Best estimate, expected value and most likely outcome

Learning objectives

• Explain the best estimate: the amount the entity would rationally pay to settle the obligation or to transfer it at the end of the reporting period, before tax.L1, L2
• Calculate a provision using the expected value for a large population of obligations (warranties, for example).L2, L3
• Calculate the mid-point of a continuous range of equally likely outcomes.L2
• Assess, for a single obligation, whether the most likely outcome should be adjusted to take account of other possible outcomes.L3, L4
• Determine how risks and uncertainties are taken into account without excessive provisions or double counting.L3, L4

Normative references

• IAS 37The amount recognised as a provision is the best estimate of the expenditure required to settle the present obligation at the end of the reporting period.
• IAS 37The best estimate is the amount that the entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time; even though such settlement or transfer is often impossible or prohibitively expensive, the estimate of that amount gives the best estimate.
• IAS 37Estimates of outcome and financial effect are determined by the judgement of management, supplemented by experience of similar transactions and, in some cases, reports from independent experts; evidence provided by events after the reporting period is taken into account.
• IAS 37 §39Uncertainties are dealt with according to the circumstances: for a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities (expected value), so the amount depends on the probability of a loss of a given amount; for a continuous range of equally likely outcomes, the mid-point of the range is used. The paragraph illustrates expected value with product warranties.
• IAS 37For a single obligation, the individual most likely outcome may be the best estimate; the entity nevertheless considers other possible outcomes: where they are mostly higher or mostly lower, the best estimate will be a higher or lower amount respectively. Example: rectifying a serious fault in a major plant constructed for a customer, the provision being increased if there is a significant chance that further attempts will be necessary.
• IAS 37The provision is measured before tax; its tax consequences, and changes in them, are dealt with under IAS 12.
• IAS 37 §42The risks and uncertainties that inevitably surround many events and circumstances are taken into account in reaching the best estimate.
• IAS 37 §43Risk describes variability of outcome; a risk adjustment may increase the amount at which a liability is measured. Caution avoids overstating income or assets and understating expenses or liabilities, but uncertainty does not justify the creation of excessive provisions or a deliberate overstatement of liabilities (a prudently estimated adverse outcome is not treated as more probable than it really is). Duplicating adjustments for risk is to be avoided.
• IAS 37Disclosure of the uncertainties surrounding the amount of the expenditure is made under para. 85(b).

Original summaries of the paragraphs (reference register), never a quotation of the standard.

16 questions

• The amount recognised as a provision is the best estimate of the expenditure required to settle the present obligation at the reporting date.L1
• How does IAS 37 describe the best estimate of the expenditure required to settle an obligation?L1
• Kalvane measures its litigation provision net of the tax saving that payment of the compensation will provide.L1
• Kalvane sold {units_sold} dishwashers with a two-year warranty in 20X5. Based on its history, {minor_rate}% of the appliances will need a minor repair ({minor_cost} each), {major_rate}% a major repair ({major_cost} each) and {replacement_rate}% a replacement ({replacement_cost} each); the others will have no defect. Compute the warranty provision at 31 December 20X5 (the effect of discounting is not material).L2
• The electric bicycle maker Lorcane covers for one year the {bikes_sold} bicycles delivered in 20X5. Its workshop statistics forecast: an adjustment on {adjust_rate}% of the bicycles ({adjust_cost} per job), a motor replacement on {motor_rate}% ({motor_cost}), a frame change on {frame_rate}% ({frame_cost}). What provision does Lorcane recognise at the reporting date, discounting having no material effect?L3
• Marvaline must compensate a customer for the delivery of non-compliant parts. Its experts estimate that the compensation will fall within a continuous range from {low_end} to {high_end}, every amount in the range being equally likely. Compute the provision.L2
• A fire in a warehouse leased by Nestane damaged the premises of a neighbour, towards which Nestane is liable. The estimate of the repair works varies continuously between {minimum_cost} and {maximum_cost}, with no amount more likely than another. What amount should be provided for?L2
• Opaliane must remedy a roof leak in a warehouse it delivered to a customer. A first intervention would cost 140,000 and is the most likely individual outcome; however, the experts consider the risk high that one or two further interventions, of 90,000 each, will be needed. How should the provision be set?L3
• For a single obligation, Pyrane estimates the most likely outcome at 500,000, but most of the other possible outcomes are lower. What is the effect on the best estimate?L3
• Querane sold {units_sold} drills with a one-year warranty. It expects {claim_rate}% of them to be repaired, at an average cost of {repair_cost} per repair. No provision existed before. Record the entry setting up the provision at the reporting date.L2
• Given the uncertainty surrounding a lawsuit, Rimbelle is entitled to deliberately overstate its provision to guard against a bad surprise.L3
• Solvéa's advisers estimate the compensation owed to a customer at between 400,000 and 700,000, with a markedly higher probability around 450,000. The finance director recognises a provision of 700,000 "out of prudence". Where is the error?L3
• Tarvène sold 40,000 kettles under warranty. For each kettle, the most likely outcome is no defect; the accountant therefore recognised no provision, although history shows that 2% of kettles are replaced, at 25 each. Where is the error?L3
• To estimate a litigation provision, which sources can Ulvane rely on?L2
• Valcrest is being sued by a single customer for underperformance of a bottling line. Its lawyers see three outcomes: a settlement at 600,000 (probability 50%), an award of 900,000 (30%), an award of 1,400,000 (20%). The finance director proposes 1,400,000 "out of prudence", the controller 600,000 "the most likely outcome". Write a memo recommending an approach and an order of magnitude, distinguishing the rule, the case data and your judgement.L4
• For a restoration provision, Wexmoor has prepared cash flows already increased by a 15% risk margin to reflect the uncertainty about the works. Its internal auditor proposes adding to the provision a second 10% margin "to cover the uncertainty", on top of the 15%. What should be concluded?L4