Best estimate
The word ‘Best estimate‘ is one of those IFRS Jargon words that never made it to a definition but is used quite often in many IFRS Standards. This is a summary of the IFRS standards were best estimate is used and how it it is used.
There are three valuation methods (or techniques)
- Expected value is used when a large population of items is being measured. A probability is assigned to each value and the sum of the probability weighted values equals the amount to be recognized.
- Present value techniques, for example probability-weighted outcomes of different scenarios using a discounted cash flow methodology. Selecting an appropriate discount rate is critical to the valuation.
- An option pricing model, such as a lattice model, to measure the fair value.
Using the most likely outcome or a single best estimate may only be considered appropriate in very simple estimations or are included in for example IFRS 9 as practical expedients (Simplified (lifetime expected losses) approach for trade receivable, contract assets and lease receivables without a significant financing component, Change of lifetime expected loss approach for credit-impaired purchased or originated assets, Low risk exception and provision matrix in the General (or three-stage) model in IFRS 9, here are more detailed explanations of these methods).
Provisions
A provision is a liability of uncertain timing or amount. In this meaning provisions look like rather abstract values. However, provisions are well distinguished and estimated liabilities. Provisions can be recognised as estimated liabilities on the following conditions:
- the presence of a legal or constructive obligation;
- the outflow of resources embodying economic benefits that will be required to settle the obligations is probable; and
- a sufficiently reliable estimate of the amount of the obligation can be made.
As it is not possible to estimate the amount of provisions precisely, IAS 37 lays down that ‘the amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. The best estimate – it is the amount that an entity would rationally pay to settle the obligation at the end of the reporting period.’
The risks and uncertainties shall be taken into account in reaching the best estimate of a provision. It is outlined in the standard that the presence of uncertainty and risk does not justify the creation of excessive provisions or a deliberate overstatement of liabilities. When there is an obvious effect caused by any changes in the value of money arising from the passage of time, the amount of provision must be estimated based on the discounted amounts of the expenditure that will be required for the repayment of a liability. The discount rates must reflect the current market assessments of the time value of money and the risks specific to the liability.
The two measurement techniques used are expected value and net present value of the cash outflow.
- Expected value is used when a large population of items is being measured. A probability is assigned to each value and the sum of the probability weighted values equals the amount to be recognized. Where the effect of the time value of money is material, the amount of the provision should be recorded at the present value of the expenditure required to settle the obligation. This could arise in the case of long term obligations where because of length of the term, the time value of money is material.
- When using present value techniques, the discount rate used should be pre-tax, and reflect the current market assessments of the time value of money. It should consider the risks specific to the liability.
IFRS 3 Business combinations
Fair value contingent consideration
Measuring the fair value of contingent consideration can be difficult. In practice, an acquirer often uses an income approach that can factor in the uncertainty associated with the amount and timing of the contingent consideration.
For instance, an acquirer might use a discounted cash flow methodology. This might be suitable for contingent consideration that will be paid in cash. In this case, selecting an appropriate discount rate is critical to the valuation. The discount rate must reflect the risks associated with the arrangement, such as credit risk and the risk that the contingent event will not occur. An acquirer might apply the discount rate to its best estimate of the contingent payout. Alternatively, an acquirer might apply the discount rate to a probability-weighted payout.
A probability-weighted payout can be derived by listing the potential payouts, assigning each one a probability, and then calculating the probability-weighted payout. For example, assume that an acquirer might pay either $50,000, $25,000 or $0 of additional consideration. The acquirer determines that the likelihood of paying $50,000 is 55%, $25,000 is 30%, and $0 is 15%. The probability-weighted payout is computed as follows:
Payout (A) |
Probability (B) |
(A) * (B) |
$50,000 |
55% |
$27,500 |
$25,000 |
30% |
$7,500 |
$0 |
15% |
$0 |
Probability-weighted payout |
$35,000 |
An acquirer then applies the discount rate to calculate the present value of the probability-weighted payout.
An acquirer also might use an option pricing model, such as a lattice model, to measure the fair value of contingent consideration. An option pricing model generally is appropriate for contingent consideration that will be paid in stock options or shares. Various assumptions typically are necessary to use an option pricing model, such as a stock option’s exercise price, the expected volatility of the share price, expected dividends and the risk-free interest rate. The expected volatility often is the most difficult to estimate.
Determining the appropriate assumptions requires significant judgment and an acquirer may wish to engage actuarial valuation specialists to assist in the valuation.
Bargain purchase
Because bargain purchases are rare, so for management of the acquirer an important aspect of the reassessment process is to be able to understand why there is a bargain purchase — why the seller would be willing to sell its business at an amount less than what a market participant would be willing to pay.
Bargain Purchase Reassessment
In performing the required reassessment, the acquirer re-evaluates all aspects of the transaction, including whether:
- The resulting gain represents management’s best estimate of the economic effect of the transaction based on all information that existed as of the acquisition date
- There are any aspects of the transaction that should be accounted for separately from the business combination, such as:
- Pre-existing relationships that were settled as a result of the business combination
- Transactions (contractual or non-contractual) entered into at or near the same time as the business combination that are primarily for the benefit of the combined entity
- The payment of transaction costs by the seller on behalf of the acquirer
- All assets acquired were evaluated for any contingencies that could prohibit recognition as of the acquisition date
- All identified intangible assets met either the contractual-legal or separability criterion of IFRS 3.B31-B34
- Conclusions reached with respect to assumed pension obligations were appropriate
- Pre-acquisition contingencies (e.g., legal contingencies or potential tax exposures) of the target were properly identified, measured and recognized
- All leases and other executory contracts were evaluated for any off-market components that should be recognized as of the acquisition date
- Conclusions reached with respect to the accounting for acquired or assumed deferred taxes were appropriate
- The buyer assessed the reasonableness of the fair value determinations by reviewing the procedures performed to measure the fair value of the consideration transferred, assets acquired, liabilities assumed and any non-controlling interest, including whether:
- The fair value measurements reflect all available information as of the acquisition date
- The significant assumptions (e.g., prospective financial information, discount rate, royalty rate, control premium, as applicable) used in the fair value calculation are reasonable and reflect the appropriate level of risk for the transaction (e.g., if management’s estimate of the prospective financial information was deemed to be aggressive, then the discount rate should be increased to reflect the additional level of risk)
- Any entity-specific synergies were inappropriately included in the initial valuation of any assets acquired or liabilities assumed (e.g., could the buyer immediately sell the asset or transfer the liability to a market participant at their recorded values)
Employee benefits – Actuarial assumptions
Salary escalation: this assumption represents company’s management’s best estimate view of what the salary increments are going to be in future. This assumption is used to predict how the salary of an employee will grow in future and therefore what their final salary would be when they leave.
Employee attrition: this assumption represents company’s management’s best estimate view of what the attrition experience is going to be in future.
The assumptions in this case usually represent a best estimate of the long term development of interest earnings, salary and prices inflation, but the discount rate may be chosen by reference to market bond yields.
The demographic assumptions to be used in group insurance are the choice of the actuary and should represent a best estimate. In calculations for pension funds the demographic assumptions are based on the standard tables derived for the statutory pension scheme for private sector employees.
IFRS 17 Fulfilment cash flows
The requirements of IFRS 17 begin with estimating the cash flows. To derive the estimated cash flows using the Baseline Delta Approach, entities need to apply adjustments ie Deltas, to their full best estimate cash flows, which currently exist either for economic or solvency related valuations. For example, an entity would have a set of cash flows, which would be expected to also be used for IFRS 17 purposes.
These cash flows then would be adjusted to reflect the requirements of IFRS 17 around: directly attributable expenses, contract boundaries, separating distinct investment and service components. These adjustments would provide the ‘fulfilment cash flows’ as required by IFRS 17.
Then the Standard requires that these cash flows are adjusted for uncertainty (risk adjustment) and the time value of money (discounting).
Example how the Baseline Delta Approach deltas can be combined to produce IFRS 17 Income Statement
Consider a 3 year term life contract with a death benefit of 5’000. The best estimate premiums are 100.00, 99.0, 98.0 and the best estimates claims are 50.0, 49.5, 49.0. The risk free interest rate is 3%. There is also a risk margin of 6.0, 5.0, 4.0 applied for IFRS
Financial instruments
IFRS 9 mentions that in limited circumstances cost may approximate fair value, for example, when:
- Insufficient more recent information is available to measure fair value; or
- There is a wide range of possible fair value measurements and cost represents the best estimate of fair value in the range. (IFRS 9.B5.2.3)
Measuring Expected Credit Losses
Measuring ECLs is, among other considerations, based on probability-weighted outcomes: Although entities do not need to identify every possible scenario, they will need to take into account the possibility that a credit loss occurs, no matter how low that possibility is. This is not the same as the most likely outcome or a single best estimate.
Investment property – Value in use
Cash flow forecasts should be based on the latest management-approved budgets or forecasts for the investment property. Assumptions made in the cash flows should be reasonable and supportable. [IAS 36.33]. For example, cash flows should be derived by contractual agreements, and they should take into consideration property yields. They should represent management’s best estimate of the economic circumstances that will prevail over the remaining life of the property.
Service concession arrangements
The terms of a service arrangement require an operator to construct a road—completing construction within two years—and maintain and operate the road to a specified standard for eight years (ie years 3–10).
Resurfacing obligations
The operator’s resurfacing obligation arises as a consequence of use of the road during the operating phase. It is recognised and measured in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, ie at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period.
For the purpose of this illustration, it is assumed that the terms of the operator’s contractual obligation are such that the best estimate of the expenditure required to settle the obligation at any date is proportional to the number of vehicles that have used the road by that date and increases by CU17 (discounted to a current value) each year. The operator discounts the provision to its present value in accordance with IAS 37. The charge recognised each period in profit or loss is:
Year |
3 |
4 |
5 |
6 |
7 |
8 |
Total |
Obligation arising in year (CU17 discounted at 6%) |
12 |
13 |
14 |
15 |
16 |
17 |
87 |
Increase in earlier years’ provision arising from passage of time |
0 |
1 |
1 |
2 |
4 |
5 |
13 |
Total expense recognised in profit or loss |
12 |
14 |
15 |
17 |
20 |
22 |
100 |
Intangible assets
An intangible asset shall be recognised if, and only if:
- it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and
- the cost of the asset can be measured reliably.
An entity shall assess the probability of expected future economic benefits using reasonable and supportable assumptions that represent management’s best estimate of the set of economic conditions that will exist over the useful life of the asset.
Income taxes
A best estimate approach involves making a judgement as to which interpretation of the relevant tax laws is most likely to be sustained in an entity’s particular circumstances. Taxes payable are then estimated according to that interpretation. In some situations tax authorities might notify the entity or market of their interpretation of certain tax laws. The entity might intend to challenge that position but the tax authority’s view is likely to indicate the most likely outcome until it is successfully challenged. Specialist tax or legal advice may be needed to determine the best estimate.
The best estimate of the taxes payable should be revised, as facts and circumstances change. The uncertainty will be removed once taxes payable have been substantially agreed by the relevant authority.
Before that, the steps and procedures for the final determination of taxes payable might provide additional evidence that makes it appropriate to revise the estimate. Typically, those steps include:
- filing a tax return
- the tax authority either accepting or querying the return
- tax audit or investigation and
- legal or other proceedings for the resolution of disputed positions.
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