Quarterly report pursuant to Section 13 or 15(d)

Summary of Significant Accounting Policies (Policies)

v3.19.2
Summary of Significant Accounting Policies (Policies)
 6 Months Ended
Jun. 30, 2019
Accounting Policies [Abstract]  
Basis of Presentation Basis of Presentation – The accompanying condensed consolidated financial statements of Sonic Automotive, Inc. and its wholly owned subsidiaries (“Sonic,” the “Company,” “we,” “us” and “our”) for the three and six months ended June 30, 2019 and 2018 are unaudited and have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information and applicable rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The accompanying unaudited condensed consolidated financial statements reflect, in the opinion of management, all material normal recurring adjustments necessary to fairly state the financial position, results of operations and cash flows for the periods presented. The operating results for interim periods are not necessarily indicative of the results to be expected for the entire fiscal year or future interim periods, because the first quarter historically has contributed less operating profit than the second, third and fourth quarters. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes thereto included in Sonic’s Annual Report on Form 10-K for the year ended December 31, 2018.
Recent Accounting Pronouncements
Recent Accounting Pronouncements – In February 2016, the Financial Accounting Standards Board (the “FASB”) established Accounting Standards Codification (“ASC”) 842, “Leases,” by issuing Accounting Standards Update (“ASU”) 2016-02 (and subsequent amendments via ASU 2018-01, ASU 2018-10 and ASU 2018-11) in order to increase transparency and comparability among organizations by recognizing operating lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. Prior to adoption of the new lease standard, only leases classified as capital leases under ASC 840, “Leases,” were recorded in the consolidated balance sheets. Under ASC 842, “Leases,” an entity must classify leases as either finance leases (formerly capital leases) or operating leases, and a right-of-use asset (“ROU asset”) and lease liability are required to be recognized in the consolidated balance sheets for both finance and operating leases with a term longer than 12 months. The new lease standard requires a modified retrospective transition approach and provides an optional transition method to either (1) record current existing leases as of the effective date; or (2) record leases existing as of the earliest comparative period presented in the financial statements by recasting comparative period financial statements. We adopted the new lease standard as of January 1, 2019 using the effective date as our date of application. As such, financial statement information and disclosures required under the new lease standard have not been provided for dates and periods prior to January 1, 2019. The new lease standard provides for a number of optional practical expedients in transition, which include: (1) not requiring an entity to reassess prior conclusions about lease identification, lease classification or initial direct costs; (2) allowing an entity to use a portfolio approach for similar lease assets; (3) allowing an entity to elect an accounting policy to choose not to separate non-lease components of an agreement from lease components (by asset class); (4) allowing the use of hindsight in estimating lease term or assessing impairment of ROU assets; and (5) not requiring an entity to reassess prior conclusions about land easements. We have elected all of the practical expedients permitted under the transition guidance within the new lease standard. The new lease standard also provides practical expedients for ongoing accounting. We have elected the short-term lease recognition exemption for our real estate and equipment leases, which means that for those leases that qualify (less than 1-year term), we will not recognize ROU assets or lease liabilities. We have also elected not to separate non-lease components of an agreement from lease components (by asset class).
The cumulative effect of the adoption of ASC 842, “Leases,” on our unaudited condensed consolidated balance sheet as of January 1, 2019 was the recognition of ROU assets of approximately $406.9 million (including approximately $18.9 million related to capital leases that was reclassified from property and equipment, net in the accompanying unaudited condensed consolidated balance sheet as of December 31, 2018) and lease liabilities of approximately $419.5 million (including approximately $20.6 million related to capital leases that was reclassified from current maturities of long-term debt and long-term debt in the accompanying unaudited condensed consolidated balance sheet as of December 31, 2018). Upon adoption of ASC 842, “Leases,” we evaluated ROU assets for impairment and determined that approximately $10.5 million of impairment was required related to newly recognized ROU assets that would have been impaired in previous periods. This impairment of the ROU asset as of January 1, 2019 was recorded, net of related income tax effects, as a $7.4 million reduction of beginning retained earnings. The adoption of ASC 842, “Leases,” did not have a material effect on our unaudited condensed consolidated statements of income or our unaudited condensed consolidated statements of cash flows. The effect of the adoption of ASC 842, “Leases,” on our unaudited condensed consolidated balance sheets as of January 1, 2019 and June 30, 2019 was as follows:
Before Impact of ASC 842 Effects of Adoption of ASC 842 After Impact of ASC 842
December 31, 2018 January 1, 2019
Balance Sheet (In thousands)
Assets:
Property and Equipment, net $ 1,178,489  $ (18,948) $ 1,159,541 
Other Intangible Assets, net 69,705 (4,005) 65,700 
Right-of-Use Assets —  406,918  406,918 
Liabilities:
Current lease liabilities $ —  $ 48,832  $ 48,832 
Other accrued liabilities 257,823  (1,987) 255,836 
Long-Term Debt 918,779  (20,557) 898,222 
Long-Term Lease Liabilities —  370,647  370,647 
Other Long-Term Liabilities 75,887  (2,508) 73,379 
Deferred Income Taxes 33,178  (3,034) 30,144 
Stockholders' Equity:
Retained earnings $ 670,691  $ (7,428) $ 663,263 

Adoption
of ASC 842 as of
January 1, 2019		 New
Leases		 Modifications (1) Amortization As Reported June 30, 2019
(In thousands)
Right-of-Use Assets:
Finance Leases $ 18,948  $ 38  $ 21,514  $ (1,572) $ 38,928 
Operating Leases 387,970  —  (33,710) (20,735) 333,525 
Total Right-of-Use Assets $ 406,918  $ 38  $ (12,196) $ (22,307) $ 372,453 
Current Lease Liabilities:
Finance Leases $ 728  $ 3  $ 4,552  $ (133) $ 5,150 
Operating Leases 48,104  89  (1,615) (2,101) 44,477 
Total Current Lease Liabilities $ 48,832  $ 92  $ 2,937  $ (2,234) $ 49,627 
Long-Term Lease Liabilities:
Finance Leases $ 19,829  $ 35  $ 16,935  $ (579) $ 36,220 
Operating Leases 350,818  —  (32,200) (19,609) 299,009 
Total Long-Term Lease Liabilities $ 370,647  $ 35  $ (15,265) $ (20,188) $ 335,229 
(1) Includes the impact of remeasurements related to lease terminations and changes in assumptions around the probability of exercise of extension options.
Three Months Ended June 30, 2019 Six Months Ended June 30, 2019
Lease Expense (In thousands)
Finance lease expense:
Amortization of right-of-use assets $ 862  $ 1,572 
Interest on lease liabilities 1,339  2,515 
Operating lease expense (1) 17,057  35,054 
Short-term lease expense (1) 473  900 
Variable lease expense 683  797 
Sublease income (3,806) (7,384)
Total $ 16,608  $ 33,454 
(1) Included in operating cash flows in the accompanying unaudited condensed consolidated statements of cash flows.
Three Months Ended June 30, 2019 Six Months Ended June 30, 2019
(In thousands)
Other Information
Cash paid for amounts included in the measurement of lease liabilities:
      Financing cash flows for finance leases $ 502  $ 782 
      Operating cash flows for finance leases $ 1,339  $ 2,515 
      Operating cash flows for operating leases $ 18,315  $ 36,784 
Right-of-use assets obtained in exchange for lease liabilities:
      Finance leases $ 9,290  $ 19,273 
      Operating leases (1) $ 1,541  $ (9,170)

(1) Includes the impact of reclassification of right-of-use assets from operating leases to finance leases due to remeasurement.
June 30, 2019
Other Information
Weighted-average remaining lease term (in years):
      Finance leases 11.22
      Operating leases 9.66
Weighted-average discount rate:
      Finance leases 18.33  %
      Operating leases 6.87  %

Undiscounted Lease Cash Flows Under ASC 842 as of June 30, 2019
Finance Operating Receipts from Subleases
Year Ending December 31, (In thousands)
2019 $ 6,965  $ 33,956  $ (8,045)
2020 6,535  63,257  (11,545)
2021 6,667  55,960  (9,299)
2022 6,667  48,103  (6,612)
2023 6,719  46,335  (6,612)
Thereafter 49,922  235,548  (9,744)
Total $ 83,475  $ 483,159  $ (51,857)
Less: Present value discount (42,105) (139,673)
Lease liabilities $ 41,370  $ 343,486 
For comparison purposes the following table provides the future minimum lease payments as presented in our Annual Report on Form 10-K for the year ended December 31, 2018 in accordance with ASC 840, “Leases,”.
Undiscounted Lease Cash Flows Under ASC 842 as of December 31, 2018
Finance Operating Receipts from Subleases
Year Ending December 31, (In thousands)
2019 $ 6,985  $ 82,177  $ (13,430)
2020 7,165  66,023  (10,508)
2021 7,357  51,501  (8,534)
2022 7,374  37,152  (7,232)
2023 7,609  33,486  (7,013)
Thereafter 482,390  127,026  (13,116)
Total minimum lease payments (receipts) $ 518,880  $ 397,365  $ (59,833)
Less: Present value discount (498,291)
Lease liabilities $ 20,589 
Current portion of lease liabilities $ 643 
Long-term portion of lease liabilities $ 19,946 
The majority of our leases are related to dealership properties that are subject to long-term lease arrangements. In addition, we have certain equipment leases and contracts containing embedded leased assets that have been evaluated and included in the ROU assets and lease liabilities above as appropriate.
We recognize a ROU asset and a lease liability at the lease commencement date. For operating leases, the lease liability is initially and subsequently measured at the present value of the unpaid lease payments at the lease commencement date. For finance leases, the lease liability is initially measured in the same manner and date as for operating leases, and is subsequently measured at amortized cost using the effective interest method.
The ROU asset is initially measured at cost, which comprises the initial amount of the lease liability adjusted for lease payments made at or before the lease commencement date, plus any initial direct costs incurred or previously recognized favorable lease assets, less any lease incentives received or previously recognized lease exit accruals. For operating leases, the ROU asset is subsequently measured throughout the lease term at the carrying amount of the lease liability, plus initial direct costs, plus (minus) any prepaid (accrued) lease payments, less the unamortized balance of lease incentives received. Lease expense for lease payments is recognized on a straight-line basis over the lease term. For finance leases, the ROU asset is subsequently amortized using the straight-line method from the lease commencement date to the earlier of the end of its useful life or the end of the lease term unless the lease transfers ownership of the underlying asset to us or we are reasonably certain to exercise an option to purchase the underlying asset. In those cases, the ROU asset is amortized over the useful life of the underlying asset. Amortization of the ROU asset is recognized and presented separately from interest expense on the lease liability.
Variable lease payments associated with our leases are recognized when the event, activity or circumstance in the lease agreement on which those payments are assessed occurs. Variable lease payments are presented as operating expense in our consolidated financial statements of income in the same line item as expense arising from fixed lease payments (operating leases) or amortization of the ROU asset (finance leases).
ROU assets for operating and finance leases are periodically reduced by impairment losses. We use the long-lived assets impairment guidance in ASC 360, “Property, Plant, and Equipment,” to determine whether an ROU asset is impaired and, if so, the amount of the impairment loss to recognize.
The Company monitors for events or changes in circumstances that require a reassessment of one of its leases. When a reassessment results in the remeasurement of a lease liability, a corresponding adjustment is made to the carrying amount of the corresponding ROU asset unless doing so would reduce the carrying amount of the ROU asset to an amount less than zero. In that case, the amount of the adjustment that would result in a negative ROU asset balance, is recorded in profit or loss.
Key estimates and judgments include how we determine: (1) the discount rate used to discount the unpaid lease payments to present value; (2) the expected lease term, including any extension options; and (3) future lease payments.
ASC 842, “Leases,” requires a lessee to discount its unpaid lease payments using the interest rate implicit in the lease or, if that rate cannot be readily determined, its incremental borrowing rate. Generally, we cannot determine the interest rate implicit in the lease because we do not have access to the lessor’s estimated residual value or the amount of the lessor’s deferred initial direct costs. Therefore, we generally use our incremental borrowing rate as the discount rate for the lease. We determined the discount rate for our leases based on the risk-free rate as of the measurement date for varying maturities corresponding to the remaining lease term, adjusted for the risk-premium attributed to Sonic’s corporate credit rating for a secured or collateralized instrument.
Many of our lease arrangements have one or multiple options to extend the lease term (typically five- to ten-year options), which were considered in the calculation of the ROU assets and lease liabilities if it was reasonably certain that an extension option would be exercised. The lease term for all of the Company’s leases includes the noncancellable period of the lease plus any additional periods covered by our option to extend the lease that we are reasonably certain to exercise. We determined the probability of the exercise of a lease extension option based on our long-term strategic business outlook and the condition and remaining useful life of the fixed assets at the location subject to the lease agreement, among other factors.
The majority of our lease agreements require fixed monthly payments (subject to either specific or index-based escalations in future periods) while other agreements require variable lease payments based on changes in the London Interbank Offer Rate (“LIBOR”). Lease payments included in the measurement of the lease liability comprise the: (1) fixed payments, including in-substance fixed payments, owed over the lease term, which include termination penalties we would owe if the lease term assumes Company exercise of a termination option; (2) variable lease payments that depend on an index or rate, initially measured using the index or rate at the lease commencement date; and (3) the exercise price of our option to purchase the underlying asset if we are reasonably certain to exercise the option. Our leases do not typically contain residual value guarantees.
In certain situations, we have entered into sublease agreements whereby we sublease all or a portion of a leased real estate asset to a third party. To the extent that we have a sublease related to a lease agreement for an asset that we are no longer using in operations, we have reduced the ROU asset by the net deficiency in expected cash flows from that sublease (either due to partial monthly sublease proceeds or a sublease term less than the remaining master lease term). As of December 31, 2018, the net liability related to these lease exit accruals was approximately $4.6 million as discussed in Note 7, “Commitments and Contingencies.” Upon the adoption of ASC 842, “Leases,” this balance was reclassified from other accrued liabilities and other long-term liabilities to a reduction in right-of-use assets in the accompanying unaudited condensed consolidated balance sheets.
Prior to the adoption of ASC 842, “Leases,” we had recorded definite life intangible assets related to favorable lease assets acquired in business combinations. As of December 31, 2018, the net unamortized balance related to these definite life intangible assets was approximately $4.0 million. Upon adoption of ASC 842, “Leases,” this balance was reclassified from other intangible assets, net to right-of-use assets in the accompanying unaudited condensed consolidated balance sheets as of June 30, 2019 and continues to be amortized over the remaining lease term.
As part of the lease standard implementation process, we assessed our existing real estate and equipment lease agreements, identified certain lease components embedded within existing service contracts, evaluated transition guidance and practical expedient elections, implemented lease accounting software and designed internal controls over lease accounting under the new standard.
In August 2017, the FASB issued ASU 2017-12, which amends the hedge accounting recognition and presentation requirements in ASC 815, “Derivatives and Hedging.” This ASU expands and refines hedge accounting for both non-financial and financial risk components and aligns the recognition and presentation of the effects of the hedging instrument and the hedged item in the financial statements. It also includes certain targeted improvements to simplify the application of current guidance related to hedge accounting. For public companies, this ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The effects of this ASU did not materially impact our consolidated financial statements.
In February 2018, the FASB issued ASU 2018-02, which allows the reclassification of stranded tax effects, as a result of the Tax Cuts and Jobs Acts of 2017, from accumulated other comprehensive income to retained earnings. For public companies, this ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The effects of this ASU did not materially impact our consolidated financial statements.
In June 2018, the FASB issued ASU 2018-07 to expand the scope of ASC 718, Compensation - “Stock - Compensation,” to include share-based payment transactions for acquiring goods and services from non-employees. For public companies, this ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The effects of this ASU did not materially impact our consolidated financial statements.
Principles of Consolidation Principles of Consolidation – All of our subsidiaries are wholly owned and consolidated in the accompanying unaudited condensed consolidated financial statements, except for one 50%-owned dealership that is accounted for under the equity method. All material intercompany balances and transactions have been eliminated in the accompanying unaudited condensed consolidated financial statements.
Revenue from Contract with Customers
Revenue from Contracts with Customers – As of January 1, 2018, we adopted ASC 606, “Revenue from Contracts with Customers.” Under this standard, revenue is recognized when a customer obtains control of promised goods or services and in an amount that reflects the consideration that the entity expects to receive in exchange for those goods or services. The standard applies a five-step model that includes: (1) identifying the contract(s) with the customer; (2) identifying the performance obligation(s) in the contract(s); (3) determining the transaction price; (4) allocating the transaction price to the performance obligation(s) in the contract(s); and (5) recognizing revenue as the performance obligation(s) are satisfied. The standard also requires disclosure of the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. We do not include the cost of obtaining contracts within the related revenue streams since we elected the practical expedient to expense the costs to obtain a contract when incurred.
Management has evaluated our established business processes, revenue transaction streams and accounting policies, and identified our material revenue streams to be: (1) the sale of new vehicles; (2) the sale of used vehicles to retail customers; (3) the sale of wholesale used vehicles at third-party auctions; (4) the arrangement of vehicle financing and the sale of service and other insurance contracts; and (5) the performance of vehicle maintenance and repair services and the sale of related parts and accessories. Generally, performance conditions are satisfied when the associated vehicle is either delivered or returned to a customer and customer acceptance has occurred, or over time as the maintenance and repair services are performed. We do not have any revenue streams with significant financing components as payments are typically received within a short period of time following completion of the performance obligation(s). Upon adoption, we accelerated the timing of revenue recognition related to: (1) service and collision repair orders that are incomplete as of a reporting date (“work in process”) and (2) certain
retrospective finance and insurance revenue earned in periods subsequent to the completion of the initial performance obligation (“F&I retro revenues”). Work in process revenues are recognized over time based on the completed work to date and F&I retro revenues are recognized when the product contract has been executed with the end customer and are estimated each reporting period based on the expected value method using historical and projected data. F&I retro revenues, which represent variable consideration, subject to constraint, are to be included in the transaction price and recognized when or as the performance obligation is satisfied. F&I retro revenues can vary based on a variety of factors, including number of contracts and history of cancellations and claims. Accordingly, we utilize this historical and projected data to constrain the consideration to the extent that it is probable that a significant reversal in the amount of cumulative revenue will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
Receivables, net in the accompanying unaudited condensed consolidated balance sheets as of June 30, 2019 and December 31, 2018 include approximately $4.8 million and $4.7 million, respectively, related to work in process and contract assets related to F&I retro revenues of approximately $5.9 million and $5.4 million, respectively. Changes in contract assets from December 31, 2018 to June 30, 2019 were primarily due to ordinary business activity. Please refer to Note 1, “Description of Business and Summary of Significant Accounting Policies,” to the consolidated financial statements in Sonic’s Annual Report on Form 10-K for the year ended December 31, 2018 for further discussion of our revenue recognition policies and processes.
Income
Income Tax Expense
Income Tax Expense – The overall effective tax rate from continuing operations was 27.4% and 29.6% for the three and six months ended June 30, 2019, respectively, and 32.4% and 29.7% for the three and six months ended June 30, 2018. Income tax expense for the three months ended June 30, 2019 includes a $0.4 million discrete benefit related to the favorable resolution of certain tax matters. Income tax expense for the six months ended June 30, 2019 includes a $1.5 million discrete charge for non-deductible executive officer compensation related to executive transition costs, a $0.2 million discrete charge related to changes in uncertain tax positions and a $0.2 million discrete charge related to vested or exercised stock compensation awards, offset partially by a $0.4 million discrete benefit related to the favorable resolution of certain tax matters. Income tax expense for the three months ended June 30, 2018 includes a $0.6 million discrete charge for non-deductible book goodwill related to dealership dispositions during the period. Income tax expense for the six months ended June 30, 2018 includes a $0.9 million discrete benefit related to vested or exercised stock compensation awards, offset partially by a $0.2 million discrete charge related to changes in uncertain tax positions and a $0.6 million discrete charge for non-deductible book goodwill related to dealership dispositions during the period. Sonic’s effective tax rate varies from year to year based on the level of taxable income, the distribution of taxable income between states in which the Company operates and other tax adjustments. Sonic expects the annual effective tax rate in future periods to fall within a range of 26.0% to 29.0% before the impact, if any, of changes in valuation allowances related to deferred income tax assets or discrete tax adjustments.

Earnings Per Share – The calculation of diluted earnings per share considers the potential dilutive effect of restricted stock units, restricted stock awards and stock options granted under Sonic’s stock compensation plans, in addition to Class A Common Stock purchase warrants.