Accounting for Onerous Construction Contracts and Loss Provisions

A construction contract is "onerous" when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. In plainer terms: a contract that will lose money. Section 23 of FRS 102 (read with the broader provisions standard in Section 21) requires the entire expected loss to be recognised in the period the loss becomes foreseeable, regardless of how complete the contract is. This is one of the most commonly understated provisions in UK construction company accounts and a recurring source of material audit adjustments.

How to identify an onerous contract

A contract is onerous when, on a forward-looking basis, total expected contract costs exceed total expected contract revenue. The key word is expected: foreseeable losses, not just losses already incurred. The mechanism for identification is the monthly cost-value reconciliation (CVR) process, where forecast cost-to-complete is compared to forecast contract revenue.

Common triggers that cause a contract to become onerous:

• Materials cost inflation that the contract does not pass through.
• Labour shortages requiring premium rates.
• Programme delays that compound preliminaries costs.
• Subcontractor failures requiring replacement at higher rates.
• Variations not yet agreed that the contractor is forced to execute on the customer's instruction.
• Disputed claims that the contractor cannot collect.
• Ground conditions or design issues uncovered after contract award.

How to measure the provision

The onerous contract provision equals the unavoidable net cost of meeting the contract obligations. The standard formula:

1. 1Calculate total expected costs to complete the contract.
2. 2Calculate total expected revenue from the contract (including reliably-measurable variations and claims).
3. 3The expected loss = total expected costs less total expected revenue.
4. 4The provision = expected loss less the loss already recognised through the POC mechanism in the period.

Worked example: a £4m contract previously expected to make £200,000 profit (total costs £3.8m). At year-end, total expected costs have risen to £4.4m (so £400,000 expected loss). The contract is 50% complete by costs. Under POC, the period to date has recognised 50% × £200,000 = £100,000 of profit. The new position requires the full £400,000 loss to be recognised. The adjustment is the £100,000 of profit reversal plus the £400,000 loss provision = £500,000 hit to the period income statement.

Documentation that survives audit

Onerous contract provisions are judgemental. Auditors challenge them in both directions: under-provision (more common) and over-provision (less common but used to manage earnings). Defensible documentation includes:

• Contract-by-contract CVR worksheets showing original budget, actual cost to date, forecast cost to complete, original contract value, agreed variations, and forecast revenue.
• A clear bridge between the prior CVR and the current one explaining each material movement.
• Sign-off by both the project commercial team and the senior commercial leadership.
• Supporting evidence for forecast assumptions (signed subcontractor orders, programme updates, materials price quotes).
• Specific identification of risks not in the central case and their potential cost impact.

Disclosure requirements

Material onerous contract provisions are disclosed in the accounts. The disclosures cover:

1. 1The nature of the obligations under the onerous contracts.
2. 2The expected timing of the cash outflows.
3. 3A reconciliation of opening provision, additions, utilisation, and unused amounts released.
4. 4Indication of the uncertainties around the estimated outflows.
5. 5Where the onerous contracts are concentrated (sector, customer, geography) where this is material to understanding the position.

Common questions

Can we choose to terminate the contract instead of provisioning?

In some cases, yes. Where contractual termination is available and is genuinely the cheapest option, the provision is set at the termination cost rather than the cost-to-complete loss. Termination economics include legal fees, customer compensation, and reputational impact, all of which need to be quantified. Most construction contracts do not have economically attractive termination clauses.

What if the position improves later?

If subsequent events reduce the expected loss (variations agreed, costs lower than forecast, claims successful), the provision is released through the income statement in the period the new position is recognised. The release reverses the original charge. Disclosures explain the movement.

Does the provision interact with deferred tax?

Yes. The provision is generally tax-deductible in the period the underlying loss arises (when work is done at a loss) rather than when the provision is booked. This creates a deferred tax asset where the provision is booked ahead of the cash loss. The accounts should reflect this temporary difference.