Onerous Contracts
Why a company can be forced to book a loss today on a contract it hasn't even started performing yet — simply because it already knows, with certainty, that the contract is going to lose money.
In plain English
Imagine an airline signed a long-term lease for aircraft years ago, committing to fixed monthly payments regardless of demand. Then a sudden, severe demand shock hits — the airline's own network planning shows those specific aircraft will sit substantially idle, generating nowhere near enough revenue to cover the fixed lease payments, for the foreseeable future. Should the airline wait to recognise a loss until each individual month's underperformance actually happens? Or, since it already KNOWS today, with reasonable certainty, that this contract is a losing proposition overall, should it recognise that entire expected future loss right now? Accounting requires the latter — this is exactly what an Onerous Contract provision is for.
Words you'll need first
A contract in which the UNAVOIDABLE costs of meeting the company's obligations under it exceed the economic benefits expected to be received from it — in plain terms, a contract the company is locked into that is now expected to lose money overall. The key word is 'unavoidable': a contract only qualifies if the company genuinely can't get out of it, or out of the loss, without incurring a penalty or cost at least as large.
The lower of the cost of fulfilling the contract as agreed, and the cost of exiting it — the standard specifically uses the LOWER of these two, since a rational company facing an onerous contract would choose whichever option is cheaper. This is exactly why the provision recognised isn't simply 'total expected losses over the life of the contract' in every case — if walking away is cheaper than continuing to perform, the provision is based on the (lower) exit cost instead.
A worked example, with numbers
| Item | ₹ crore |
|---|---|
| Remaining unavoidable lease payments | 160 |
| Expected revenue from continuing to operate the aircraft | 100 |
| Net cost of CONTINUING to fulfil the contract (160 − 100) | 60 |
| Cost of exiting the contract early (penalty) | 70 |
| Onerous contract provision (the LOWER of the two options) | 60 |
- Since it's cheaper to keep flying these aircraft at a loss (a net ₹60 crore cost) than to pay the ₹70 crore early-exit penalty, the airline recognises a ₹60 crore provision now — the entire expected future net loss, taken as a single charge today, rather than spread across the remaining 2 years as it's actually incurred.
- This ₹60 crore hits the P&L immediately, well before most of the actual underlying cash losses have physically occurred, exactly mirroring the logic of the Provisions & Contingent Liabilities article.
- If exiting the contract had instead been the CHEAPER option, the provision would be based on that lower exit cost instead — the standard reflects whatever the more rational, cost-minimising choice would be, not simply the full theoretical loss from continuing to perform.
- As the contract is actually performed over the following 2 years and the real losses materialise, they're charged against this already-recognised provision rather than hitting the P&L again as fresh expenses — the provision essentially 'pre-pays' the recognition of a loss that was already known to be coming.
What it does to the financial statements
Impact on the P&L
- Recognising an onerous contract provision creates an immediate, often large, one-off P&L expense in the period the contract is first identified as onerous — well ahead of when the actual underlying losses are physically incurred.
- As the contract is subsequently performed, the real losses are charged against the provision already set up, rather than creating fresh expenses — meaning a company's reported results in the LATER, loss-making years can actually look artificially better than the true cash economics, since the expense was already front-loaded.
- A sudden shift in a company's business outlook can convert previously ordinary, profitable-looking contracts into onerous ones almost overnight, creating a genuine source of sudden, large, one-off charges.
- This is one of the more judgement-intensive corners of accounting — estimating unavoidable future costs and expected future benefits both require real forecasting, and reasonable people can disagree meaningfully on both.
Impact on the Balance Sheet
- The onerous contract provision sits on the balance sheet as a genuine liability, split between current and non-current portions based on expected timing, reducing net assets and equity by the same amount as the matching P&L expense.
- As the contract is performed and actual losses are incurred, the provision balance is drawn down correspondingly, until it reaches zero by the time the contract's remaining onerous period ends.
- A large onerous contract provision, once recognised, is a real, quantified signal that a company is contractually locked into a loss-making arrangement it can't easily escape.
- Recall from the Lease Accounting article that most leases already sit on the balance sheet as Right-of-Use assets and Lease Liabilities; when a leased asset also becomes onerous, companies typically first test the Right-of-Use asset itself for impairment under Ind AS 36 before considering any residual onerous contract provision under Ind AS 37.
Which standard covers this
In India this is governed by the onerous contracts provisions within Ind AS 37 – Provisions, Contingent Liabilities and Contingent Assets, the same standard covered in the Provisions & Contingent Liabilities article, notified under the Companies (Indian Accounting Standards) Rules and applicable to companies that follow Ind AS.
How it's recognised globally
Globally, the equivalent sits within IAS 37, and Ind AS 37 mirrors its 'lower of fulfilment cost and exit cost' approach closely — including a notable 2020 clarification by the IASB on exactly which costs count as the 'unavoidable costs of fulfilling' a contract, which Ind AS 37 has also incorporated. Under US GAAP, there is no single, comprehensive standard dedicated to onerous contracts the way IAS 37/Ind AS 37 provides — guidance is more scattered across specific situations (such as ASC 420 for exit or disposal activities, and specific provisions within revenue recognition and lease accounting standards for contract-specific losses), meaning the treatment of an economically similar loss-making contract can genuinely differ, and can sometimes be recognised later or differently, under US GAAP compared to the more unified Ind AS 37/IAS 37 approach.
Real example — Indian listed company
India's airline sector during the COVID-19 pandemic provides a stark, real-world illustration of onerous contracts at scale. With air travel demand collapsing almost overnight in 2020, airlines including SpiceJet found themselves locked into long-term aircraft lease commitments — fixed monthly payments agreed years earlier — for aircraft that, for extended periods, were flying dramatically reduced schedules or sitting grounded entirely, generating nowhere near enough revenue to cover those fixed lease obligations. This is precisely the scenario the worked example in this article describes: airlines in this position had to assess whether specific aircraft leases had become onerous contracts, and if so, recognise the expected future net loss immediately as a provision, rather than waiting for each month's shortfall to occur individually. The severity and duration of the pandemic-era demand shock made this a genuinely material accounting issue across the Indian aviation sector, illustrating how quickly a routine, previously-unremarkable set of lease commitments can turn into a formally recognised, front-loaded accounting loss when the underlying business environment changes sharply and unexpectedly.
Where you'll see this
Related concepts
Provisions & Contingent Liabilities
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Deferred Tax Assets & Liabilities
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