November 15, 2010

Probability in New FASB Lease Accounting Explained

Lucernex real estate finance expert Jim Duport, after completing an upgrade to our core financial engine to support the new proposed FASB / GAAP rules, discusses how probability used to be used with the new FASB rules.

This is the second in a series of Blogs by Jim describing his findings during the process of developing the architecture within the core Lucernex financial engine to handle the new proposed FASB rules.

In my previous life I was a math major (actually also a high school math teacher), but, more importantly, I have a friend who is a PhD in Math. I figured if I didn’t understand the probability in the multiple examples I have seen of the new PROPOSED FASB Lease Accounting, then others might also be having issues understanding it.

For example: Assume ABC Company has a lease that has a non-cancellable 10-year term, an option to renew for 5 years at the end of 10 years and another option to renew for an additional 5 years at the end of the 15 years. Assume ABC Co. determines the probability for each term as follows:

a) 40% probability of a 10-year term
b) 30% probability of a 15-year term
c) 30% probability of a 20-year term

The term will be at least 10 years. There is a 60% chance that the term will be 15 years or longer, but only a 30% change that the term will be 20 years. So, there is a 60% chance that the term will be 15 years, which is the longest possible term more likely than not to occur. So, the “term” to use for calculating the “Rent / Right-to-Use” under the proposed new FASB GAAP accounting is 15 years.

Ugh! That doesn’t make sense to me initially, 40% + 30% = 70% (math 101).
BTW: Statements a, b, & c are the standard way I have seen probability presented (more below in another approach).

First things first – notice the TOTAL probability adds up to 1, or 100% (40% + 30% + 30%). In probability, the total of all possible outcomes must be 1. In other words, taking into account ALL actions, the total must = 1 since there are no other actions possible. Make sense so far?

Now, let’s see I can explain the 60% in layman’s terms. Let’s assume that ABC Co. is a bank with 100 branch offices all with identical leases, i.e. 10-year term with two 5-year renewal options.

• Year 1 – leasing 100 branches
• End of Year 10 – “40% probability of ONLY a 10-year term” (added in ONLY). This means 40 branches close, and 60 are still open and exercise their renewal (as drafted in the initial lease). So a 60% (100% – 40%) chance the term will be at least 15 years since 60 offices are still open.
• End of Year 15 – “30% probability of ONLY a 15-year term”. We had 100 branches when we started, 70 are now closed (40 in Year 10, an additional 30 in year 15); so now there is only a 30% chance the office will be extended to a 20-year term (100% – 40% – 30%).

Make sense?

Summarizing (Assuming no “issues” (i.e. the company went bankrupt or did a restructuring):

• Year 1: 100 offices open. Conclusion: all 100 offices will be leased for 10 years, 100% probability.
• End of Year 10: 60 offices open, 40 closed. Conclusion: 60 offices will be leased for 15 years; 60% probability.
• End of Year 15: 30 offices open, 70 closed. Conclusion: 30 offices will be leased for 20 years; 30% probability
• End of Year 20: I’m retired – NMP (Not My Problem) ☺

In terms of FASB, the conclusion is that more likely than not 60 offices will be leased for 15 years and this becomes the FASB 13 commitment.

Another approach to explaining the probability:
For example: Assume ABC Company has a lease that has a non-cancellable 10-year term, an option to renew for 5 years at the end of 10 years and another option to renew for an additional 5 years at the end of the 15 years. Assume ABC Co. determines the probability for its occupancy ending with each lease term as follows:

a) 40% probability of its occupancy ending after a 10-year term
b) 30% probability of its occupancy ending after a 15-year term
c) 30% probability of its occupancy ending after a 20-year term

Notes: Added in “its occupancy ending” and remember we are only dealing with the renewal options in the lease; so, it is still possible ABC may negotiate a new renewal after 20 years.

We know the term will be at least 10 years and there is only a 40 % chance that ABC will vacate in the 10th year. Therefore, there is a 60% chance (100%-40%) that the 1st renewal will be exercised by ABC and the term will be 15 years, but only a 30% chance (100%-40%-30%) that the 2nd renewal will be exercised and the term will be longer than 15 years, in this case 20 years. Since a 30% probability of 20 years of occupancy is less than 50%, this term clearly is NOT “more likely than not” to occur. Accordingly, the more likely than not lease term for FASB purposes is considered 15 years. Said differently; with a 60% chance that the occupancy term will be 15 years, from a simple math standpoint that is the longest possible term thought more likely than not to occur. So, the “term” to use for calculating the “Rent / Right-to-Use” under the proposed new FASB GAAP accounting is 15 years.

We are currently demo’ing the new financial engine as part of Lx LseMod Corporate v15.

If you are interested in being a beta user on Lx LseMod Corporate version 15, please contact Michael Hammerslag by sending an email to Lucernex Beta Request with “LseMod 15 beta request” in the subject line.

Shameless Plug

The new Lucernex financial engine has been upgraded to support the new, proposed FASB rules. This was a massive undertaking led by Jim Duport, our resident financial modeling expert, which, once complete, was verified at the formula level by an independent CPA. The new engine was released initially inside Lx LseMod Corporate version 15, at the end of 2010. We then used the upgraded financial engine in Lx Contracts, our lease administration and rent accounting solution and as part of our Q1 2011 release of the Lease Analysis module of Lx Retail. Lx Retail, Lx Contracts (which is sold alone or as part of the Lx Retail suite) and the financial engine all share a single platform and single database.