Onerous (loss-making) construction contracts · IAS 37

In plain words

A fixed-price contract can become loss-making, for example when steel prices jump. The question is whether to spread the loss or book it now. Once total expected costs exceed total expected revenue, the contractor first writes down any related contract asset, then immediately recognises a provision for the remaining expected loss in full, measured at the lower of the cost of completing the contract and the cost of exiting it (such as compensation or penalties). The provision is reassessed every period and is not offset against profits on other contracts.

Why it matters

An onerous contract provision forces immediate recognition of the entire remaining expected loss the moment a fixed-price contract turns loss-making, rather than allowing the loss to be smoothed or deferred over the remaining construction period; missing this or delaying it materially overstates both current profit and the remaining asset base, and is a frequent source of restatement in the sector when cost overruns (steel, labor, subcontractor claims) are identified late or minimized in internal reporting.

Diagnostic questions

Does the latest cost-to-complete forecast reflect known risks such as delays, price escalation, or subcontractor claims rather than an outdated budget? Do total expected contract costs, net of highly probable recoveries, now exceed total expected contract revenue for the remaining scope? Has any related contract asset or fulfilment cost asset already been written down to its recoverable amount before measuring the onerous provision? Is the provision measured at the lower of the unavoidable cost of fulfilling the contract and any exit penalty?

Recognition

At each reporting date, compare the latest total expected contract revenue (including highly probable variable consideration) against the latest total expected contract cost to complete.
If total expected costs exceed total expected revenue, the contract is onerous for its remaining scope.
First write down any related contract asset (unbilled revenue) or fulfilment cost asset to its recoverable amount.
If a loss remains after that write-down, recognize an onerous contract provision for the unavoidable net cost of the remaining obligations.
Reassess the provision every period as cost-to-complete estimates, variation approvals and claim recoveries change; release or top up as facts change.
Do not net an onerous position on one contract against profitable margin on a different, unrelated contract.

Measurement

Measure the provision at the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfil it, using the latest cost-to-complete estimate net of highly probable recoveries (approved variations, claims, insurance). The cost of fulfilling the contract includes both incremental costs (materials, labor, subcontractors directly attributable) and an allocation of other costs directly related to the contract; do not include costs unrelated to fulfilling the specific contract. Discount the provision if the effect of the time value of money is material given the remaining duration.

Presentation & disclosure

Disclose: (1) the onerous contract provision as a separate line from contract liabilities, not merged into 'other provisions'; (2) the contracts or contract classes affected and the reasons the contracts became onerous; (3) key assumptions underlying the cost-to-complete estimate (cost escalation, recoveries assumed); (4) movements in the provision during the period (additions, utilization, unwinding of discount, releases); (5) any related impairment of contract assets recognized in the same assessment.

Common mistakes

Recognizing the loss ratably over the remaining construction period instead of immediately and in full
netting an onerous provision against profitable contracts in the same portfolio or segment
not updating the cost-to-complete estimate before quarter-end reporting, so a known overrun is missed for a full reporting cycle
forgetting to write down the related contract asset first before booking a separate onerous provision (double-counting the loss or missing part of it)
including uncommitted general overhead or head-office costs not directly attributable to the specific contract in the loss calculation
assuming a claim not yet highly probable will offset the loss and therefore under-providing.

Simple example

A bridge contract has SAR 90,000,000 of remaining contract revenue. After a steel price escalation, the updated cost-to-complete estimate for the remaining scope is SAR 98,000,000, with no highly probable recovery from variations. The remaining scope is therefore expected to generate an SAR 8,000,000 loss. Assume there is no related contract asset to write down first (contract billed exactly to revenue recognized to date).
Journal entry to recognize the onerous contract provision in full, immediately:
Dr Onerous contract loss (P&L) 8,000,000
Cr Provision for onerous contract 8,000,000
As the remaining work is performed in the following periods, actual costs incurred are charged first against the provision (not to P&L again) up to the provisioned amount:
Dr Provision for onerous contract 8,000,000
Cr Cash / accounts payable 8,000,000 (over the remaining construction period, in aggregate)

Professional judgment

Forecasting cost-to-complete under IFRS 15 and applying the onerous contract test under IAS 37 both depend on the same estimation process and should be governed by one consistent, commercially-reviewed forecast rather than two disconnected exercises, a common failure mode is an optimistic operations forecast used for progress billing that differs from a more conservative finance forecast used for the onerous test. Whether a variation or claim recovery is 'highly probable' enough to net against the cost overrun before concluding the contract is onerous requires the same constraint judgment as in revenue recognition, and should not be assumed simply because a claim has been submitted. The unit of account for the onerous test (whole contract versus a distinct performance obligation within a larger contract) can also be judgmental where a contract contains multiple deliverables.

Source basis

IAS 37 · Provisions, Contingent Liabilities and Contingent Assets

Paragraph references

IAS 37.66–69IAS 37.68A

Verified against the official standard texts used in the IFRS Expert skill.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets

Issued: September 1998 · Effective: 1 July 1999

Related issues

Educational and navigation content only. Not professional advice. Does not reproduce official IFRS/IAS text. Consult the authoritative standards and qualified professionals; professional judgment may still be required.