Accounting for Outcome Based Payments

A supplier is paid based on cost saves they identify. How to account for the cost.

Didn't find your answer?

In this example supplier A identifies £1m of annual cost savings in 2024 but they do not commence until 2025.

is there a requirement to accrue the full cost as soon as the amount payable becomes clear or is it possible to recognise the cost over the period in which the cost saves are realised & contractually linked to?

Replies (25)

Please login or register to join the discussion.

avatar
By FactChecker
16th Mar 2024 09:57

Can you be a little clearer ...

* What is actually being supplied (merely identifying a potential cost saving or actually providing something - goods/services - that are planned to deliver those savings)?

* ".. they do not commence until 2025" refers to what (the supply or the cost savings)?

* ".. is there a requirement to accrue .." - what do the terms of the Contract say with regard to payment (any fixed or minimum fees / method of agreeing saving and thus payment / frequency of that measurement / etc)?

There is a (thoroughly checked-out) written contract isn't there?
So what does the company's accountant think after reading it?

Thanks (2)
avatar
By User deleted
16th Mar 2024 11:04

For background I work in ‘commercial finance’ rather than technical. We don’t have any contract in place & there’s a separate team that deal with contracts. There’s also a separate Finance Team that will ultimately approve the accounting treatment but they won’t look until the contract is complete. So I’m interested in understanding whether the approach is likely to be viable under IFRS.

As I see it the performance obligation would be the identification & agreement of cost saves with payment linked to the savings that are agreed by both parties. For example we produce widgets in a way that turns out to be somewhat inefficient and the supplier of the ‘cost save identification service’ identifies 3 changes to our production process that could save £200k p.a. each.

We then both agree that one idea won’t work; one can be implemented but will save £100k p.a. not £200k and the third can be implemented with the £200k saves as proposed. At that point the payment can be calculated as (e.g.) 50% of the annualised saves - so a total of £150k.

To my mind the work of the supplier has already been completed though they, to support the funding constraints of their customer are happy to receive payment as we recognise the benefits. So in the aforementioned example, if we took a while to implement the changes and only managed to save £50k in 2025 with the first full year of saves being 2026, they would receive £50k in 2025 and the remaining £100k in 2026.

So I’m trying to understand if there is any mileage in the idea that the £150k cost can be recognised broadly in line with the delivery of the outcome (£300k annual saves) or if it would need to be accrued into 2024 when the amount of savings & payments were agreed.

Hope that makes sense!

Thanks (0)
Replying to User deleted:
avatar
By David Ex
16th Mar 2024 11:37

Tom1978 wrote:

For background I work in ‘commercial finance’ rather than technical. We don’t have any contract in place & there’s a separate team that deal with contracts. There’s also a separate Finance Team that will ultimately approve the accounting treatment but they won’t look until the contract is complete. So I’m interested in understanding whether the approach is likely to be viable under IFRS.

Hope that makes sense!

It doesn’t make a lot of sense (to me at least) to be asking an anonymous internet forum for accounting advice when your organisation has a “Finance Team”. You might want to tell them it’s a complete nonsense to only “approve” accounting disclosures after a transaction is completed. Surely accounting disclosures are part of the project approval and financial forecasting process?

Thanks (0)
Replying to User deleted:
Stepurhan
By stepurhan
16th Mar 2024 21:08

Tom1978 wrote:
We don’t have any contract in place & there’s a separate team that deal with contracts. There’s also a separate Finance Team that will ultimately approve the accounting treatment but they won’t look until the contract is complete.

These sentences appear to contradict themselves. You don't have a contract in place. You have a team that deals with contracts (irrelevant information if you don't have a contract in place). The accounting treatment won't be looked at until the contract, that you don't have, is complete.

Do you actually have a contract with whoever found these cost savings? If not, then you don't accrue for the cost until you do have a contract that agrees to pay them and finalises any further conditions.

If you do already have a contract in place, when does a legally enforceable obligation to pay them kick in? If it is when they identify the cost savings, even if those won't actually happen until a later year, then the cost needs to be recognisedthen. If it is as the cost savings are proved to materialise, then it is as the cost saving materialises. Is it some mix of the two, then split it accordingly.

If your supplier has done their part (identifying the savings) without any contract confirming how and when they would be paid, more fool them.

Thanks (0)
avatar
By User deleted
16th Mar 2024 11:45

It’s theoretical at this stage - I’m just trying to understand perspectives and interpretations.

But I’m figuring some here may have experience of outcome based contracts for example so trying to build an informed view - I just see that as additional diligence and will help me understand better future conversations with technical team.

Presumably there’s no rule against this in terms of the forum guidelines?

Thanks (0)
Replying to User deleted:
avatar
By David Ex
16th Mar 2024 12:02

Tom1978 wrote:

It’s theoretical at this stage - I’m just trying to understand perspectives and interpretations.

But I’m figuring some here may have experience of outcome based contracts for example so trying to build an informed view - I just see that as additional diligence and will help me understand better future conversations with technical team.

Presumably there’s no rule against this in terms of the forum guidelines?

https://www.accountingweb.co.uk/about-accountingweb

“AccountingWEB.co.uk is the largest independent online community for accounting and finance professionals in the UK”

Your Finance Team are the ones who you say are the arbiters of the accounting treatment so I’m baffled why you aren’t simply discussing this with them. The Finance Team should be “partners” to commercial colleagues helping the organisation achieve its objectives not stereotypical bean counters. Have a word with the finance director; I’m sure he/she will be appalled to discover his/her team are so limited in their outlook.

Thanks (0)
Replying to David Ex:
avatar
By User deleted
16th Mar 2024 12:18

Ok - well thanks for all inputs thus far - probably not going to get much further with this particular line of enquiry though.

If anyone else does have any experience of similar arrangements or thoughts then I’d definitely be interested to hear.

Thanks (0)
avatar
By DKB-Sheffield
16th Mar 2024 12:56

As mentioned by others previously... the accounting treatment under IFRS - or ANY standard for that matter, will follow the contractual obligation. Rights under that contract will confirm the rights to receive (seller), and obligations to pay (buyer), alongside contingencies/ retention (of which there will certainly be some clause(s)).

Without full knowledge of that contract (which you have stated you don't know... hence it is clearly not known to the forum) the accounting treatment will be unclear.

However, given that you are not in the 'finance dept', are not an external accountant, and are not the auditor, we may even be considering MAs... usually loosely based on the standards, but allowing for more flexibility on recognition. I've seen highly inaccurate MAs (for stat purposes) that are also highly accurate (for their intended purpose). Management, and other stakeholders (e.g. lenders), may be interested to see whole-job phased costs in a way that would, otherwise, contravene accounting standards. Examples such as showing loan repayments in a MA 'P&L' come to mind (it ain't right for GAAP but it's often requested by lenders!).

Either way... the fact you are concerned with IFRS suggests either the company is large (possibly listed), or has significant overseas interests. That would suggest the finance hierarchy to include at least 3, likely 4, possibly more levels 'above' your position (i.e. finance team, FD, auditors, external accountant(s), external adviser(s)). They are the ones to ask - regardless of answers in here - and if I were in one of those roles, I'd be somewhat miffed at a 'non-accounting' team member quoting 'facts' obtained from an accounting forum - instead of asking.

I'd also query why this matters, and why it's not left to the accounting team (et. al.) to resolve. My suspicion is that we're talking bonus targets... which - ultimately - are unlikely to be based on the IFRS stat accounts.

Finally, I appreciate this does not answer, or attempt to answer, your question. However, with... no contract, no understanding of obligation, no knowledge of contingencies/ retention... the question (IMO) is unanswerable. Indeed, we have no idea of the business, it's internal policies, level of materiality, or even the jurisdiction.

P.S. your reference to widgets does make this sound a lot like accounting exams... admittedly, I'm referring to exams from a few moons ago (maybe things have changed).

Thanks (1)
Replying to DKB-Sheffield:
avatar
By User deleted
16th Mar 2024 13:23

Crikey - I just wanted to have a bit of conversation on accounting treatment of outcome based contracts - had no idea it would cause so much offence!

I am qualified as an accountant (though some while back) but I don’t work in the technical side so have limited exposure to the detailed impacts of new standards as they apply to specific situations. I have seen changing commercial context leading to revised interpretations and indeed new standards over time though.

From my perspective, when I have a conversation with the technical accountants I’d like to already have a broad understanding of the relevant standards and interpretations, as I think it helps bridge the gap between the commercial and the technical.

Your point re. the specifics of the contract is one reason it’s hard for those teams to engage early on but equally it’s often hard to have complete certainty over all variables in the early stages of this sort of proposal.

If there is a better forum, somewhere people do discuss this sort of thing on a hypothetical basis (I’m thinking that place may not be here) then I’d be interested to know.

I’m certainly not trying to provoke or offend though so please take in the spirit intended!

Thanks (0)
Replying to User deleted:
avatar
By DKB-Sheffield
16th Mar 2024 14:19

Certainly no offence taken... and I hope none has been caused.

The simple point I was trying to make is that the contractual obligations are likely to be all important in how the cost can be realised (and when).

If payment (or a contractual obligation/ liability) is made (or recognised) today for £150K on the basis that £300K savings will be achieved over 2 (future) years...
- What is justification for recognising an asset (e.g. prepayment) of £150K in today's accounts?
- Is there sufficient expectation of future profits (savings) to recognise that?
- What if the savings don't materialise... is any of the £150K 'paid' back?
- Is any of the £150K retained based on a future 'event'?
- Are there any contingent liabilities to be considered resulting from the contract?
- What is the company's policy on the matter?

I can see why the technical accountants are unable to engage if the contractual terms are unknown to them. However, alas, they have the one benefit AWebbers don't... the ability to discuss the contract with your legal team.

As you will be aware... regardless of whether we're talking of new, old, UK&I, or International accounting standards... all GAAP is designed to reflect the reality of transactions... be it cash paid, cash received, contractual obligations/ rights, expectations of future 'income', etc. However, if one, or more of those is a 'complete unknown', advising on, or even contemplating the application of relevant GAAP is going to be a struggle. That is the reason for suggesting the discussions on what can/ can't be done in the specific case with those in the finance hierarchy (who know the business, it's policies, and it's norms) are the only ones who can advise (indeed, they are the only ones that matter in your case).

I appreciate you're trying to resolve this and show a keen interest in the finance treatment (and possibly have more knowledge of it that some of the 'technical accountants').

The hypothetical is that... in some circumstances, it may be perfectly possible that some or all of the cost may be recognised as an asset, but that would assume the contractual rights/ obligations, the certainty of future 'savings', the relevant contingency measures, (and more!) had been considered, and accepted by the directors, accountants, the auditors, and any other relevant stakeholder.

Incidentally, these are observations, may be entirely irrelevant to your business, do not constitute advice, and are certainly not to be provided as 'proof' to your technical accountants, the board, or to any other stakeholders.

Thanks (1)
Replying to DKB-Sheffield:
avatar
By User deleted
16th Mar 2024 14:53

Thanks and appreciate the thoughts.

I’m absolutely just trying to inform myself here so not interpreting any conversations as advice. I can also be 100% certain that I will not be able to resolve anything like this without the full engagement of other teams.

In some of the large organisations you refer to there seem to be more departments or teams than you can shake a stick at so it can just help to know a bit about the grey areas to help ensure things don’t fall through the cracks.

My initial and simplistic interpretation had been that if

- the performance obligation was the ‘identification of the saves, as agreed with both parties’ and
- that had been completed in line with the contract and
- payment therefore committed irrespective of whether those savings were actually realised

then the service would have already been provided before the benefits began to crystallise and therefore would have to accrue the cost irrespective of when the payments were made.

I just want to challenge my initial thinking so that I’m better prepared for future conversations.

Thanks (0)
Replying to User deleted:
avatar
By FactChecker
16th Mar 2024 15:31

We, or rather you, seem to have moved from what sounded like a factual situation to it all being just theoretical (a bit like in those TV dramas when they cop out with 'but it was just a dream') ... so which is it?
It doesn't matter, but it's polite to indicate at the start if it's all just conceptual.

Of course, either way DKB's patient explanation still applies.
Your "simplistic interpretation had been that if .." is based on 3 conditions that, if I were the CEO, would make me livid that we'd signed up to such a one-way Contract.
As DKB, again, pointed out one might expect a more balanced Contract to have triggers/clawbacks and much else that will likely then affect the degree of liability committed at various points.
[Even the likes of PWC don't expect to get upfront commitment to full potential fees "irrespective of whether those savings were actually realised".]

Thanks (3)
Replying to FactChecker:
avatar
By User deleted
16th Mar 2024 15:42

-

Thanks (0)
Replying to FactChecker:
avatar
By User deleted
16th Mar 2024 15:47

Well this has been an interesting experience but I think I’m going to end the misery here!

Happy Saturday

Thanks (0)
Replying to User deleted:
avatar
By DKB-Sheffield
16th Mar 2024 15:52

Tom1978 wrote:

My initial and simplistic interpretation had been that if

- the performance obligation was the ‘identification of the saves, as agreed with both parties’ and
- that had been completed in line with the contract and
- payment therefore committed irrespective of whether those savings were actually realised

then the service would have already been provided before the benefits began to crystallise and therefore would have to accrue the cost irrespective of when the payments were made.

Ah... yes...

From what you have stated, the contractual obligation to pay would commence with the completion of the contract. An accrual, trade creditor (or a mix of the 2) will be recognised on completion - £150K in your scenario. Assuming there are no clauses in the contract to suggest differently (e.g. payment of £50K now is unconditional, but the next £100K will depend on reality of savings). Either way, there will be a liabilty equivalent to the full contract value (including, potentially a conditional one if the contract so determines).

The flip side is therefore whether the cost is recognised - in full - in the current year, or whether there is sufficient economic certainty to recognise an asset (on account of there being future economic benefit). That is more likely to require significant knowledge of the business, the processes, the policies, and is clearly not something that can be determined in here.

The main thing to note is that there are 2 transactions/ considerations...

1. The company's obligation to pay the supplier (thus, a liability based on contractual terms)

2. The company's recognition of the cost/ asset considering potential future values (thus, whether an asset can be recognised based on internal assessment)

There should be a creditor of £150K included IF (and it's a big IF) the contractual liability exists (or will likely exist in the case of contingents). The creditor/ accrual balance should not be lower based on the recognition of costs (i.e. the creditor should not be 'netted off' against the asset/ prepayment).

Realistically, you're considering 2 separate matters. (1) Debt and (2) Cost/Asset recognition. The latter is potentially the hardest to consider without the 'technical accountant's' input/ views.

Thanks (1)
Replying to DKB-Sheffield:
avatar
By User deleted
16th Mar 2024 16:23

Ah ok thanks so sounds like key to possibly recognising the cost over a more protracted period then could be whether payment is contingent on the ‘agreement’ or the ultimate realisation of the benefit. That’s helpful.

Thanks (0)
Replying to DKB-Sheffield:
avatar
By FactChecker
16th Mar 2024 16:30

Full marks for staying the course (as well as, needless to say, the relevance of your points).
Whereas I seem to have induced what lion has taken to referring to as 'flouncing off' by OP - which puzzles me as I neither intended to say, nor as far as I can see said, anything to which offence might expect to be taken.

Ah well, the rest of the weekend beckons ... and, recalcitrant frogs having been persuaded (in between posts) to spawn in the water rather than in a damp but distinctly land-locked courtyard, I can turn my mind to more communing with nature before the WhatsApp calls start to the internationally dispersed family.

Thanks (3)
avatar
By kim.shaw-and-co.com
17th Mar 2024 03:29

As regards how much of the cost of any fees can be 'accrued' it might help to keep in mind the definition of a "liability" under the IAS conceptual framework which is essentially outlined here :

https://www.ifrs.org/content/dam/ifrs/meetings/2013/january/iasb/concept...

Consider provisions also (the 'probable' condition in particular, contrasting with virtual certainty in effect in the case of a vanilla 'payable' ) :

https://www.ifrs.org/issued-standards/list-of-standards/ias-37-provision...

As an accountant you might also be interested in the following - given FRS102 (UK GAAP) is in my mind at least more straightforward to implement in practice than IAS (including IFRS37) :

https://www.ifrs.org/content/dam/ifrs/meetings/2023/april/iasb/ap22-prov...

You clearly first have to ascertain what the past event giving rise to any obligation to transfer economic resource to another 'person' in consequence. Future events or actions taken by the company should not be able to 'displace' the obligation that exists at the balance sheet date and the company should have no realistic alternative but to settle the obligation in a future accounting period.

You need to demonstrate how and when the obligation to transfer that economic resource arises, hence it is not really possible to speculate outside of the terms of a contract (as explained extensively above).

Unless/until it is established BOTH that an obligation exists at the balance sheet date (legally or constructively) to 'pay' and that the obligation cannot be avoided by future actions of the company then under IFRS the recognition criteria for a liability is not met.

It is the latter criterion which may in practice be most problematic if the company tried to accrue for the cost of an outcome-based contract where that outcome determined whether or not economic benefit would have to be transferred.

It may be difficult to show that future actions of the company could not 'displace' the obligation - hence why an accrual may be limited to any minimum guaranteed payment under the agreement. Which would make sense because that is all that is guaranteed to the third party in consideration for the identification of potential cost savings.

Thanks (0)
Replying to kim.shaw-and-co.com:
avatar
By User deleted
17th Mar 2024 08:37

Thanks - this is really helpful.

Hopefully I’ve not misunderstood, and I take the point on the contract, but this I think helps broadly outline two ‘book end’ scenarios.

If the performance obligation in the contract is to (1) agree the actions that will be taken to reduce costs (e.g. new supplier, change in organisation structure, revised processes, new machinery) and (2) To agree the likely size of those savings then it looks like costs would need to be accrued at that point and discounted to reflect future payment date.

If the performance obligation went as far as to link the payment amount to a subsequent assessment of the future cost savings then it would depend on the certainty of those savings, timing and amount so in that instance a contingent liability.

In the first scenario, the cost would be recognised most likely when the work had been completed but in the second the cost could potentially be accrued in line with realisation of benefits with a net nil impact on the reported cost (on the basis that saving = accrued cost)

It looks like the ‘value based pricing’ construct arose in life sciences, presumably to mitigate the high costs of drug development, and there seems to be some guidance on revenue recognition in some cases but nothing on implications for accounting for the cost of these arrangements.

Thanks (0)
Replying to User deleted:
avatar
By kim.shaw-and-co.com
17th Mar 2024 20:41

Tom1978 wrote:

It looks like the ‘value based pricing’ construct arose in life sciences, presumably to mitigate the high costs of drug development, and there seems to be some guidance on revenue recognition in some cases but nothing on implications for accounting for the cost of these arrangements.

Revenue recognition is a whole different ball-game and whilst notionally easier to follow and implement, in practice often very poorly understood.

In the case of R&D (on the costs side) there is the 'complication' that often what is happening is the creation of a 'possible' future internally generated intangible asset in the sense that relevant costs ultimately become comprised in a patent, licence etc. However, recognition of costs as an asset requires that certain other hurdles are jumped through first. Historic costs expensed when incurred are extremely difficult to 'pull back' onto a balance sheet.

IAS38 is relevant to R&D : https://www.iasplus.com/en-gb/standards/ias/ias38

It is clear that there has to be a probability economic benefit will flow from capitalized costs representing an intangible fixed asset if those costs are to be recognized as such.

It is for this reason all research costs have to be immediately expensed. Only at the development stage, once the probable inflow of economic benefit can be demonstrated as arising from an intangible, can recognition as an asset be considered.

In practice that may be unlikely to preceed successful registration of a patent - and even if one were registered, the 'probable inflow' following development ('viability') must still be demonstrated before an assumption of full impairment can be rebutted.

Digressing a little, if you consider the restriction on use of carried forward losses introduced in 2017 (to £5m per UK CT Group), one source of potential 'push back' against immediate expensing (apart from detriment to the balance sheet of a company) will be obvious. Against this is (the potential for repayable) R&D tax credits. It's a complex web of trade-offs for companies to weigh up in that sphere, which is why there are firms who do little else than assist companies maximize their R&D reliefs.

On the strict accounting front though, any commercial arrangement has to be weighed up against the relevant accounting standards and recognized in a consistent way that is compliant with the relevant requirement(s) and a company's accounting policy.

Thanks (0)
Replying to kim.shaw-and-co.com:
avatar
By User deleted
17th Mar 2024 22:43

Yes - I can see a link in the sense that I suppose the ‘identification of saves’ could in some circumstances be part of the R&D phase preceding an asset build.

I’ve seen various interpretations of IAS 38 re. Intangibles though agree that R&D seems quite clear cut.

Another interesting one for (non-technical) me actually as I’ve been trying to get my head around practical application in the context of:

1) Some of the ‘Ways of Working’ in the Development space - Lean Portfolio Management / Agile / SAFe - for example how release cadence impacts trigger dates / UEL or the idea of funding ‘outcomes’ (this outcome / value approach confusing me again)

2) Move to cloud and software as a service model - specifically around control (of benefits) and of course the ‘benefit measurement’ question rears its head again here.

Thanks (0)
Routemaster image
By tom123
17th Mar 2024 12:19

I've never really fallen for any of these saving "scammers" myself - as I just don't believe the concept ever really results in actual savings - simply more overheads of fees.

We could save money (in our school, as it happens) by moving to low grade rubbish photocopying paper - but, at 6 million copies per year, we find that cheaper paper blocks the machines, needing callouts, stopping teaching etc etc.

Good luck, anyway, OP

Thanks (1)
Replying to tom123:
avatar
By User deleted
17th Mar 2024 12:25

Yes - this is a concern for me too - the ‘value based pricing’ brings with it a lot of questions and of course a degree of overhead in terms of contract design / management.

Thanks (0)
Replying to User deleted:
avatar
By FactChecker
17th Mar 2024 15:13

Just out of (honest) curiosity, and as per t'other Tom's point, do you attempt to measure (or even estimate) the 'additional costs' to which you've referred that are incurred simply to implement whatever is needed to achieve the 'cost savings'?
And, if so, how far down that road do you go (as in CO2 comparisons where they start to include the transportation costs, then move on to the differing output from micro-organisms in a different location, and so on almost ad infinitum)?

I guess what I'm asking (irrespective of the point of this thread) is at what point do you question whether the 'saving' is a net, rather than gross, saving? And whether or not it is beneficial or damaging to your brand/reputation (i.e. the whole picture)?

I'm not expecting concrete answers ... but, as I said, just curious as to how this all works in principle (outside of the accounting treatment).

Thanks (1)
Replying to FactChecker:
avatar
By User deleted
17th Mar 2024 16:43

Well I think these points are all relevant to the question of value based pricing and, as I say, most of what is written is regarding the ‘supplier’ - I’ve not stumbled across much in the way of impacts on the customer.

The theory is nice but the devil is in the detail and I'd still think any proposal should be put out to tender.

Obviously would also reccommend confirmation on accounting impacts of proposed contract with appropriately technical accountants before anything is signed!

Thanks (0)