This is from the “Accounting Makes Cents” podcast episode #121 released on Monday, 7 September 2026.

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Picture this. Your company signs a five-year lease on a warehouse. Eighteen months in, the market shifts, demand disappears, and you’re stuck paying rent on a building you don’t really need anymore. There’s no way out except to keep paying, or pay to get out. That contract just went from an asset on paper to a liability in real life.

That’s an onerous contract. And today, we’re going to unpack exactly what that means, and how IAS 37 tells you to account for it. I actually got the idea for this topic because a student asked me about it — so if you’ve ever wondered how something like that lease ends up hitting the accounts as a loss, this one’s for you.

Jump to show notes.

What is an onerous contract?

Let’s start with where this sits in the bigger scheme of things. The accounting standard covering onerous contracts is IAS 37 — Provisions, Contingent Liabilities and Contingent Assets. So before we’re even talking about onerous contracts specifically, we’re inside the wider world of provisions: situations where a company has an obligation that isn’t paid yet, but is real enough to recognise now. An onerous contract is really just one specific trigger for a provision under that same standard.

I’ve actually got an episode covering IAS 37 in full detail. I’ll link it in the show notes if you want the broader picture.

With that context set, let’s start with the definition.

IAS 37 defines an onerous contract as one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.

Say that a few times, because that’s your exam-ready definition. Two things to notice there.

First, unavoidable costs. Not costs you might incur, not costs if things go badly. Unavoidable. That means costs you can’t escape, either because you fulfil the contract, or because you pay to get out of it. 

Second, economic benefits expected. This is forward-looking. We’re not asking “did this contract lose money last year?” We’re asking, “going forward, is this going to cost us more than it brings in?”

When Do You Recognise a Provision? 

Here’s where it gets practical. IAS 37 says that if you have an onerous contract, you recognise a provision for the present obligation under that contract. We’ll talk about how to measure in a second.

But, and this is a common trip-up, you don’t provide for every contract that’s simply loss-making in a general sense. It has to meet the recognition criteria for a provision under IAS 37 generally: a present obligation from a past event, probable outflow of resources, and a reliable estimate. For an onerous contract, the “past event” is signing the contract, and the obligation crystallises once the unavoidable-cost test is met.

It’s really important that you can distinguish an onerous contract from a contract that’s merely expected to be less profitable than hoped. Less profitable is not the same as loss-making on unavoidable costs. Keep that distinction clear.

How Do You Measure It?

This is the number-crunching bit, and it’s simple once it clicks.

IAS 37 says you measure the provision at the lower of two amounts:
Option one: the cost of fulfilling the contract. So, what will it cost you to see it through to the end?
Option two: the cost of exiting the contract, which usually means any compensation or penalties payable for not fulfilling it.

You take whichever of those two is cheaper, because that’s the economically rational path management would choose, and the provision reflects that.

Let’s do a quick example: Say your company has a contract with three years left to run. If you continue, you’ll pay costs of 900,000 dollars over those three years, and you’ll receive revenue of 600,000 dollars. So the shortfall from fulfilling it is 300,000 dollars. Alternatively, you could exit now by paying a penalty of 200,000 dollars.

Which is lower? The exit cost, at 200,000. So your provision, the amount you recognise as a liability today, is 200,000 dollars. That’s the number that goes into your provisions note and hits your income statement as an expense.

Now let’s talk about what that actually does to the company’s bottom line, because this is where the “net loss” question comes in.

That 200,000 dollars is a straight hit to profit and loss in the period you recognise it. The entry is simple: debit an expense, often called “provision for onerous contract” or bundled into cost of sales, depending on the scenario; and credit a provision on the balance sheet. So if the company’s profit before this adjustment was, say, 500,000 dollars, recognising the 200,000 dollars provision drops reported profits to 300,000 dollars for that period.

Here’s a part students sometimes miss: once that provision is sitting on the balance sheet, the actual costs you incur in later years as you fulfil or exit the contract get set against the provision, not charged to profit again. So if in year two you actually pay out 70,000 dollars of those unavoidable costs, you debit the provision and credit cash. There is no further P&L hit, because you already recognised the full expected loss upfront. If your original estimate turns out to be off, you true it up through profit or loss in the period the estimate changes, but you’re not re-recognising the same loss twice.

To be precise: the amount you provide for is the best estimate of the net loss the company will suffer overall on that contract. It is not the gross cost, and not the total remaining contract value. It’s already a net figure. That single number is designed to capture, in one line, the full economic damage that contract is going to do to the business.

Hang On — Isn’t This Just Normal Expenses Happening in Real Time?

Now, if you’re thinking practically, you might be asking: why bother providing for this now at all? In the real world, the cash just goes out the door month by month as the contract runs. So why not just let it hit the income statement as it happens, like any other expense?

It’s a fair question, and it actually gets at the whole point of accrual accounting.

Here’s the issue with just waiting. If you only expense costs as cash goes out, your financial statements this year would show a perfectly healthy company, because none of next year’s or the year after’s losses have shown up yet. But the obligation already exists today. You signed a contract that, as of the reporting date, is going to lose money no matter what you do. That’s not a future risk, that’s a present fact. Under the accounting standard, a liability is a present obligation arising from a past event. The past event already happened, you signed the contract. So the obligation exists now, even though the cash hasn’t moved yet.

Think about what happens if you don’t recognise it. An investor, a lender, or a fellow finance manager looks at this year’s balance sheet and sees no hint of the three years of losses baked into that lease. They make a lending decision, or a valuation, based on incomplete information. Then, eighteen months later, the losses start showing up, and by the time all the numbers are in, the company may already be in serious trouble. The provision is what stops that surprise. It front-loads the bad news into the period where you actually found out about it, the moment the contract turned onerous, instead of hiding it in slices across future years.

There’s also a matching angle. Good accounting tries to reflect economic reality, not just cash movements. The economic loss was locked in the moment the contract became onerous. Recognising it there, in one go, matches the expense to the event that caused it, rather than smearing it thinly across periods in a way that understates how bad things actually are in the year the problem was discovered.

And even where the numbers are hard to pin down exactly, IAS 37 still wants disclosure — the nature of the obligation, an estimate of its financial effect, and the uncertainties involved. That’s about transparency. Users of the accounts have a right to know a company is sitting on a contract that’s expected to lose money, even before every last dollar is nailed down.

So the short answer to “isn’t this just normal expenses happening anyway” is: yes, the cash flows are ordinary and unavoidable, but the accounting question isn’t about cash timing, it’s about when you tell your stakeholders the truth about your financial position. Provisioning brings forward that truth to the moment you know it, rather than the moment you feel it in the bank account.

So, what did we learn today?

Here’s our takeaways:
1. An onerous contract exists when unavoidable costs of meeting the contract exceed the expected economic benefits.
2. Measure the provision at the lower of the cost to fulfil versus the cost to exit.
3. That provision figure is already the net loss the company expects to suffer on the contract, and it hits profit in full in the period you recognise it. Later cash payments are then set against the provision, not charged to profit again.
4. Remember why we provide at all. The obligation exists at the reporting date, even though the cash hasn’t moved yet, so waiting to expense it as incurred would hide a known loss from anyone reading the accounts.

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Show notes simplified

In this episode, MJ the tutor looks at onerous contracts under IAS 37, the point at which a contract stops being a normal commercial commitment and becomes a liability a company has to account for.

Resources and links from this episode: MJ the tutor on IAS 37