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Organization (Policies)

12 Months Ended

Feb. 02, 2019

RH, a Delaware corporation, together with its subsidiaries (collectively, the “Company”), is a luxury home furnishings retailer that offers a growing number of categories, including furniture, lighting, textiles, bathware, décor, outdoor and garden, and child and teen furnishings. These products are sold through the Company’s stores, catalogs and websites.

On May 27, 2016, the Company acquired a controlling interest in Design Investors WW Acquisition Company, LLC, which owns the business operating under the name “Waterworks.” Refer to Note 4—Business Combination.

As of February 2, 2019, the Company operated a total of 86 retail Galleries and 39 outlet stores in 32 states, the District of Columbia and Canada, and includes 15 Waterworks showrooms throughout the United States and in the U.K., and had sourcing operations in Shanghai and Hong Kong.

Basis of Presentation

These consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States (“GAAP”). The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Accordingly, all intercompany balances and transactions have been eliminated through the consolidation process.

Revision

During the third quarter of fiscal 2018, management determined that the Company had incorrectly reported the impact during the fiscal year ended February 3, 2018 of retiring its common stock in accordance with Accounting Standards Codification (“ASC”) 505—Equity. The common stock retired in fiscal 2017 was related to shares repurchased under the Company’s equity plans. This resulted in an overstatement of treasury stock of $19.5 million and an overstatement of additional paid-in capital of $19.5 million on the consolidated balance sheets as of February 3, 2018, May 5, 2018 and August 4, 2018. There was no impact on the consolidated statements of income or cash flows related to this misstatement. This error was not considered to be material to any of the previously issued annual or interim financial statements.

The following are selected line items from the Company’s consolidated balance sheets and consolidated statements of stockholders’ equity (deficit) illustrating the effect of the revision (in thousands):

	Consolidated Balance Sheets
	February 3, 2018
	As Reported			Adjustment			As Revised
Stockholders’ deficit:
Common stock	$	2		$	—		$	2
Additional paid-in capital		860,288			(19,523	)		840,765
Accumulated other comprehensive income		(171	)		—			(171	)
Retained earnings		152,394			—			152,394
Treasury stock		(1,019,849	)		19,523			(1,000,326	)
Total stockholders’ deficit	$	(7,336	)	$	—		$	(7,336	)

	Unaudited Condensed Consolidated Balance Sheets
	May 5, 2018
	As Reported			Adjustment			As Revised
Stockholders’ equity:
Common stock	$	2		$	—		$	2
Additional paid-in capital		870,751			(19,523	)		851,228
Accumulated other comprehensive income		(1,436	)		—			(1,436	)
Retained earnings		159,417			—			159,417
Treasury stock		(1,020,092	)		19,523			(1,000,569	)
Total stockholders’ equity	$	8,642		$	—		$	8,642

	Unaudited Condensed Consolidated Balance Sheets
	August 4, 2018
	As Reported			Adjustment			As Revised
Stockholders’ equity:
Common stock	$	2		$	—		$	2
Additional paid-in capital		944,610			(19,523	)		925,087
Accumulated other comprehensive income		(1,918	)		—			(1,918	)
Retained earnings		223,459			—			223,459
Treasury stock		(1,020,092	)		19,523			(1,000,569	)
Total stockholders’ equity	$	146,061		$	—		$	146,061

Fiscal Years

The Company’s fiscal year ends on the Saturday closest to January 31. As a result, the Company’s fiscal year may include 53 weeks. The fiscal years ended February 2, 2019 (“fiscal 2018”) and January 28, 2017 (“fiscal 2016”) each consisted of 52 weeks. The fiscal year ended February 3, 2018 (“fiscal 2017”) consisted of 53 weeks.

Use of Accounting Estimates

The preparation of the Company’s consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and such differences could be material to the consolidated financial statements.

Cash and Cash Equivalents

The Company considers all highly liquid investments with original maturities of 90 days or less to be cash equivalents.

Concentration of Credit Risk

The Company maintains its cash and cash equivalent accounts in financial institutions in both U.S. dollar and Canadian dollar denominations. Accounts at the U.S. institutions are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $250,000 and accounts at the Canadian institutions are insured by the Canada Deposit Insurance Corporation (“CDIC”) up to $100,000 Canadian dollars. As of February 2, 2019 and February 3, 2018, and at various times throughout these fiscal years, the Company had cash in financial institutions in excess of the amount insured by the FDIC and CDIC. The Company performs ongoing evaluations of these institutions to limit its concentration of credit risk.

Accounts Receivable

Accounts receivable consist primarily of receivables from the Company’s credit card processors for sales transactions, receivables related to the Company’s contract business and other miscellaneous receivables. Accounts receivable is presented net of allowance for doubtful accounts, which is recorded on a specific identification basis. The allowance for doubtful accounts was $1.9 million and $1.8 million as of February 2, 2019 and February 3, 2018, respectively.

Merchandise Inventories

The Company’s merchandise inventories are comprised of finished goods and are carried at the lower of cost or net realizable value, with cost determined on a weighted-average cost method. To determine if the value of inventory should be marked down below original cost, the Company considers current and anticipated demand, customer preference and the merchandise age. The inventory value is adjusted periodically to reflect current market conditions, which requires management judgments that may significantly affect the ending inventory valuation, as well as gross margin. The significant estimates used in inventory valuation are obsolescence (including excess and slow-moving inventory and lower of cost or net realizable value reserves) and estimates of inventory shrinkage. The Company adjusts its inventory for obsolescence based on historical trends, aging reports, specific identification and its estimates of future retail sales prices.

Reserves for shrinkage are estimated and recorded throughout the period as a percentage of shipped sales based on historical shrinkage results and current inventory levels. Actual shrinkage is recorded throughout the year based upon periodic cycle counts and the results of the Company’s annual physical inventory counts. Actual inventory shrinkage and obsolescence can vary from estimates due to factors including the mix of the Company’s inventory (which ranges from large furniture to décor) and execution against loss prevention initiatives in the Company’s stores, distribution centers, off-site storage locations and with its third-party transportation providers.

Due to these factors, the Company’s obsolescence and shrinkage reserves contain uncertainties. Both estimates have calculations that require management to make assumptions and to apply judgment regarding a number of factors, including market conditions, the selling environment, historical results and current inventory trends. If actual obsolescence or shrinkage estimates change from the Company’s original estimates, the Company will adjust its inventory reserves accordingly throughout the period. Management does not believe that changes in the assumptions used in these estimates would have a significant effect on the Company’s net income or inventory balances. The Company’s inventory reserve balances were $30.7 million and $31.4 million as of February 2, 2019 and February 3, 2018, respectively.

Product Recalls

During fiscal 2018, fiscal 2017 and fiscal 2016, the Company initiated product recalls for certain of its products. In addition, in fiscal 2018 and fiscal 2017, the Company adjusted the accrual related to certain product recalls previously initiated and received insurance reimbursements associated with certain product recalls. Product recalls had the following effect on the Company’s income before income taxes (in thousands):

	Year Ended
	February 2,			February 3,		January 28,
	2019			2018		2017
Reduction of net revenues	$	4,733		$	3,207	$	3,441
Impact on cost of goods sold		(4,139	)		4,315		535
Impact on gross profit		594			7,522		3,976
Incremental selling, general and administrative expenses		1,025			185		639
Impact on income before income taxes	$	1,619		$	7,707	$	4,615

The product recall accrual as of February 2, 2019 and February 3, 2018 was $7.8 million and $1.2 million, respectively, and is included in other current liabilities on the consolidated balance sheets.

Advertising Expenses

Advertising expenses primarily represent the costs associated with the Company’s catalog mailings, as well as print and website marketing. Total advertising expense, which is recorded in selling, general and administrative expenses on the consolidated statements of income, was $97.0 million, $106.6 million and $79.8 million in fiscal 2018, fiscal 2017, and fiscal 2016, respectively.

Capitalized Catalog Costs

Capitalized catalog costs consist primarily of third-party incremental direct costs to prepare, print and distribute Source Books. Such costs are capitalized and recognized as expense upon the delivery of the Source Books to the carrier. In the case of multiple printings of a Source Book, the creative costs will be expensed in full upon the initial delivery of Source Books to the carrier.

The Company had $16.2 million and $44.1 million of capitalized catalog costs that are included in prepaid expense and other current assets on the consolidated balance sheets as of February 2, 2019, and February 3, 2018, respectively.

Website and Print Advertising

Website and print advertising expenses, which include e-commerce advertising, web creative content and direct marketing activities such as print media, radio and other media advertising, are expensed as incurred or upon the release of the content or the initial advertisement.

Property and Equipment

Property and equipment is recorded at cost, net of accumulated depreciation and amortization. Depreciation is calculated using the straight-line method, generally using the following useful lives:

Category of Property and Equipment		Useful Life
Building and building improvements		40 years
Machinery, equipment and aircraft		3 to 10 years
Furniture, fixtures and equipment		3 to 7 years
Computer software		3 to 10 years

The cost of leasehold improvements and lease acquisitions is amortized over the lesser of the useful life of the asset or the applicable lease term.

The Company expenses all internal-use software costs incurred in the preliminary project stage and capitalizes certain direct costs associated with the development and purchase of internal-use software, including external costs of materials and services and internal payroll costs related to the software project, within property and equipment. Capitalized costs are amortized on a straight-line basis over the estimated useful lives of the software, generally between three and ten years.

Interest is capitalized on construction in progress and software projects during the period in which expenditures have been made, activities are in progress to prepare the asset for its intended use and interest expense is being incurred. The Company capitalized interest of $3.1 million, $3.3 million and $2.4 million in fiscal 2018, fiscal 2017 and fiscal 2016, respectively. During fiscal 2018, $2.7 million of the $3.1 million capitalized interest relates to the capitalization of non-cash interest associated with the amortization of the convertible senior notes debt discount. During fiscal 2017, $2.5 million of the $3.3 million capitalized interest relates to the capitalization of non-cash interest associated with the amortization of the convertible senior notes debt discount. During fiscal 2016, all of the $2.4 million capitalized interest relates to the capitalization of non-cash interest associated with the amortization of the convertible senior notes debt discount.

Property and equipment acquired under non-cancelable leases, which meet the criteria of capital leases, are capitalized and amortized over the lesser of the useful life of the asset or the lease term. For buildings held under capital lease, unless the fair value of the land at lease inception exceeds 25% of the aggregate fair value of the leased land and building, rent payments under the leases are recognized using the effective interest method as a reduction of the capital lease obligation and interest expense. Pursuant to Accounting Standards Codification (“ASC”) 840—Leases (“ASC 840”), at lease inception, if the fair value of the underlying land exceeds 25% of the fair value of the real estate (land and building), the Company allocates a portion of the cash payments under the lease to land rent expense equal to the product of the fair value of the leased land at construction commencement and the Company’s incremental borrowing rate. The remaining cash payment is treated as debt-service payments and recognized as a reduction of the capital lease obligation and an increase in interest expense.

The land purchased by the Company is recorded at cost and is a non-depreciable asset.

Property and equipment is reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. For further discussion regarding impairments refer to the “Impairment” accounting policy below.

Intangible Assets

Intangible assets reflect the value assigned to tradenames, trademarks, domain names and the fair market value of the Company’s leases. The Company does not amortize tradenames, trademarks and domain names as the Company defines the life of these assets as indefinite.

Impairment

Goodwill

The Company evaluates goodwill annually to determine whether it is impaired or whenever events occur or circumstances change that would indicate that the fair value of a reporting unit is less than its carrying amount. Conditions that may indicate impairment include, but are not limited to, a significant adverse change in customer demand or business climate that could affect the value of an asset; general economic conditions, such as increasing Treasury rates or unexpected changes in gross domestic product growth; a change in the Company’s market share; budget-to-actual performance and consistency of operating margins and capital expenditures; a product recall or an adverse action or assessment by a regulator; or changes in management or key personnel.

The Company performs its annual goodwill impairment testing in the fourth fiscal quarter. Historically, through its fourth quarter ended January 28, 2017, the Company applied a two-step impairment test: in step one, the carrying value of the reporting unit was compared with its fair value; in step two, which was applied when the carrying value was more than its fair value, the amount of goodwill impairment, if any, was derived by deducting the fair value of the reporting unit’s assets and liabilities from the fair value of its equity, and comparing that amount with the carrying amount of goodwill.

In January 2017, the FASB issued Accounting Standards Update No. 2017-04—Intangibles—Goodwill and Other (Topic 350) (“ASU 2017-04”). ASU 2017-04 amends the guidance to simplify the subsequent measurement of goodwill by removing step two of the goodwill impairment test (the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge). Instead, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount, limited to the total amount of goodwill of the reporting unit. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The Company early adopted ASU 2017-04 in fiscal 2017 and applied the amended guidance to its annual impairment tests performed in fiscal 2017 and fiscal 2018.

The Company determines fair values using the discounted cash flow approach (“income approach”) or the market multiple valuation approach (“market approach”), when available and appropriate, or a combination of both. The Company assesses the valuation methodology based upon the relevance and availability of the data at the time it performs the valuation. If multiple valuation methodologies are used, the results are weighted appropriately.

Under the income approach, fair value is determined based on the present value of estimated future cash flows, discounted at an appropriate risk-adjusted rate. The Company uses its internal forecasts to estimate future cash flows and includes an estimate of long-term future growth rates based on its most recent views of the long-term outlook for each respective reporting unit. Actual results may differ from those assumed in the Company’s forecasts. The Company derives its discount rates using a capital asset pricing model and analyzing published rates for industries relevant to its reporting units to estimate the cost of equity financing. The Company uses discount rates that are commensurate with the risks and uncertainty inherent in the respective businesses and in its internally developed forecasts.

Valuations using the market approach are derived from metrics of publicly traded companies or historically completed transactions of comparable businesses. The selection of comparable businesses is based on the markets in which the reporting units operate giving consideration to risk profiles, size, geography, and diversity of products and services. A market approach is limited to reporting units for which there are publicly traded companies that have the characteristics similar to the Company’s businesses.

Estimating the fair value of reporting units requires the use of estimates and significant judgments that are based on a number of factors including actual operating results. It is reasonably possible that the judgments and estimates described above could change in future periods.

A reporting unit is an operating segment, or a business unit one level below that operating segment for which discrete financial information is prepared and regularly reviewed by the Chief Operating Decision Maker (“CODM”). The Company has deemed RH Segment and Waterworks to be the reporting units for which goodwill is independently tested, as these operating segments are the lowest level for which discrete financial information is prepared and regularly reviewed by the CODM.

RH Segment Reporting Unit

During fiscal 2018, fiscal 2017 and fiscal 2016, the Company reviewed the RH Segment reporting unit goodwill for impairment by assessing qualitative factors to determine whether it was more likely than not that the fair value of the reporting unit was less than its carrying amount. Based on the qualitative tests performed in each fiscal year, the Company determined that it was not more likely than not that the fair value of the reporting unit was less than its carrying amount for fiscal 2018, fiscal 2017 and fiscal 2016, and therefore the Company did not recognize goodwill impairment with respect to the RH Segment in any such fiscal year.

Waterworks Reporting Unit

During the fourth fiscal quarters of 2018 and 2017, the Company conducted its annual strategic planning process. Based upon the outcome of this process in each fiscal year, management identified indicators that there could be an impairment of the Waterworks reporting unit. These indicators included (i) an updated long-range financial plan provided by the Waterworks segment management that indicated a reduction of revenues and EBITDA as compared to prior long-range financial plans, (ii) a review of the strategic initiatives of the Waterworks segment and (iii) the Waterworks segment not achieving revenue and operating income objectives compared to plans.

In determining the Waterworks reporting unit estimated fair value using the income approach in both fiscal 2018 and fiscal 2017, the Company projected future cash flows based on management’s estimates and long-term plans and applied a discount rate based on a weighted average cost of capital. This analysis required the Company to make judgments about revenues, expenses, fixed asset and working capital requirements, the impact of updated tax legislation and other subjective inputs. In determining the Waterworks reporting unit estimated fair value using the market approach, the Company considered assumptions that it believes market participants would use in valuing the Waterworks reporting unit, based on EBITDA multiples and including the application of a control premium. For purposes of this analysis, in both fiscal years, the Company weighted the results 80% towards the income approach and 20% towards the market approach.

Based on the estimated fair value of the Waterworks reporting unit as of the assessment date of each of its fiscal 2018 and fiscal 2017 analysis, the Company recorded a $17.4 million and $33.7 million non-cash impairment in the fourth quarter of fiscal 2018 and fiscal 2017, respectively, to reduce the carrying value of goodwill in the Waterworks reporting unit. The impairment is recorded in goodwill and tradename impairment on the consolidated statements of income and the Waterworks reporting unit goodwill was fully impaired as of February 2, 2019.

Tradenames, Trademarks and Domain Names

The Company annually evaluates whether tradenames, trademarks and domain names continue to have an indefinite life. Tradenames, trademarks and domain names are reviewed for impairment annually in the fourth quarter and may be reviewed more frequently if indicators of impairment are present. Conditions that may indicate impairment include, but are not limited to, a significant adverse change in customer demand or business climate that could affect the value of an asset, a product recall or an adverse action or assessment by a regulator.

The Company qualitatively assesses indefinite-lived intangible asset impairment to determine whether it is more likely than not that the fair value of the asset is less than its carrying amount. If tradenames, trademarks and domain names are not qualitatively assessed or if such intangible assets are qualitatively assessed and it is determined it is not more likely than not that the asset’s fair value is greater than its carrying amount, an impairment review is performed by comparing the carrying value to the estimated fair value, determined using a discounted cash flow methodology. Factors used in the valuation of intangible assets with indefinite lives include, but are not limited to, management’s plans for future operations, brand initiatives, recent results of operations and projected future cash flows.

RH Segment Reporting Unit

During fiscal 2018, fiscal 2017 and fiscal 2016, the Company qualitatively assessed the RH Segment reporting unit indefinite-lived intangible asset for impairment and determine it was more likely than not that the fair value of the assets were greater than their carrying amounts. Based on the qualitative tests performed in each fiscal year, the Company did not perform quantitative impairment tests in any year. The Company did not recognize any impairment with respect to intangible assets for the RH Segment reporting unit in fiscal 2018, fiscal 2017, or fiscal 2016.

Waterworks Reporting Unit

In connection with the goodwill impairment test performed for the Waterworks reporting unit in fiscal 2017, described above, the Company performed an impairment test on the tradenames allocated to the reporting unit which utilized the discounted cash flow methodology under the relief-from-royalty method. Under the relief-from-royalty method, the Company’s significant assumptions include the forecasted future revenues and the estimated royalty rate, expressed as a percentage of revenues. Based on the quantitative impairment test performed, which resulted in fair value of the tradename in excess of book value by approximately 26%, the Company concluded that the tradename allocated to the Waterworks reporting unit was not impaired as of February 3, 2018 and did not recognize any impairment with respect to the tradename for the Waterworks reporting unit in fiscal 2017.

At the end of each of the first three fiscal quarters of 2018, the Company determined that there were no events or circumstances that indicated any impairment for the Waterworks reporting unit tradename. During the fourth fiscal quarter of 2018, management updated the fiscal 2019 budget and financial projections beyond fiscal 2019 for the Waterworks reporting unit. There were certain factors that caused the key financial inputs for the tradename valuation model to significantly decrease from the previous inputs, the most significant of which was a reduction of future forecasted net revenues resulting from an expected shift in product mix, challenges in continuing to grow the showrooms business and supply chain constraints.

These factors arising during the fourth fiscal quarter of 2018 had a significant and negative impact on the estimated future cash flows of the Waterworks reporting unit. In connection with the goodwill impairment test performed for the Waterworks reporting unit in fiscal 2018, described above, the Company performed an impairment test on the tradename allocated to the reporting unit which utilized the discounted cash flow methodology under the relief-from-royalty method. Under the relief-from-royalty method, the Company’s significant assumptions include the forecasted future revenues and the estimated royalty rate, expressed as a percentage of revenues. Based on the quantitative impairment test performed and the result of changes in forecasted revenues and the valuation assumption around future royalty rates, the Company concluded that the Waterworks reporting unit tradename was impaired as of February 2, 2019. As a result, the Company recognized a $14.6 million non-cash impairment with respect to the tradename for the Waterworks reporting unit in fiscal 2018, which was recorded in goodwill and tradename impairment on the consolidated statements of income. The remaining tradename balance of the Waterworks reporting unit was $37.5 million as of February 2, 2019.

Long-Lived Assets

Long-lived assets, such as property and equipment and intangible assets subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Conditions that may indicate impairment include, but are not limited to, a significant adverse change in customer demand or business climate that could affect the value of an asset, a product recall or an adverse action or assessment by a regulator. If the sum of the estimated undiscounted future cash flows related to the asset is less than the carrying value, the Company recognizes a loss equal to the difference between the carrying value and the fair value, usually determined by the estimated discounted cash flow analysis of the assets.

Since there is typically no active market for the Company’s long-lived tangible assets, the Company estimates fair values based on the expected future cash flows of the asset or asset group, using a discount rate commensurate with the related risk. The asset group is defined as the lowest level for which identifiable cash flows are available and largely independent of the cash flows of other groups of assets, which for the stores is the individual gallery level. The Company estimates future cash flows based on gallery-level historical results, current trends, and operating and cash flow projections. The Company’s estimates are subject to uncertainty and may be affected by a number of factors outside its control, including general economic conditions and the competitive environment. While the Company believes its estimates and judgments about future cash flows are reasonable, future impairment charges may be required if the expected cash flow estimates, as projected, do not occur or if events change requiring the Company to revise its estimates.

The Company did not record impairment for long-lived tangible assets at the individual gallery level in fiscal 2018, fiscal 2017 or fiscal 2016. Due to certain distribution center closures and business line integrations in fiscal 2018, fiscal 2017 and fiscal 2016, the Company recorded impairment for certain corporate assets and other long-lived assets in fiscal 2018, fiscal 2017 and fiscal 2016, as discussed below under “Distribution Center Closures,” “Asset Held for Sale” and “RH Contemporary Art Impairment.” No additional impairment has been recorded for corporate assets and other long-lived assets in fiscal 2018, fiscal 2017 and fiscal 2016.

Distribution Center Closures

During the third quarter of fiscal 2018, the Company initiated and executed a plan to close its distribution center located in Essex, MD. As a result of the distribution center closure, the Company incurred restructuring related costs in the RH Segment in fiscal 2018, including a lease loss liability of $2.2 million, loss on disposal of capitalized property and equipment of $0.2 million, as well as costs for employee termination benefits of $0.2 million. The impact to selling, general and administrative expenses on the consolidated statements of income was $2.6 million, which represents the total charges expected to be incurred with this distribution center closure.

During the third quarter of fiscal 2017, the Company initiated a plan to close two of its distribution centers, one located in Mira Loma, CA and one located in Dallas, TX. The Mira Loma distribution center closure was finalized in November 2017 and the Dallas distribution center closure was finalized in January 2018, both of which occurred in the fourth quarter of fiscal 2017. As a result of the distribution center closures, the Company incurred restructuring related costs in the RH Segment in fiscal 2017, including loss on disposal of capitalized property and equipment and lease loss liability of $2.1 million, as well as costs for employee termination benefits of $0.9 million. The total expense of $3.0 million was included in selling, general and administrative expenses on the consolidated statements of income.

During the first quarter of fiscal 2018, the Company decreased the lease loss liability associated with the Dallas distribution center closure by $1.2 million primarily due to the remeasurement of the lease loss liability resulting from a sublease agreement entered into by the Company in April 2018 that resulted in an update to both the timing and the terms of future lease-related cash inflows. The Company does not expect to incur additional charges in the future associated with this distribution center closures.

As of February 2, 2019 and February 3, 2018, the Company’s lease loss liability associated with all distribution center closures, which is estimated as the net present value of the difference between lease payments and receipts under sublease agreements, was $2.2 million and $2.6 million, respectively, and is included in other non-current obligations on the consolidated balance sheets.

The distribution center lease loss liability activity in fiscal 2018 and fiscal 2017 was as follows (in thousands):

	Year Ended
	February 2,			February 3,
	2019			2018
Balance at beginning of fiscal year	$	2,585		$	—
Lease loss liability additions		1,927			2,447
Lease loss liability remeasurements		(1,232	)		—
Payments made under lease agreements		(6,041	)		(583	)
Payments received under sublease agreements		4,904			716
Interest		34			5
Balance at end of fiscal year	$	2,177		$	2,585

Asset Held for Sale

An asset is considered to be held for sale when all of the following criteria are met:

•

Management commits to a plan to sell the property;

•

It is unlikely that the disposal plan will be significantly modified or discontinued;

•

The property is available for immediate sale in its present condition;

•

Actions required to complete the sale of the property have been initiated;

•

Sale of the asset is probable and the completed sale is expected to occur within one year; and

•

The property is actively being marketed for sale at a price that is reasonable given its current market value.

Upon designation as an asset held for sale, the carrying value of the asset is recorded at the lower of its carrying value or its estimated fair value less estimated costs to sell, and the Company ceases depreciating the asset.

During the fourth quarter of fiscal 2016, the Company committed to a plan to sell an aircraft, which resulted in a reclassification of such aircraft from property and equipment to asset held for sale on the consolidated balance sheets. The Company performed an assessment and determined that based on management’s best estimate of the selling price of the aircraft as of January 28, 2017, it had an impairment of $4.8 million in fiscal 2016 in the RH Segment. Such impairment charge is included in selling, general and administrative expenses on the consolidated statements of income. In April 2017, the sale of the aircraft was completed for a purchase price of $5.2 million and the Company incurred additional costs of $0.3 million to dispose of the asset.

RH Contemporary Art Impairment

During the fourth quarter of fiscal 2016, the Company initiated and executed a plan to integrate the RH Contemporary Art (“RHCA”) product line into the broader RH platform and no longer operates RHCA as a separate division. As a result, the Company incurred restructuring related costs in the RH Segment, including loss on disposal of capitalized property and equipment of $5.5 million, lease loss liability of $3.2 million, inventory impairment of $2.7 million and other associated costs of $0.3 million. The Company did not incur any costs for employee termination benefits associated with the integration. The impact to cost of goods sold and selling, general and administrative expenses on the consolidated statements of income in fiscal 2016 was $1.1 million and $10.6 million, respectively.

During the third quarter of fiscal 2018 and the fourth quarter of fiscal 2017, the Company recorded expense of $3.4 million and $4.4 million, respectively, in the RH Segment related to the remeasurement of the lease loss liability for RHCA resulting from an update to both the timing and the amount of future estimated lease related cash inflows based on present market conditions, which is included in selling, general and administrative expenses on the consolidated statements of income.

As of February 2, 2019 and February 3, 2018, the Company’s lease loss liability associated with the RHCA impairment, which is estimated as the net present value of the difference between lease payments and receipts under sublease agreements, was $9.8 million and $7.1 million, respectively, and is included in other non-current obligations on the consolidated balance sheets.

The RHCA lease loss liability activity in fiscal 2018 and fiscal 2017 was as follows (in thousands):

	Year Ended
	February 2,			February 3,
	2019			2018
Balance at beginning of fiscal year	$	7,100		$	3,188
Lease loss liability remeasurement		3,411			4,417
Payments made under lease agreement		(2,249	)		(1,699	)
Payments received under sublease agreement		1,138			1,003
Interest		415			191
Balance at end of fiscal year	$	9,815		$	7,100

Lease Accounting

The Company leases stores, distribution facilities, office space and, less significantly, certain machinery and equipment. The Company classifies leases at the inception of the lease as a capital lease or an operating lease.

Build-to-Suit Lease Transactions

The Company is sometimes involved in the construction of leased stores, which, depending on the extent to which it is involved, the Company may be the “deemed owner” of the leased premises for accounting purposes during the construction period pursuant to ASC 840—Leases. If the Company is the “deemed owner” for accounting purposes, upon commencement of the construction project, it is required to capitalize the cash and non-cash assets contributed by the landlord for construction as property and equipment on its consolidated balance sheets. 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 due to build-to-suit lease transactions 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 does not have any forms of “continuing involvement” and therefore can remove the assets and related liabilities from its consolidated balance sheets. If the assets and related liabilities cannot be removed from the Company’s consolidated balance sheets, the Company accounts for the transactions as a financing lease. These lease transactions are referred to as build-to-suit lease transactions.

Rent expense relating to the land is recognized on a straight-line basis once construction begins, which is determined using the fair value of the leased land at construction commencement and the Company’s incremental borrowing rate. Once cash payments commence under the lease, all amounts in excess of land rent expense are recorded as a debt-service payment and are recognized as interest expense and a reduction of the financing obligation.

Similar to capital leases, the expense recorded within the consolidated statements of income over the lease term is equal to the cash rent payments made under the lease. The primary difference in the consolidated statements of income between build-to-suit lease transactions and operating leases is the timing of recognition and the classification of expenses. Expenses related to operating leases are classified as rent expense compared to expenses related to build-to-suit lease transactions which are classified as a combination of rent expense, depreciation expense and interest expense.

Operating and Capital Leases

In a capital or an operating lease, the expected lease term begins with the date that the Company takes possession of the equipment or the leased space for construction and other purposes. The expected lease term may also include the exercise of renewal options if the exercise of the option is determined to be reasonably assured. The expected term is also used in the determination of whether a store is a capital or operating lease.

Certain of the Company’s property and equipment are held under capital leases. These assets are included in property and equipment and depreciated over the lesser of the useful life of the asset or the lease term. For buildings held under capital leases, unless the fair value of the land at lease inception exceeds 25% of the aggregate fair value of the leased land and buildings, rent payments under the leases are recognized using the effective interest method as a reduction of the capital lease obligation and interest expense. Pursuant to ASC 840, at lease inception, if the fair value of the underlying land exceeds 25% of the fair value of the real estate (land and buildings), the Company allocates a portion of the cash payments under the lease to land rent expense equal to the product of the fair value of the leased land at construction commencement and the Company’s incremental borrowing rate. The remaining cash payment is treated as debt-service payments and recognized as interest expense and a reduction of the capital lease obligation.

All other leases are considered operating leases in accordance with ASC 840. Assets subject to an operating lease and the related lease payments are not recorded on the consolidated balance sheets. For leases that contain lease incentives, premiums and minimum rent expenses, the Company recognizes rent expense on a straight-line basis over the lease term. Tenant improvement allowances received from landlords under operating leases are recorded in deferred rent and lease incentives on the consolidated balance sheets, and are amortized on a straight-line basis over the lease term.

Debt Issuance Costs

Debt issuance costs related to debt, excluding the asset based credit facility, are recorded as a contra-liability and are presented net against the respective debt balance on the consolidated balance sheets. Debt issuance costs are amortized utilizing the effective interest method over the expected life of the respective debt. Such amortization is included in interest expense–net on the consolidated statements of income.

Deferred financing fees related to the asset based credit facility are included in non-current assets on the consolidated balance sheets. Deferred financing fees related to the asset based credit facility are amortized utilizing the straight-line method. Such amortization is included in interest expense–net on the consolidated statements of income.

Revenue Recognition

The Company recognizes revenues and the related cost of goods sold when a customer obtains control of the merchandise, which is when the customer has the ability to direct the use of and obtain the benefits from the merchandise. Revenue recognized for merchandise delivered via the home-delivery channel is recognized upon delivery. Revenues recognized for merchandise delivered via all other delivery channels are recognized upon shipment. Revenues from “cash-and-carry” store sales are recognized at the point of sale in the store. Discounts or other accommodations provided to customers are accounted for as a reduction of sales.

The Company recognizes shipping and handling fees as activities to fulfill the promise to transfer the merchandise to customers. The Company applies this policy consistently across all of its distribution channels. In instances where revenue is recognized for the related merchandise upon delivery to customers, the related costs of shipping and handling activities are accrued for in the same period. In instances where revenue is recognized for the related merchandise prior to delivery to customers (i.e., revenue recognized upon shipment), the related costs of shipping and handling activities are accrued for in the same period. Costs of shipping and handling are included in cost of goods sold.

Sales tax collected is not recognized as revenue but is included in accounts payable and accrued expenses on the consolidated balance sheets as it is ultimately remitted to governmental authorities.

The Company reserves for projected merchandise returns. Merchandise returns are often resalable merchandise and are refunded by issuing the same payment tender of the original purchase. Merchandise exchanges of the same product and price are not considered merchandise returns and, therefore, are excluded when calculating the sales returns reserve.

The Company’s customers may return purchased items for a refund. The Company provides an allowance for sales returns based on historical return rates, which is presented on a gross basis. The allowance for sales returns is presented within other current liabilities and the estimated value of the right of return asset for merchandise is presented within prepaid expense and other assets on the consolidated balance sheets.

A summary of the allowance for sales returns is as follows (in thousands):

	Year Ended
	February 2,			February 3,			January 28,
	2019			2018			2017
Balance at beginning of fiscal year	$	10,565		$	10,077		$	12,688
Waterworks acquisition—beginning balance		—			—			523
Impact of Topic 606 adoption		5,862			—			—
Provision for sales returns		112,218			108,134			106,508
Actual sales returns		(108,824	)		(107,646	)		(109,642	)
Balance at end of fiscal year	$	19,821		$	10,565		$	10,077

Refer to “Revenue from Contracts with Customers” below for the impact of Topic 606 on the Company, which was effective in the first quarter of fiscal 2018.

Deferred Revenue and Customer Deposits

The Company defers revenue associated with merchandise delivered via the home-delivery channel. In instances where the Company recognizes revenue when the merchandise is delivered to customers, it is included as deferred revenue on the consolidated balance sheets while in-transit. Deferred revenue also includes the unrecognized portion of the annual RH Members Program fee. New membership fees are recorded as deferred revenue when collected from customers and recognized as revenue based on expected product revenues over the annual membership period, based on historical trends of sales to members. Membership renewal fees are recorded as deferred revenue when collected from customers and are recognized as revenue on a straight-line basis over the membership period, or one year.

Customer deposits represent payments made by customers on custom orders. At the time of purchase the Company collects deposits for all custom orders equivalent to 50% of the customer purchase price. Custom order deposits are recognized as revenue when the customer obtains control of the merchandise.

Refer to “Revenue from Contracts with Customers” below for the impact of Topic 606 on the Company, which was effective in the first quarter of fiscal 2018.

Gift Cards and Merchandise Credits

The Company sells gift cards and issues merchandise credits to its customers in its stores and through its websites and product catalogs. Such gift cards and merchandise credits do not have expiration dates. The Company recognizes breakage associated with gift cards and merchandise credits proportional to actual gift card redemptions. Breakage of $1.5 million was recorded in net revenues in fiscal 2018. Breakage resulted in a reduction of selling, general and administrative expenses on the consolidated statements of income of $3.0 million in both fiscal 2017 and fiscal 2016. Refer to “Revenue from Contracts with Customers” below for the impact of Topic 606 on the Company, which was effective in the first quarter of fiscal 2018.

Self Insurance

The Company maintains insurance coverage for significant exposures, as well as those risks that, by law, must be insured. In the case of the Company’s health care coverage for employees, the Company has a managed self insurance program related to claims filed. Expenses related to this self insured program are computed on an actuarial basis, based on claims experience, regulatory requirements, an estimate of claims incurred but not yet reported (“IBNR”) and other relevant factors. The projections involved in this process are subject to uncertainty related to the timing and amount of claims filed, levels of IBNR, fluctuations in health care costs and changes to regulatory requirements. The Company had liabilities of $2.0 million and $2.7 million related to health care coverage as of February 2, 2019 and February 3, 2018, respectively.

The Company carries workers’ compensation insurance subject to a deductible amount for which the Company is responsible on each claim. The Company had liabilities of $3.3 million related to workers’ compensation claims, primarily for claims that do not meet the per-incident deductible, as of both February 2, 2019 and February 3, 2018.

Stock-Based Compensation

The Company recognizes the fair value of stock-based compensation in the consolidated financial statements as compensation expense over the requisite service period. For service-only awards, compensation expense is recognized on a straight-line basis, net of forfeitures, over the requisite service period for the fair value of awards that actually vest. Fair value for restricted stock units is valued using the closing price of the Company’s stock on the date of grant. The fair value of each option award granted under the Company’s award plan is estimated on the date of grant using a Black-Scholes Merton option pricing model (“OPM”) which requires the input of subjective assumptions regarding the expected term, expected volatility, dividend yield and risk-free interest rate. The Company elected to calculate the expected term of the option awards using the “simplified method.” This election was made based on the lack of sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term. Under the “simplified” calculation method, the expected term is calculated as an average of the vesting period and the contractual life of the options.

Cost of Goods Sold

Cost of goods sold includes, but is not limited to, the direct cost of purchased merchandise, inventory shrinkage, inventory reserves and write-downs, inbound freight, all freight costs to get merchandise to the Company’s stores, design and buying costs, occupancy costs related to store operations and supply chain, such as rent, property tax and common area maintenance, depreciation and amortization, and all logistics costs associated with shipping product to customers.

Selling, General and Administrative Expenses

Selling, general and administrative expenses include all operating costs not included in cost of goods sold. These expenses include payroll and payroll related expenses, store expenses other than occupancy, and expenses related to many of the Company’s operations at its corporate headquarters, including utilities, depreciation and amortization, credit card fees and marketing expense, which primarily includes catalog production, mailing and print advertising costs. All store pre-opening costs are included in selling, general and administrative expenses and are expensed as incurred.

Net Income Per Share

Basic net income per share is computed as net income divided by the weighted-average number of common shares outstanding for the period. Diluted net income per share is computed as net income divided by the weighted-average number of common shares outstanding for the period, common share equivalents under equity plans using the treasury-stock method and the calculated common share equivalents in excess of the respective conversion rates related to each of the convertible senior notes. Potential dilutive securities are excluded from the computation of diluted net income per share if their effect is anti-dilutive.

Treasury Stock

The Company records its purchases of treasury stock at cost as a separate component of stockholders’ equity (deficit). Upon retirement of treasury stock, the Company allocates the excess of the purchase price over par value to additional paid-in capital subject to certain limitations with any remaining purchase price allocated to retained earnings.

Income Taxes

The Company accounts for income taxes under an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. In estimating future tax consequences, the Company generally takes into account all expected future events then known to it, other than changes in the tax law or rates which have not yet been enacted and which are not permitted to be considered. Accordingly, the Company may record a valuation allowance to reduce its net deferred tax assets to the amount that is more-likely-than-not to be realized. The determination as to whether a deferred tax asset will be realized is made on a jurisdictional basis and is based upon management’s best estimate of the recoverability of the Company’s net deferred tax assets. Future taxable income and ongoing prudent and feasible tax planning are considered in determining the amount of the valuation allowance, and the amount of the allowance is subject to adjustment in the future. Specifically, in the event the Company were to determine that it is not more-likely-than-not able to realize its net deferred tax assets in the future, an adjustment to the valuation allowance would decrease income in the period such determination is made. This allowance does not alter the Company’s ability to utilize the underlying tax net operating loss and credit carryforwards in the future, the utilization of which is limited to achieving future taxable income.

The accounting standard for uncertainty in income taxes prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues. Differences between tax positions taken in a tax return and amounts recognized in the financial statements generally result in an increase in liability for income taxes payable or a reduction of an income tax refund receivable, or a reduction in a deferred tax asset or an increase in a deferred tax liability, or both. The Company recognizes interest and penalties related to unrecognized tax benefits in tax expense.

The United States enacted the Tax Cuts and Jobs Act (the “Tax Act”) on December 22, 2017, which had a significant impact to the Company’s provision for income taxes as of February 2, 2019. The Tax Act includes a number of changes to existing U.S. tax laws that impact us, including the reduction of the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. The Tax Act also provides for a one-time transition tax on accumulated foreign earnings and the acceleration of depreciation for certain assets, as well as prospective changes beginning in 2018, including limitations on the deductibility of executive compensation and interest, the elimination of certain domestic deductions and credits, the elimination of the Alternative Minimum Tax regime, and modifications to the deductibility and carryforward period of net operating losses. The Tax Act transitions U.S. international taxation from a worldwide system to a modified territorial system and includes base erosion prevention measures on non-U.S. earnings, which may have the effect of subjecting certain earnings of the Company’s foreign subsidiaries to U.S. taxation. The Company’s provision for income taxes in fiscal 2017 included $7.0 million of income tax expense as a result of the Tax Act, including $6.0 million for the provisional re-measurement of the deferred tax assets for the reduction in the U.S. corporate income tax rate from 35% to 21% and a $1.0 million charge for the provisional estimate of the transition tax.

The Tax Act requires complex computations to be performed that were not previously required under U.S. tax law, significant judgments to be made in interpretation of the provisions of the Tax Act and significant estimates in calculations, and the preparation and analysis of information not previously relevant or regularly produced. The U.S. Treasury Department, the Internal Revenue Service, and other standard-setting bodies could interpret or issue guidance on how provisions of the Tax Act will be applied or otherwise administered that is different from the Company’s interpretation. The Company has completed its analysis of the Tax Act, and has not made material adjustments to the provisional amounts that the Company previously recorded.

Comprehensive Income

Comprehensive income is comprised of net income and other gains and losses affecting equity that are excluded from net income. The components of other comprehensive income consist of net gains (losses) on foreign currency translation and net unrealized holding gains (losses) on available-for-sale investments, both of which are presented net of tax.

Foreign Currency Translation

Local currencies are generally considered the functional currencies outside the United States. Assets and liabilities denominated in non-U.S. currencies are translated at the rate of exchange prevailing on the date of the consolidated balance sheets and revenues and expenses are translated at average rates of exchange for the period. The related translation gains (losses) are reflected in the accumulated other comprehensive income section of the consolidated statements of stockholders’ equity (deficit). Foreign currency gains (losses) resulting from foreign currency transactions are included in selling, general and administrative expenses on the consolidated statements of income and are not material for all periods presented.

Recently Issued Accounting Standards

Revenue from Contracts with Customers

In May 2014, the Financial Accounting Standards Board (“FASB”) and International Accounting Standards Board issued their converged accounting standards update on revenue recognition, Accounting Standards Update 2014-09—Revenue from Contracts with Customers (Topic 606). This guidance outlines a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that revenue is recognized when a customer obtains control of a good or service. A customer obtains control when it has the ability to direct the use of and obtain the benefits from the good or service. Under the new guidance, transfer of control is no longer the same as transfer of risks and rewards as indicated in the prior guidance.

Adoption and Accounting Policy

The Company adopted Topic 606, on February 4, 2018, using the modified retrospective transition method and recorded a decrease to opening retained earnings of $21.0 million, inclusive of the tax impact. Results reported within the Company’s condensed consolidated financial statements for reporting periods beginning February 4, 2018 are presented under Topic 606 while prior periods are not adjusted and continue to be reported in accordance with the Company’s historic accounting under ASC 605—Revenue Recognition (Topic 605).

Under Topic 606, changes were made to the recognition timing or classification of revenues and expenses for the following:

Description	Policy under Topic 605	Policy under Topic 606
Advertising expenses	Costs associated with Source Books were capitalized and amortized over their expected period of future benefit. Expense was amortized based upon the ratio of actual revenues to the total of actual and estimated future revenues on an individual Source Book basis, generally over a twelve-month period after they were mailed.	Costs associated with Source Books are expensed upon the delivery of the Source Books to the carrier. In the case of multiple printings of a Source Book, the creative costs will be expensed in full upon the initial delivery of Source Books to the carrier.
Gift card breakage	Recognized gift card breakage (amounts not expected to be redeemed) within selling, general and administrative expenses.	Recognize gift card breakage within net revenues proportional to actual gift card redemptions.
Membership revenue	Annual fees for new memberships in the RH Members Program and renewals were recorded as deferred revenue when collected from customers and recognized as revenue on a straight-line basis over the twelve month membership period.	Annual fees for new memberships in the RH Members Program are recorded as deferred revenue when collected from customers and recognized as revenue based on expected product revenues over the annual membership period, using historical trends of sales to members. RH Members Program renewal fees are recorded as deferred revenue when collected from customers and will continue to be recognized as revenue on a straight-line basis over the twelve month membership period.
Revenue recognition	Revenue for merchandise that is not delivered via the home-delivery channel was recognized upon delivery.	Revenue for merchandise that is not delivered via the home-delivery channel will be recognized upon shipment.
Allowance for sales returns	Recognized an allowance for sales returns as a net liability within other current liabilities.	Recognize an allowance for sales returns on a gross basis as a liability within other current liabilities and a right of return asset for merchandise within prepaid expense and other current assets.

Advertising expenses—The adoption of Topic 606 materially impacts the timing of recognizing advertising expense related to direct response advertising, including costs associated with the Company’s Source Books. Under Topic 606, the Company will recognize expense associated with the Source Books upon the delivery of the Source Books to the carrier. In the case of multiple printings of a Source Book, the creative costs will be expensed in full upon the initial delivery of Source Books to the carrier. Prior to adoption of Topic 606, costs associated with Source Books were capitalized and amortized over their expected period of future benefit. Such amortization was based upon the ratio of actual revenues to the total of actual and estimated future revenues on an individual Source Book basis. Each Source Book was generally fully amortized within a twelve-month period after they were mailed and the majority of the amortization occurred within the first five to nine months, with the exception of the Holiday Source Books, which were generally fully amortized within a three-month period after they were mailed. Upon adoption of Topic 606, capitalized costs associated with Source Books of $37.8 million that had been delivered to the carrier prior to or on February 3, 2018 were reclassified to retained earnings on the consolidated balance sheets, resulting in a decrease to the opening retained earnings balance.

Gift card breakage—Under Topic 606, the Company recognizes gift card breakage proportional to actual gift card redemptions and such breakage is recorded within net revenues on the condensed consolidated statements of income. Gift card breakage was previously recorded as a reduction to selling, general and administrative expenses when the likelihood of redemption was remote. Upon adoption of Topic 606, gift card liabilities of $6.0 million were reclassified to retained earnings on the consolidated balance sheets, resulting in an increase to the opening retained earnings balance.

Membership revenue—Under Topic 606, the annual fee for new memberships in the RH Members Program is recorded as deferred revenue when collected from customers and recognized as revenue based on expected product revenues over the annual membership period, using historical trends of sales to members. Prior to the adoption of Topic 606, new memberships were recorded as deferred revenue when collected from customers and recognized as revenue on a straight-line basis over the twelve month membership period. This will result in a majority of revenue being recognized during the first six months of the membership period. The adoption of Topic 606 will not have an impact on membership renewal fees, which will continue to be recognized as revenue on a straight-line basis over the twelve month membership period, until the Company has more information regarding membership renewal purchasing trends. Upon adoption of Topic 606, deferred membership revenue of $3.8 million was reclassified to retained earnings on the consolidated balance sheets, resulting in an increase to the opening retained earnings balance.

Revenue recognition—Under Topic 606, the Company will continue to recognize revenue for merchandise delivered via the home-delivery channel upon delivery. Under Topic 606, revenue for merchandise delivered via all other delivery channels will be recognized upon shipment, whereas previously such revenue was recognized upon delivery. Upon adoption of Topic 606, deferred revenue (net of cost of goods sold) of $1.3 million was reclassified to retained earnings on the consolidated balance sheets, resulting in an increase to the opening retained earnings balance.

The Company adopted the practical expedient related to shipping and handling activities. Under this option, in instances where revenue is recognized for the related merchandise prior to delivery to customers (i.e., revenue recognized upon shipment), the related costs of shipping and handling activities will be accrued for in the same period. Costs of shipping and handling continue to be included in cost of goods sold.

Allowance for sales returns—In connection with adoption of Topic 606, the Company is required to recognize its allowance for sales returns on a gross basis rather than as a net liability. Upon adoption, this resulted in an increase to prepaid and other current assets (“right of return asset for merchandise”), with a corresponding increase to other current liabilities on the consolidated balance sheets, and did not impact the consolidated statements of income. As of February 2, 2019, the right of return asset for merchandise was $5.9 million.

Sales tax collection from customers—Under Topic 606, the Company has not changed its policy regarding sales tax collected from customers. Sales tax collected is not recognized as revenue but is included in accounts payable and accrued expenses on the consolidated balance sheets as it is ultimately remitted to governmental authorities.

In connection with adoption of Topic 606, the Company recorded a $6.6 million tax adjustment associated with the charges listed above to retained earnings on the consolidated balance sheets, resulting in an increase to the opening retained earnings balance.

Contract Liabilities

The Company defers revenue associated with merchandise delivered via the home-delivery channel. As the Company recognizes revenue when the merchandise is delivered to its customers, it is included as deferred revenue on the consolidated balance sheets while in-transit. Customer deposits represent payments made by customers on custom orders. At the time of order placement the Company collects deposits for all custom orders equivalent to 50% of the purchase price. Custom order deposits are recognized as revenue when a customer obtains control of the merchandise. In addition, the Company collects annual membership fees related to the RH Members Program. New membership fees are recorded as deferred revenue when collected from customers and recognized as revenue based on expected product revenues over the annual membership period, using historical trends of sales to members. Membership renewal fees are recorded as deferred revenue when collected from customers and are recognized as revenue on a straight-line basis over the membership period, or one year. The Company expects that substantially all of the deferred revenue, customer deposits and deferred membership fees as of February 2, 2019 will be recognized within the next six months as the performance obligations are satisfied.

In addition, the Company defers revenue when cash payments are received in advance of performance for unsatisfied obligations related to its gift cards and merchandise credits. Customer liabilities related to gift cards and merchandise credits was $17.2 million and $24.1 million as of February 2, 2019 and February 3, 2018, respectively. As discussed above, $6.0 million of the decrease was due to the reclassification of gift card liabilities to retained earnings upon adoption of Topic 606. During fiscal 2018, the Company recognized $21.6 million of revenue related to previous deferrals related to its gift cards and merchandise credits and recorded gift card breakage of $1.5 million. The Company expects that approximately 70% of the remaining gift card and merchandise credit liabilities will be recognized when the gift cards are redeemed by customers.

Disaggregated Revenue

The Company recognizes revenue from its stores and direct sales channels. Stores net revenues represent sales originating in retail stores, including Waterworks showrooms, and outlet stores. Direct net revenues include sales originating from the Company’s Source Books, websites, and phone orders, including its Contract business and a portion of its Trade business. During fiscal 2018, net revenues recognized from the stores and direct sales channels were $1,412.1 million and $1,093.5 million, respectively.

Adoption Impact on Fiscal 2018 Results

The following tables summarize the impact of adopting Topic 606 on the Company’s consolidated statement of income (in thousands):

	Year Ended February 2, 2019
	As Reported		Adjustments			Balances without Adoption of Topic 606
Net revenues	$	2,505,653	$	(9,868	)	$	2,495,785
Cost of goods sold		1,504,806		(3,485	)		1,501,321
Gross profit		1,000,847		(6,383	)		994,464
Selling, general and administrative expenses		711,617		(2,616	)		709,001
Income from operations		289,230		(3,767	)		285,463
Other expenses
Interest expense—net		75,074		—			75,074
Goodwill and tradename impairment		32,086		—			32,086
Loss on extinguishment of debt		917		—			917
Total other expenses		108,077		—			108,077
Income before income taxes		181,153		(3,767	)		177,386
Income tax expense		30,514		(3,945	)		26,569
Net income	$	150,639	$	178		$	150,817

The following table summarizes the impact of adopting Topic 606 on certain line items of the Company’s consolidated balance sheet (in thousands):

	As of February 2, 2019
	As Reported			Adjustments			Balances without Adoption of Topic 606
Prepaid expense and other current assets	$	104,719		$	33,587		$	138,306
Deferred tax assets		30,033			(6,561	)		23,472
Accounts payable and accrued expenses		320,441			(686	)		319,755
Deferred revenue and customer deposits		152,595			9,304			161,899
Other current liabilities		101,347			(2,806	)		98,541
Accumulated deficit		(376,810	)		21,214			(355,596	)

Leases

In February 2016, the FASB issued Accounting Standards Update 2016-02—Leases, which requires a lessee to recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in its balance sheet. The standard also requires a lessee to recognize a single lease cost for operating leases, calculated so that the cost of the lease is allocated over the lease term, generally on a straight-line basis. In July 2018, the FASB issued Accounting Standards Update 2018-10—Codification Improvements to Topic 842 (Leases), and Accounting Standards Update 2018-11—Leases (Topic 842)—Targeted Improvements, which (i) narrows amendments to clarify how to apply certain aspects of the new lease standard, (ii) provides entities with an additional transition method to adopt the new standard, and (iii) provides lessors with a practical expedient for separating components of a contract. Accounting Standards Update 2016-02, Accounting Standards Update 2018-10 and Accounting Standards Update 2018-11 are collectively referred to the “ASUs.”

The ASUs are effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company adopted the ASUs, in the first quarter of fiscal 2019, using a retrospective approach and will apply the new accounting standard to each prior reporting period presented. The Company continues to evaluate the effects that the adoption of this guidance will have on its consolidated financial statements and anticipates the new guidance will significantly impact its consolidated financial statements given that the Company has a significant number of leases. Additionally, the Company anticipates that the new guidance will impact its internal controls over financial reporting, including new processes and internal controls that may be required to comply with the new lease accounting and disclosure requirements set by the new standard.

The Company continues to assess all potential impacts of the ASUs. The Company plans to elect to adopt the package of transition practical expedients, which permits the Company not to reassess its prior conclusions regarding lease identification, lease classification and initial direct costs. The Company does not expect to apply the hindsight practical expedient upon adoption. The Company plans to adopt the policy election to not separate lease and non-lease components for certain asset classes, as well as the short-term lease policy election offered under the ASUs.

The adoption of the ASUs will have a material impact on the Company’s consolidated balance sheets due to the initial recognition of right of use (“ROU”) assets and lease liabilities for the Company’s operating and finance lease arrangements, which will be partially offset by the derecognition of existing assets and financing obligations related to build-to-suit lease transactions.

The Company anticipates the adoption will have a material impact on its consolidated statements of income, specifically cost of goods sold and interest expense—net, primarily due to the change from build-to-suit lease transactions under the previous accounting guidance to the new finance lease classification treatment. The finance lease classification for these leases will generally result in a higher expense than the corresponding cash payments at the beginning of the lease term and will decline over the lease term as the liability is reduced. The ROU asset amortization portion of the expense will be recorded within cost of goods sold and the debt service (interest portion) will be recorded within interest expense—net. Additionally, the Company expects the adoption will impact its selling, general, and administrative expenses and income tax expense.

Variable lease payments, such as percent rent and rent escalations not known upon lease commencement, are not included in the determination of the minimum lease payments to recognize the ROU assets and lease liabilities, and will be expensed as incurred.

The Company expects the adoption will impact its consolidated statement of cash flows due to the effects of the finance lease classification for certain of its leases, as the guidance requires the cash payments for the principal portion of the lease to be presented in financing activities and the cash payments for the interest portion to be presented within operating activities.

As mentioned above, the adoption of the ASUs will result in the derecognition of the build-to-suit property asset (included in property and equipment—net) and the financing obligations under build-to-suit lease transactions on the consolidated balance sheets as follows (in thousands):

	February 2,		February 3,
	2019		2018
Build-to-suit property	$	245,217	$	237,909
Financing obligations under build-to-suit lease transactions		228,928		229,323

The Company preliminarily expects the adoption to result in the following amounts being recorded on its consolidated balance sheets for its operating and finance leases (in millions):

	February 2,	February 3,
	2019	2018
ROU assets	$1,090 - $1,190	$930 - $1,030
Lease liabilities	$880 - $980	$750 - $850

The above amounts are inclusive of a reclassification from leasehold improvement (included in property and equipment—net) to ROU assets in the range of approximately $250 million to $300 million as of February 2, 2019 and approximately $200 million to $250 million as of February 3, 2018, as well as a reclassification of deferred rent and lease incentives related to operating leases to ROU assets of $48.0 million and $48.9 million as of February 2, 2019 and February 3, 2018, respectively.

The Company is in the process of finalizing the impact of adopting the ASUs on retained earnings as of January 28, 2017, the earliest prior reporting period presented, but preliminarily expects the retrospective adoption to increase opening retained earnings within the consolidated balance sheets.

Financial Instruments

In January 2016, the FASB issued Accounting Standards Update 2016-01—Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which amends various aspects of the recognition, measurement, presentation and disclosure for financial instruments. The new standard is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted only for certain provisions. The Company adopted this new accounting standard in the first quarter of fiscal 2018 and such adoption did not have an impact on its consolidated financial statements.

Cash Flow: Classification and Restricted Cash

In August 2016, the FASB issued Accounting Standards Update No. 2016-15—Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The new guidance addresses eight specific cash flow issues with the objective of reducing existing diversity in practice regarding the manner in which certain cash receipts and payments are presented and classified in the consolidated statements of cash flows. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. The Company adopted this new accounting standard in the first quarter of fiscal 2018 which resulted in a change to the presentation of the loss on early extinguishment of debt on the consolidated statement of cash flows for fiscal 2017. Adoption of this new accounting standard resulted in an increase in the loss on extinguishment of debt amount in cash flows from operating activities of $3.0 million and an increase in repayments under term loans in cash flows from financing activities of $3.0 million for fiscal 2017.

In November 2016, the FASB issued Accounting Standards Update No. 2016-18—Statement of Cash Flows (Topic 230): Restricted Cash. The new guidance requires that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts on the statement of cash flows. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. Adoption of the standard will be applied using a retrospective transition method to each period presented. The Company adopted this new accounting standard in the first quarter of fiscal 2018 which resulted in a change to the presentation of the construction related deposits on the consolidated statement of cash flows. The Company considers the construction related deposits (included in other non-current assets on the consolidated balance sheets) to be “restricted cash equivalents” and therefore, under the new accounting guidance, is required to include such deposits in beginning and ending “cash and cash equivalents and restricted cash equivalents” on the consolidated statement of cash flows. Previously, funding of the construction related deposit accounts was included within the “investing” section of the consolidated statement of cash flows and usage of the deposits was presented as a non-cash transaction. Under the new accounting guidance, funding of the construction related deposit accounts will not be presented on the consolidated statement of cash flows and the usage of the deposits will be presented within the “capital expenditures” line item under the “investing” section. Adoption of this new accounting standard resulted in an increase of the beginning and ending “cash and cash equivalents and restricted cash equivalents” amounts of $28.0 million and $7.4 million, respectively, as well as resulted in an increase in capital expenditures of $33.7 million and a decrease in construction related deposits of $14.4 million in cash flows from investing activities, and resulted in an increase in prepaid expense and other assets of $1.3 million in cash flows from operating activities for fiscal 2017. Adoption of this new accounting standard resulted in an increase of the beginning and ending “cash and cash equivalents and restricted cash equivalents” amounts of $15.4 million and $28.0 million, respectively, as well as resulted in an increase in capital expenditures of $12.4 million and a decrease in construction related deposits of $23.4 million in cash flows from investing activities, and resulted in a decrease in prepaid expense and other assets of $1.6 million in cash flows from operating activities for fiscal 2016.

Income Taxes: Intra-Entity Asset Transfers

In October 2016, the FASB issued Accounting Standards Update No. 2016-16—Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory. The new guidance requires the recognition of the income tax consequences of an intercompany asset transfer, other than transfers of inventory, when the transfer occurs. For intercompany transfers of inventory, the income tax effects will continue to be deferred until the inventory has been sold to a third party. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. The Company adopted this new accounting standard in the first quarter of fiscal 2018 and such adoption did not have an impact on its consolidated financial statements.

Stock-Based Compensation

In May 2017, the FASB issued Accounting Standards Update No. 2017-09—Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting. The new guidance clarifies when modification accounting should be applied for changes to terms or conditions of a share-based payment award. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within that reporting period, with early adoption permitted. The standard will be applied prospectively. The Company adopted this new accounting standard in the first quarter of fiscal 2018 and such adoption did not have an impact on its consolidated financial statements.

Cloud Computing

In August 2018, the FASB issued Accounting Standards Update 2018-15—Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement that is a Service Contract, which amends Accounting Standards Update 2015-05—Customers Accounting for Fees in a Cloud Computing Agreement. The amendments in this ASU more closely align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal use software license). The ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effects that the adoption of this new accounting standard will have on its consolidated financial statements.

Commitments and Contingencies

The Company reviews the need for any loss contingency reserves and establishes reserves when, in the opinion of management, it is probable that a matter would result in liability, and the amount of loss, if any, can be reasonably estimated. Generally, in view of the inherent difficulty of predicting the outcome of those matters, particularly in cases in which claimants seek substantial or indeterminate damages, it is not possible to determine whether a liability has been incurred or to reasonably estimate the ultimate or minimum amount of that liability until the case is close to resolution, in which case no reserve is established until that time. When and to the extent that the Company does establish a reserve, there can be no assurance that any such recorded liability for estimated losses will be for the appropriate amount, and actual losses could be higher or lower than what the Company accrues from time to time. The Company believes that the ultimate resolution of its current matters will not have a material adverse effect on its consolidated financial statements.