impairment: Before establishing a separate onerous contract provision, the entity must first recognise any impairment loss on assets used in fulfilling the contract under IAS 36 (IAS 37.69). Assets are impaired first; only then is the residual contractual obligation assessed and provisioned.

Measurement — best estimate: The provision is measured at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period (IAS 37.36). This is the amount an entity would rationally pay to settle or transfer the obligation. Measurement uses the least net cost of exit: either fulfil at a net cost or exit by paying penalties — whichever is lower.

Cost of fulfilling a contract (2020 amendment): The 2020 amendments, effective for annual periods beginning on or after 1 January 2022, clarified what costs are included when determining whether a contract is onerous (IAS 37.105). The amendments added paragraph 68A to address directly attributable costs versus allocated overheads. Entities apply the amendments to contracts not yet fully fulfilled at the date of initial application and do not restate comparatives (IAS 37.94A).

Tax and measurement: The provision is measured before tax; the tax consequences are dealt with separately under IAS 12 (IAS 37.41).

Disclosure: For each class of provision, entities disclose a description of the nature of the obligation, the expected timing of outflows, and an indication of the uncertainties about the amount or timing of those outflows (IAS 37.85).

IAS 37 Onerous Contracts — Common Pitfalls

Forgetting the impairment-first sequence. Many preparers jump straight to provisioning without first testing dedicated contract assets for impairment under IAS 36. IAS 37.69 is explicit: impair assets first, then provision the residual.

Using the wrong cost base. The measurement is based on the least net cost of exit, not the total cost to fulfil. If penalties for exiting are lower than the net cost of completion, the provision is measured at the penalty amount.

Ignoring the 2020 amendments. The clarification on directly attributable costs (effective 1 January 2022) changed practice for many entities. Applying a broad overhead allocation when assessing whether a contract is onerous overstates the provision.

Misclassifying expected future operating losses. An expectation of future operating losses does not itself give rise to an onerous contract provision, though it may indicate assets are impaired and should be tested under IAS 36.

Netting against related assets. The onerous contract provision is a liability and must not be offset against any related asset on the face of the statement of financial position.

IAS 37 Onerous Contracts — Key Paragraphs

IAS 37.14 — Sets out the three recognition criteria for all provisions: present obligation, probable outflow, and reliable estimate.
IAS 37.36 — Requires the provision to be measured at the best estimate of expenditure to settle the present obligation at the reporting date.
IAS 37.66 — Core rule: a present obligation under an onerous contract shall be recognised and measured as a provision.
IAS 37.68 — Defines an onerous contract and establishes the least-net-cost-of-exit measurement principle.
IAS 37.69 — Requires impairment of contract assets under IAS 36 before a separate onerous contract provision is established.
IAS 37.85 — Specifies disclosure requirements for each class of provision, including nature, timing, and uncertainties of outflows.