NOTE 7—LEASES

Accounting Policy

The Company leases nearly all of its retail and outlet store locations, corporate headquarters, distribution and home delivery facilities, as well as other storage and office space. The initial lease terms of the Company’s real estate leases generally range from ten to fifteen years, and certain leases contain renewal options for up to an additional 25 years, the exercise of which is at the Company’s sole discretion. In recognizing the lease right-of-use assets and lease liabilities, the Company utilizes the lease term for which it is reasonably certain to use the underlying asset, including consideration of options to extend or terminate the lease. The Company also leases certain equipment with lease terms generally ranging from three to seven years. The Company’s lease agreements generally do not contain any material residual value guarantees or material restrictions or covenants.

Leases, or lease extensions, with a term of twelve months or less are not recorded on the condensed consolidated balance sheets, and the Company recognizes lease expense for these leases on a straight-line basis over the lease term.

The Company accounts for lease and non-lease components as a single lease component for real estate leases, and for all other asset classes the Company accounts for the components separately. The Company determines the lease classification and begins to recognize lease and any related financing expenses upon the lease’s commencement, which for real estate leases is generally upon store opening or, to a lesser extent, when the Company takes possession or control of the asset.

As most of the Company’s leases do not include an implicit interest rate, the Company determines the discount rate for each lease based upon the incremental borrowing rate (“IBR”) in order to calculate the present value of lease payments at the commencement date. The IBR is computed as the rate of interest that the Company would have to pay to (i) borrow on a collateralized basis (ii) over a similar term (iii) an amount equal to the total lease payments and (iv) in a similar economic environment. The Company utilizes its asset based credit facility as the basis for determining the applicable IBR for each lease.

Certain of the Company’s lease agreements include rental payments based on a percentage of retail sales over contractual levels. Due to the variable and unpredictable nature of such payments, the Company does not recognize a lease right-of-use asset and lease liability related to such payments. Estimated variable rental payments are included in accounts payable and accrued expenses on the condensed consolidated balance sheets.

The Company has a small group of leases that include rental payments periodically adjusted for inflation (e.g., based on the consumer price index). The Company includes these variable payments in the initial measurement of the lease right-of-use asset and lease liability if such increases have a minimum rent escalation (e.g., floor). However, the Company excludes these variable payments from the initial measurement of the lease right-of-use asset and lease liability in the case of lease arrangements that do not specify a minimum rent escalation.

The Company rents or subleases certain real estate to third parties under operating leases and recognizes rental income received on a straight-line basis over the lease term, which is recorded as an offset to selling, general and administrative expenses on the condensed consolidated statements of income.

Lease arrangements may require the landlord to provide tenant allowances directly to the Company. Standard tenant allowances received from landlords, typically those received under operating lease agreements, are recorded as cash and cash equivalents with an offset recorded in lease right-of-use assets on the condensed consolidated balance sheets. In certain instances tenant allowances are provided for the Company to design and build the leased asset. Tenant allowances received from landlords during the construction phase of a leased asset and prior to lease commencement are recorded as cash and cash equivalents with an offset recorded in other non-current assets (to the extent the Company has incurred related capital expenditure for construction costs) or in other current liabilities (to the extent that payments are received prior to capital construction expenditures by the Company) on the condensed consolidated balance sheets. After the leased asset is constructed and the lease commences, the Company reclassifies the tenant allowance from other non-current assets or other current liabilities to lease right-of-use assets on the condensed consolidated balance sheets.

Lease Classification

Certain of the Company’s real estate and property and equipment are held under finance leases. Lease related assets are included in finance lease right-of-use assets within property and equipment—net on the condensed consolidated balance sheets.

Leases that do not meet the definition of a finance lease are considered operating leases. Lease related assets are included in operating lease right-of-use assets on the condensed consolidated balance sheets.

Construction Related Activities

The Company is sometimes involved in the construction of leased stores for certain of its newer Design Galleries. Prior to construction commencement, the Company evaluates whether or not it, as lessee, controls the asset being constructed and, depending on the extent to which it is involved, the Company may be the “deemed owner” of the leased asset for accounting purposes during the construction period.

If the Company is not the “deemed owner” for accounting purposes during the construction period, such lease is classified as either an operating or finance lease upon lease commencement. During the construction period and prior to lease commencement, any capital amounts contributed by the Company toward the construction of the leased asset (excluding normal leasehold improvements, which are recorded within property and equipment—net) are recorded as “Landlord assets under construction” within other non-current assets on the condensed consolidated balance sheets (refer to Note 3—Prepaid Expense and Other Assets). Upon completion of the construction project, and upon lease commencement, the Company reclassifies amounts of the construction project determined to be the landlord asset to lease right-of-use assets on the condensed consolidated balance sheets. The construction costs determined not to be part of the leased asset are classified as property and equipment—net on the condensed consolidated balance sheets.

If the Company is the “deemed owner” for accounting purposes, upon commencement of the construction project, it is required to capitalize (i) costs incurred by the Company and (ii) the cash and non-cash assets contributed by the landlord for construction as property and equipment on its condensed consolidated balance sheets as build-to-suit assets, with an offsetting financing obligation under build-to-suit lease transactions. The contributions by the landlord toward construction, including the building, existing site improvements at construction commencement and any amounts paid by the landlord to those responsible for construction, are included as property and equipment additions due to build-to-suit lease transactions within the non-cash section of the consolidated statements of cash flows. Over the lease term, these non-cash additions to property and equipment do not impact the Company’s cash outflows, nor do they impact net income within the consolidated statements of income.

Upon completion of the construction project, the Company performs a sale-leaseback analysis to determine if it can derecognize the build-to-suit asset and corresponding financing obligation. If the asset and liability cannot be derecognized, the Company accounts for the agreement as a debt-like arrangement.

As of May 4, 2019 and February 2, 2019, the Company did not have any build-to-suit lease transactions recorded on its condensed consolidated balance sheets.

Lease Disclosures

Lease costs consist of the following (in thousands):


	Three Months Ended
	May 4,			May 5,
	2019			2018
Operating lease cost (1)(2)	$	19,117	$	21,346

Finance lease costs
Amortization of leased assets (1)		8,852		5,899
Interest on lease liabilities (3)		5,514		3,092

Sublease income (4)		(3,282)		(1,010)
Total lease costs—net	$	30,201	$	29,327

(1)

Operating lease costs and amortization of finance lease right-of-use assets are included in cost of goods sold or selling, general and administrative expenses on the condensed consolidated statements of income based on the Company’s policy. Refer to Note 3—Significant Accounting Policies in the 2018 Form 10-K.

(2)

Includes short-term leases and variable lease costs.

(3)

Included in interest expense—net on the condensed consolidated statements of income.

(4)

Included in selling, general and administrative expenses on the condensed consolidated statements of income.

Lease right-of-use assets and lease liabilities consist of the following (in thousands):


		May 4,		February 2,
		2019		2019
	Balance Sheet Classification
Assets
Operating leases	Operating lease right-of-use assets	$	432,212	$	440,504
Finance leases (1)(2)	Property and equipment—net		658,077		646,875
Total lease right-of-use assets			1,090,289		1,087,379

Liabilities
Current
Operating leases	Operating lease liabilities	$	56,601	$	66,249
Finance leases	Other current liabilities		7,716		9,184
Total lease liabilities—current			64,317		75,433

Non-current
Operating leases	Non-current operating lease liabilities	$	427,961	$	437,557
Finance leases	Non-current finance lease liabilities		436,228		421,245
Total lease liabilities—non-current			864,189		858,802
Total lease liabilities		$	928,506	$	934,235

(1)

Finance lease right-of-use assets include capitalized amounts related to the Company’s construction activities to design and build leased assets, as well as rent payments made to landlords for which the respective Galleries are not yet opened.

(2)

Finance lease right-of-use assets are recorded net of accumulated amortization of $64.1 million and $55.5 million as of May 4, 2019 and February 2, 2019, respectively.

The maturities of lease liabilities are as follows as of May 4, 2019 (in thousands):


Fiscal year	Operating Leases		Finance Leases		Total
Remainder of fiscal 2019	$	54,016	$	22,058	$	76,074
2020		76,683		33,426		110,109
2021		63,728		33,880		97,608
2022		56,804		34,388		91,192
2023		53,453		35,138		88,591
2024		49,688		35,680		85,368
Thereafter		228,008		548,155		776,163
Total lease payments (1)		582,380		742,725		1,325,105
Less—imputed interest (2)		(97,818)		(298,781)		(396,599)
Present value of lease liabilities (3)	$	484,562	$	443,944	$	928,506

(1)

Total lease payments exclude $211.3 million of legally binding payments for leases signed but not yet commenced as of May 4, 2019.

(2)

Calculated using the incremental borrowing rate for each lease at lease commencement.

(3)

Excludes future commitments under short-term lease agreements of $6.4 million as of May 4, 2019.

Supplemental information related to leases consists of the following:


	Three Months Ended
	May 4,		May 5,
	2019		2018
Weighted-average remaining lease term (years)
Operating leases		9.1	9.7
Finance leases		19.1	18.2

Weighted-average discount rate
Operating leases		3.80%	3.71%
Finance leases		5.26%	4.82%

Other information related to leases consists of the following (in thousands):


	Three Months Ended
	May 4,			May 5,
	2019			2018
Cash paid for amounts included in the measurement of lease liabilities
Operating cash flows from operating leases	$	(31,780)	$	(23,026)
Operating cash flows from finance leases		(5,514)		(3,092)
Financing cash flows from finance leases		(2,129)		(1,776)
Total cash outflows from leases	$	(39,423)	$	(27,894)

Lease right-of-use assets obtained in exchange for lease obligations (non-cash)
Finance leases	$	17,984	$	5,023
Operating leases		8,173		4,666