Regal Enterprises enters into a contract with a customer to build a customized asset for a consideration of $500,000. However, this amount will be reduced or increased depending on the timing of completion of the asset. Specifically, for each day after March 31, 20X7 that the asset takes to complete, the promised consideration is reduced by $5,000. For each day before March 31, 20X7 that the asset is complete, the promised consideration increases by $3,000. In addition, upon completion of the asset, a third party will inspect the asset and assign a rating based on metrics that are defined in the contract. If the asset receives a specified rating, the entity will be entitled to an incentive bonus of $50,000. In determining the transaction price, what method would Regal most likely use to estimate the amount of variable consideration to which it will be entitled associated with the daily penalty or incentive and with the incentive bonus.
An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:
The expected value—The expected value is the sum of probability weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics. Regal would most likely decide to use the expected value method to estimate the variable consideration associated with the daily penalty or incentive (that is, $500,000, plus or minus $5,000 or $3,000 per day) as there are large number of possible outcomes.
The most likely amount—The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not). Regal would most likely decide to use the most likely amount to estimate the variable consideration associated with the incentive bonus. This is because there are only two possible outcomes ($50,000 or $0).