A business signs a fixed-price supply contract, then material costs rise before the remaining deliveries are completed. Performance now looks loss-making, and someone proposes a provision for every expected loss next year. The commercial problem is real, but that proposal confuses an existing contractual obligation with a general forecast of operating losses.
IAS 37 addresses onerous contracts, where unavoidable fulfilment costs exceed expected benefits. It does not permit a general reserve for future operating losses. Identify the existing contract, enforceable exit terms and fulfilment costs, then assess the obligation from evidence rather than management's preferred reduction in this year's profit.
Is performance cheaper than exit?
In a short-term educational example, remaining supplies will earn SAR 200,000, while relevant direct fulfilment costs have risen to SAR 230,000. Assume the estimates are complete, there are no assets requiring impairment or additional benefits, and the time value of money is immaterial. The estimated loss from performance is SAR 30,000.
Suppose an enforceable contract term permits complete termination for compensation of SAR 18,000, without other costs. Compare the SAR 30,000 net cost of performance with the SAR 18,000 exit cost. Under these assumptions, the minimum net burden is SAR 18,000, not automatically SAR 230,000 or SAR 30,000. An unavailable termination option cannot be invented to reduce the measurement.
| Illustrative alternative | Expected benefits | Relevant costs | Net burden |
|---|---|---|---|
| Complete supply | 200,000 | 230,000 | 30,000 |
| Enforceable termination under the assumptions | Zero | 18,000 | 18,000 |
This calculation does not independently decide whether commercial management should cancel. It illustrates measurement in the assumed circumstances. Other consequences may matter, and enforceability or compensation terms require contract review and appropriate legal input rather than reading an isolated clause.
Why a material-cost list is insufficient
Purchasing may report only higher material prices, while fulfilment also involves direct labour and other costs directly related to performing contracts. IAS 37 clarifies that the assessment is not restricted to incremental costs: relevant directly related allocations also matter. Conversely, every budgeted business expense does not become a contract cost merely because it exists.
Start with remaining quantities, supported prices, service quotations and labour requirements, then document allocation bases. Separate costs already incurred from remaining performance so that an amount is not counted twice. If estimated volume or productivity changes, revise the assumption rather than adding an unexplained contingency percentage.
Also review impairment of assets used in fulfilling the contract before establishing a separate onerous-contract provision, applying the relevant standards. Dedicated goods or equipment whose value is no longer recoverable may affect the analysis. Avoid recognising the same loss in both the asset and provision, without omitting one assessment simply because the other was completed.
The review file should contain the contract and amendments, remaining-quantity calculation, cost estimates, benefit evidence and exit alternatives. Date assumptions and identify their approvers. If management is negotiating a price increase, distinguish an unaccepted offer from an effective contractual amendment. Hope that negotiations will succeed is not evidence of a new revenue amount.
Recognition does not make the contract a closed file. Monitor performance, settlements and changes affecting the best estimate, linking use of the provision to the obligation for which it was created. Do not consume it against unrelated contracts that perform worse than expected. A provision explains a specific burden; it is not a mechanism for smoothing profits between periods.
Sources & further reading
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General educational content. Appropriate treatment depends on your business and accounting policies; consult your accounting professional when applying it to business records.
