Key Points
- The best estimate reflects what rational management would pay to settle the obligation at the reporting date, not the worst-case or most optimistic outcome.
- For large populations of obligations (warranty claims, product returns), the standard requires an expected value calculation that weights each outcome by its probability.
- For a single obligation (a lawsuit or a decommissioning liability), the most likely outcome is often the best estimate, though the entity must also consider other possible outcomes if the range is skewed.
- When settlement is more than 12 months away, the provision must be discounted to present value using a pre-tax rate.
What is Best Estimate of Expenditure?
IAS 37.36 defines the best estimate as the amount the entity would rationally pay to settle the obligation at the reporting date or to transfer it to a third party at that date. This is not the maximum exposure. It is not the midpoint of a range. It is the amount that reflects the full set of possible outcomes, weighted by their likelihood.
Two measurement methods apply depending on the nature of the obligation. IAS 37.39 prescribes the expected value method for a large population of items. If a retailer has 10,000 active product warranties and historical data shows that 4% will require repair at an average cost of EUR 120, the best estimate is EUR 48,000. For a single obligation, IAS 37.40 directs the entity to the individual most likely outcome, adjusted where the range of outcomes is asymmetric. The auditor's job under ISA 540.13(a) is to test whether management picked the right method for the right type of obligation, and whether the inputs (claim rates, settlement amounts, legal assessments) rest on supportable data rather than unanchored judgment.
IAS 37.42 adds a further constraint: the estimate must take into account risks and uncertainties surrounding the obligation. That does not mean the entity inflates the provision to be conservative. It means the probability weighting must reflect genuine uncertainty, not a bias in either direction.
Worked example
Client: Swedish forestry and paper company, FY2025, revenue EUR 75M, IFRS reporter. Bergstrom operates a pulp mill on leased land. The lease requires full site remediation at expiry in 2033. Environmental engineers assessed three remediation scenarios in October 2025.
Step 1 — Identify the obligation and estimation context
The obligation is a decommissioning and remediation liability arising from the lease contract (legal obligation under IAS 37.17). This is a single obligation with multiple possible outcomes, not a large population. IAS 37.40 applies.
Documentation note: record the nature of the obligation, the contractual basis, and the classification as a single obligation requiring individual assessment per IAS 37.40. Attach the lease clause requiring remediation and the environmental engineer's report.
Step 2 — Map the range of outcomes
The engineers provided three scenarios with associated probabilities.
| Scenario | Description | Estimated cost | Probability |
|---|---|---|---|
| Base case | Standard soil remediation, no groundwater contamination | EUR 2,800,000 | 55% |
| Moderate | Soil remediation plus localised groundwater treatment | EUR 3,600,000 | 30% |
| Severe | Full groundwater remediation with off-site disposal | EUR 5,100,000 | 15% |
The most likely individual outcome is the base case at EUR 2,800,000.
Documentation note: record each scenario, cost estimate, and probability assessment from the engineer's report. Document the basis for the probability assignments (historical contamination data from comparable pulp mill sites, soil sampling results dated September 2025).
Step 3 — Determine the best estimate
The most likely outcome is EUR 2,800,000. However, the range is asymmetric: the severe scenario extends EUR 2,300,000 above the base case, while the base case sits only EUR 800,000 below the moderate scenario. IAS 37.40 requires consideration of other possible outcomes when they could produce a materially different result. The expected value is (EUR 2,800,000 x 0.55) + (EUR 3,600,000 x 0.30) + (EUR 5,100,000 x 0.15) = EUR 3,385,000. Because the upward skew is material, management adopts EUR 3,385,000 as the best estimate rather than the most likely outcome alone.
Documentation note: record both the most likely outcome and the expected value calculation. Document the rationale for selecting the expected value over the most likely outcome (asymmetric range, material upward skew per IAS 37.40). Cross-reference the engineer's probability assessments.
Step 4 — Discount to present value
Settlement is expected in 2033, approximately eight years away. The pre-tax discount rate, derived from Swedish government bond yields adjusted for obligation-specific risk, is 3.2%. Present value: EUR 3,385,000 / (1.032)^8 = EUR 2,630,200. Bergstrom recognises a provision of EUR 2,630,200. The annual unwinding of the discount will be recognised as a finance cost under IAS 37.60.
Documentation note: record the discount rate derivation (risk-free rate source, adjustment for obligation-specific risk per IAS 37.47), the discounting calculation, and the expected settlement date. Note that the discount unwind of approximately EUR 84,200 in year one will be charged to finance costs, not operating expenses.
Conclusion: the best estimate of EUR 3,385,000 (EUR 2,630,200 at present value) is defensible because it reflects a documented range of outcomes from an independent environmental assessment, applies the expected value method where the asymmetric range makes the most likely outcome insufficient on its own, and discounts at a traceable market-based rate over the obligation's eight-year horizon.
Why it matters in practice
Teams frequently default to the most likely outcome without testing whether the distribution of possible outcomes is symmetric. IAS 37.40 states that the most likely outcome may be the best estimate for a single obligation, but adds that "other possible outcomes" must be considered. When the range skews upward (as it often does with environmental or litigation provisions), accepting the mode without adjusting for skew understates the provision. ISA 540.18 requires the auditor to evaluate whether the point estimate selected by management is reasonable given the range of outcomes.
Discount rates on long-dated provisions are sometimes borrowed from the entity's WACC or from a rate used for impairment testing without adjustment. IAS 37.47 requires a rate that reflects current market assessments of the time value of money and the risks specific to the liability. A provision for environmental remediation carries different risks from an operating asset's cash flows, and using the wrong rate can misstate the provision by 10% to 15% over a multi-year horizon.
Best estimate of expenditure vs. fair value
| Dimension | Best estimate of expenditure (IAS 37) | Fair value (IFRS 13) |
|---|---|---|
| Perspective | Entity-specific: what this entity would rationally pay to settle | Market-based: what a market participant would pay or receive in an orderly transaction |
| Inputs | Management's own probability assessments, entity-specific cost data, internal projections | Market participant assumptions, observable inputs where available |
| Discount rate | Pre-tax rate reflecting risks specific to the liability (IAS 37.47) | Rate consistent with market participant expectations (IFRS 13.B14) |
| When it applies | Measurement of provisions under IAS 37 | Measurement of assets and liabilities under IFRS 13, including some provisions when the transfer approach is used |
| Risk adjustment | Embedded in the probability weighting of outcomes (IAS 37.42) | Reflected in the price a market participant would demand to assume the obligation (IFRS 13.40) |
The distinction matters because IAS 37 and IFRS 13 can produce different figures for the same obligation. A provision measured at best estimate reflects what this entity expects to pay; the same obligation measured at fair value reflects what the market would charge to assume it (including a profit margin and risk premium the entity itself would not include). On most engagements the best estimate approach applies. Fair value measurement enters the picture mainly when the entity acquires a provision through a business combination under IFRS 3.
Related terms
Frequently asked questions
How do I choose between expected value and most likely outcome?
IAS 37.39 prescribes the expected value method for a large population of similar obligations (warranties, returns, penalty clauses across multiple contracts). IAS 37.40 directs the entity to the most likely outcome for a single obligation, adjusted for skew. The auditor tests whether management matched the method to the obligation type per ISA 540.13(a), and whether the probability inputs are supported by historical data or external evidence.
Does the best estimate include VAT or other taxes?
The best estimate should reflect the actual cash outflow the entity expects to incur. If the entity cannot recover VAT on the remediation or settlement cost, the gross amount including VAT forms part of the estimate. IAS 37.36 refers to the expenditure "required to settle the present obligation," which means the net-of-recovery amount from the entity's perspective. The auditor verifies the tax treatment against the entity's VAT position per the applicable local regime.
When should I update the best estimate?
IAS 37.59 requires the entity to review provisions at each reporting date and adjust them to reflect the current best estimate. If the underlying assumptions change (new legal advice, updated engineering reports, revised probability assessments), the estimate must be remeasured. The auditor tests whether management has incorporated new information available before the date the financial statements are authorised for issue, applying ISA 560.7 to subsequent events that affect the estimate.