Sonic Automotive, Inc. Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

Leases, Codification Topic 842

Leases, Codification Topic 842

Jan. 01, 2019

16. Leases

The cumulative effect of the adoption of ASC 842, “Leases,” on our unaudited consolidated balance sheet as of January 1, 2019 was the recognition of right-of-use 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 consolidated balance sheet as of December 31, 2018) and related 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 consolidated balance sheet as of December 31, 2018). Upon adoption of ASC 842, “Leases,” we evaluated right-of-use assets for impairment and determined that approximately $10.5 million of impairment was required related to newly recognized right-of-use assets that would have been impaired in previous periods. This impairment of the right-of-use assets 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 consolidated statements of income or our consolidated statements of cash flows.

The effect of the adoption of ASC 842, “Leases,” on our unaudited consolidated balance sheet as of January 1, 2019 and our consolidated balance sheet as of December 31, 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 December 31, 2019
	(In thousands)
Right-of-Use Assets
Finance Leases	$	18,948	$	121	$	18,835	$	(3,213)	$	34,691
Operating Leases	387,970		10,081		(15,205)		(45,004)		337,842
Total Right-of-Use Assets	$	406,918	$	10,202	$	3,630	$	(48,217)	$	372,533

Current Lease Liabilities
Finance Leases	$	728	$	12	$	4,513	$	(3,689)	$	1,564
Operating Leases	48,104		1,560		(2,650)		(3,682)		43,332
Total Current Lease Liabilities	$	48,832	$	1,572	$	1,863	$	(7,371)	$	44,896

Long-Term Lease Liabilities
Finance Leases	$	19,829	$	109	$	17,867	$	(1,492)	$	36,313
Operating Leases	350,818		8,521		(12,400)		(42,788)		304,151
Total Long-Term Lease Liabilities	$	370,647	$	8,630	$	5,467	$	(44,280)	$	340,464

(1) Includes the impact of remeasurements related to lease terminations and changes in assumptions around the probability of exercise of extension options.


	Twelve Months Ended December 31, 2019
Lease Expense	(In thousands)
Finance lease expense
Reduction of right-of-use assets	$	3,213
Interest on lease liabilities	5,097
Operating lease expense (1)	68,367
Short-term lease expense (1)	1,570
Variable lease expense	2,120
Sublease income	(14,207)
Total	$	66,160

(1) Included in operating cash flows in the accompanying consolidated statements of cash flows.


	Twelve Months Ended December 31, 2019
Other Information	(In thousands)
Cash paid for amounts included in the measurement of lease liabilities
Financing cash flows for finance leases	$	5,181
Operating cash flows for finance leases	$	5,097
Operating cash flows for operating leases	$	69,834
Right-of-use assets obtained in exchange for lease liabilities
Finance leases	$	10,926
Operating leases (1)	$	22,055

(1) Includes the impact of reclassification of right-of-use assets from operating leases to finance leases due to remeasurement.


	December 31, 2019
Other Information
Weighted-average remaining lease term (in years)
Finance leases	11.8
Operating leases	9.5
Weighted-average discount rate
Finance leases	18.74	%
Operating leases	6.69	%


	Undiscounted Lease Cash Flows Under ASC 842 as of December 31, 2019
	Finance		Operating		Receipts from Subleases
Year Ending December 31,	(In thousands)
2020	$	6,608	$	64,577	$	(10,795)
2021	6,760		58,093		(8,078)
2022	6,768		51,337		(6,103)
2023	6,829		49,689		(6,103)
2024	6,947		44,012		(5,042)
Thereafter	43,787		215,240		(4,270)
Total	$	77,699	$	482,948	$	(40,391)

Less: Present value discount	(39,822)		(135,465)
Lease liabilities	$	37,877	$	347,483

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 840 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	48,239		127,026		(13,116)
Total minimum lease payments (receipts)	$	84,729	$	397,365	$	(59,833)
Less: Present value discount	(64,140)
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 right-of-use assets and lease liabilities above as appropriate.

We recognize a right-of-use 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 reduced cost using the effective interest method.

The right-of-use 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 right-of-use 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 right-of-use asset is reduced 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 right-of-use asset is reduced over the expected useful life of the underlying asset. Expense related to the reduction of the right-of-use 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 statements of income in the same line item as expense arising from fixed lease payments (operating leases) or expense related to the reduction of the right-of-use asset (finance leases).

Right-of-use 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 right-of-use assets are 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 right-of-use asset unless doing so would reduce the carrying amount of the right-of-use asset to an amount less than zero. In that case, the amount of the adjustment that would result in a negative right-of-use asset balance is recorded in profit or loss.

Key estimates and judgments related to the measurement and recording of right-of-use assets and lease liabilities include how we determine: (1) the discount rate used to discount the unpaid lease payments to present value; and (2) the expected lease term, including any extension options.

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 more existing renewal options to extend the lease term (typically in five- to 10-year increments), which were considered in the calculation of the right-of-use assets and lease liabilities if we determined that 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 LIBOR or any replacement thereof. Lease payments included in the measurement of the lease liability comprise the: (1) fixed lease payments, including in-substance fixed payments, owed over the lease term, which include termination penalties we would owe if the estimated lease term assumes that we would be likely to exercise a termination option prior to the earliest expiration date; (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 right-of-use asset by any applicable 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 12, “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 consolidated balance sheet as of December 31, 2019.

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 consolidated balance sheet as of December 31, 2019 and continues to be amortized over the remaining lease term.

As part of the new 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 implemented internal controls over lease accounting under the new lease standard.