A contract can become commercially unattractive without automatically creating an accounting provision. Ind AS 37 focuses on a narrower question: has the contract become onerous, meaning that the unavoidable costs of meeting the contractual obligations exceed the economic benefits expected from the contract?
This distinction matters when a fixed-price supply, service, construction or other executory contract starts losing money. Management may know that the margin has disappeared, but the provision is not simply the latest forecast loss. The finance team has to identify the unavoidable cost of the contract, compare the realistic ways of exiting it, include the right directly related fulfilment costs, and recognise impairment on assets used for the contract before a separate onerous-contract provision is established.
The governing requirements are in the current ICAI text of Ind AS 37. They apply to onerous contracts that fall within the Standard's scope; contracts dealt with by another Ind AS may require a different analysis.
A bad margin is a warning sign, not the accounting conclusion
Ind AS 37 generally does not apply to executory contracts unless they are onerous. An executory contract is one in which neither party has performed, or both parties have performed to an equal extent. A routine purchase order that can be cancelled without paying compensation may therefore create no present obligation simply because market prices have moved against the entity.
By contrast, a contract becomes onerous when the unavoidable costs of meeting the obligations exceed the economic benefits expected to be received under it. Once that condition is met, the present obligation under the onerous contract is recognised and measured as a provision.
This should also be kept separate from a forecast of future operating losses. Ind AS 37 does not permit a provision merely because management expects a future period or business unit to make losses. Such a forecast may instead be an indicator that assets need to be tested for impairment.
Measure the least net cost of getting out of the contract
The Standard describes unavoidable costs as the least net cost of exiting the contract. In practical terms, management compares the economic loss from fulfilling the remaining contract with the compensation or penalties that would arise from not fulfilling it. The lower unavoidable amount is the starting point for the onerous-contract obligation, subject to the normal measurement requirements for provisions.
This is why the legal terms matter as much as the forecast. A contract that appears deeply loss-making on a fulfilment basis may have a relatively small, enforceable termination payment. Another contract may carry a very high cancellation penalty, making continued performance the less costly route.
Hypothetical example: fulfil or terminate?
Assume a company has a fixed-price contract with expected remaining economic benefits of ₹100 lakh. The costs that relate directly to fulfilling the remaining obligations are estimated at ₹118 lakh. The net cost of continuing with the contract is therefore ₹18 lakh.
The contract also allows the company to terminate by paying compensation of ₹12 lakh. On these assumptions, the least net cost of exiting is ₹12 lakh, because termination costs less than absorbing an ₹18 lakh loss through continued performance. The provision would therefore be based on the lower unavoidable amount, subject to the entity confirming that the termination clause is legally available and that no other relevant settlement effects change the estimate.
If the termination compensation were ₹25 lakh instead, continued performance would create the lower loss: ₹18 lakh rather than ₹25 lakh. The provision would then be measured using the lower continuation loss, again subject to the detailed facts and the general measurement requirements of Ind AS 37.
The cost of fulfilling the contract is broader than just incremental cash spend
Paragraph 68A of Ind AS 37 clarifies what goes into the cost of fulfilling a contract. It includes costs that relate directly to the contract. That includes both:
- incremental costs of fulfilling the contract, such as direct labour and materials; and
- an allocation of other costs that relate directly to fulfilling the contract, such as depreciation of an item of property, plant and equipment used in fulfilling it.
This prevents a common understatement. If the onerous assessment uses only additional materials and wages while ignoring other directly related costs, the entity may conclude too late that the contract is onerous.
The reverse error is to load the calculation with broad corporate overhead merely because it exists. The Standard's test is whether the cost relates directly to fulfilling the contract. The working should therefore show why each allocated amount has that direct relationship rather than applying an arbitrary share of head-office costs.
Test contract-related assets for impairment before recording the separate provision
Ind AS 37 requires an entity to recognise any impairment loss on assets used in fulfilling the contract before establishing a separate onerous-contract provision. The order matters because an asset carrying amount should not remain overstated while the same deterioration is absorbed only through a provision.
For example, a dedicated machine, tooling or other asset used to perform the contract may need to be assessed under impairment testing under Ind AS 36. Any required impairment is recognised first. The remaining present obligation under the onerous contract is then measured separately under Ind AS 37.
A year-end file should make that sequence visible. If the impairment review and the onerous-contract calculation are prepared by different teams, reconcile them before the provision is posted so that the same economic deterioration is not ignored on one side or counted twice.
Do not turn every difficult contract into a contingent liability
Once a contract is onerous and gives rise to a present obligation within Ind AS 37, the Standard requires a provision. It is not enough to describe the matter only as a possible loss because the final amount is uncertain. The wider provision and contingent-liability distinction still depends on whether a present obligation exists, an outflow is probable and a reliable estimate can be made.
At the same time, the contract terms may show that there is no unavoidable obligation. If an unperformed contract can genuinely be cancelled without compensation and without another present obligation, a deteriorated market price does not by itself create an onerous-contract provision.
A practical review sequence for year-end contracts
Finance does not need to reassess every contract from zero. A targeted review can start with contracts showing signs that the original economics have changed, such as sharp input-cost increases, fixed selling prices, delays, penalties, loss of expected volumes or assets dedicated to underperforming work. These are review indicators, not automatic recognition triggers.
- Read the enforceable contract terms. Identify remaining performance obligations, cancellation rights, penalties, compensation clauses and any realistic route to renegotiation that is already enforceable at the reporting date.
- Estimate the remaining economic benefits. Use the benefits expected from the contract under the terms that exist at the reporting date rather than an unsupported target margin.
- Build the fulfilment cost on the paragraph 68A basis. Include incremental direct costs and a supportable allocation of other costs that relate directly to fulfilling the contract.
- Price the alternative exit route. Determine the compensation or penalties that would arise from failure to fulfil, based on the actual contractual and legal position.
- Identify the least net cost of exit. Compare the continuation loss with the enforceable exit cost and document why the lower amount represents the unavoidable obligation.
- Run impairment first. Assess assets used in fulfilling the contract and recognise any required impairment before calculating the separate provision.
- Measure and document the provision. Apply the Ind AS 37 measurement requirements, including risks, uncertainties and discounting where the time value of money is material.
- Reassess at each reporting date. Update costs, benefits, contract terms and settlement assumptions when the underlying facts change.
What the supporting file should make clear
A reviewer should be able to reconstruct the conclusion without relying on management's description that a contract is simply “loss-making”. A useful file normally contains the executed contract and amendments, the remaining benefit forecast, the direct-cost build-up, the basis for allocated directly related costs, termination or penalty clauses, the impairment conclusion, and the calculation that selects the least costly exit route.
It should also separate assumptions from enforceable facts. A hoped-for price increase or future renegotiation should not be treated as an existing contractual right unless the reporting-date evidence supports it. Equally, a penalty should not be assumed merely because management expects a difficult negotiation; it should come from the contract, law or other supportable settlement evidence.
ICAI's 2025–26 Ind AS compendium provides the current official index for Ind AS 37 and related standards. For a live contract, the accounting conclusion should be tied to the exact enforceable terms and the facts existing at the reporting date.
The discipline is to price the obligation, not just describe the commercial pain. A defensible onerous-contract analysis shows why the contract is unavoidable, what it costs to continue, what it costs to exit, which directly related fulfilment costs were included, whether contract-related assets were impaired first, and how the final provision follows from those facts.
