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.