What it means
The test has two halves: the economic benefits expected from the contract and the unavoidable costs of meeting it. Unavoidable cost is defined as the lower of the cost of fulfilling the contract and any compensation or penalty payable for failing to fulfil it, because a rational business will choose the cheaper way out.
If that lower figure exceeds the expected benefit, the contract is onerous. The provision goes on the balance sheet as a liability with a matching charge to profit, which is why a single bad long-term contract can wipe out a year's earnings.
Construction, outsourcing, shipping and property are the classic settings, since all involve prices fixed years before the costs are known. A fixed-price contract signed just before a jump in steel or labour costs is the textbook case.
There is an important limit to the rule. A contract is not onerous simply because it is less profitable than hoped, or because the capacity could earn more elsewhere; it has to lose money on its own terms after counting the costs directly related to fulfilling it.
Nor can you provide for expected losses on a contract you have not yet signed. Before recognising the provision, the standards require you to test for impairment any assets dedicated to the contract, so the provision only covers the shortfall that remains.
This ordering avoids counting the same loss twice. The provision is then released as the loss actually crystallises, which is why later periods can look artificially profitable.
For managers, the practical value of the rule is that it forces an early and honest conversation. Someone has to model the remaining costs, compare them with the remaining revenue and put a number on the damage, which often triggers a renegotiation or an early exit.
Boards that discover onerous contracts late tend to discover them alongside a going concern discussion.
In practice
Real-world examples
Example 1
A shipping operator chartered a vessel for three years at $18,000 a day just before spot rates fell to $11,000. With 730 days left to run, the daily shortfall of $7,000 gives an expected loss of $5,110,000, which must be provided in full now.
Example 2
A professional services firm vacates an office it leases for $600,000 a year with four years remaining, a total commitment of $2,400,000. It expects to sublet for $900,000 in total, so it recognises a provision of $1,500,000.
Example 3
A software integrator quoted $900,000 for a fixed-scope implementation and now expects total costs of $1,250,000. The $350,000 shortfall is recognised at once, rather than appearing as thin margins over the following four quarters.
Think of it
Imagine buying a non-refundable gym membership for 1,000 pounds per year, only to break your leg the next day and discover you are not allowed to use the pool or weights. You are still legally required to pay the remaining 900 pounds, but you get zero health benefit in return.
Formula
Calculation
Provision = the lower of (unavoidable cost of fulfilling the contract - benefits expected) and (penalty for exiting the contract)
A building services firm has a fixed-price maintenance contract with $1,400,000 of revenue still to be earned. Rising wage rates mean the remaining unavoidable costs are now $1,800,000.
Expected loss from fulfilling the contract = $1,800,000 - $1,400,000 = $400,000.
Penalty for early termination = $500,000.
Unavoidable cost is the lower of the two exits, so the provision is $400,000.
If the termination penalty had been $250,000 instead, the firm would provide only $250,000, because walking away would be the cheaper obligation. Either way the charge hits profit immediately. The $400,000 provision is then released against the actual monthly losses as the remaining work is delivered, so those later months show no further hit to profit.Case study
Seen in the real world
The story that follows is illustrative and Weyburn Modular Homes is a fictional company. Weyburn had won a $12,000,000 fixed-price contract to build a student accommodation block, priced on timber and steel costs quoted 14 months earlier.
By the interim reporting date, $5,000,000 of revenue had been billed and the project team's revised estimate showed $9,500,000 of costs still to be incurred against $7,000,000 of remaining revenue. The contract was clearly onerous by $2,500,000, and the exit penalty in the contract was $4,000,000, so fulfilling it was the cheaper obligation and $2,500,000 had to be provided.
The provision reduced full year operating profit from $3,100,000 to $600,000 and prompted an immediate review of every open fixed-price job. Weyburn's board introduced two changes: indexation clauses on material costs in all future tenders, and a quarterly recalculation of cost to complete on every contract over $1,000,000. The next round of bids was less competitive on price, but none of them turned onerous.
Watch out
Common mistakes
- Waiting until the losses actually occur, when the rules require the whole expected loss to be provided as soon as the contract becomes onerous.
- Calling a contract onerous because it is less profitable than expected, when the test is whether it loses money outright.
- Forgetting to test the assets dedicated to the contract for impairment before setting up the provision, which counts part of the loss twice.
Questions
People also ask
Which costs count as unavoidable?
The costs directly related to fulfilling the contract, including direct labour and materials and an allocation of directly attributable overheads, but not general administration.
Can a provision be reversed?
Yes, if circumstances improve through a renegotiated price or lower input costs, the unused part of the provision is released back to profit.
Does an onerous contract provision affect cash?
Not at the moment it is recognised, since it is an accounting entry, but it flags cash losses that will be incurred as the contract is performed.