In its most recent quarterly filing ending July 31, 2015, Wal-Mart concluded that it did not have sufficient controls in place to “properly identify and account for leases.” Consequently, the company found a “material weakness” in its internal controls over financial reporting and in its internal controls and procedures.
Background
According to 2014 Fortune Global 500 list, Wal-Mart Stores Inc. (Walmart) is the world’s largest company, based on revenue, and the biggest private employer in the world with 2.2 million employees. Wal-Mart operates under three business segments: (1) Wal-Mart Stores, (2) Sam’s Club, and (3) International segment. In the U.S., Wal-Mart operates more than 1,000 discount stores, 2,447 supercenters, 132 neighborhood markets, and 591 Sam’s Club with the average store space exceeding 100,000 square feet.
Accounting for leases
Walmart frequently leases its retail store spaces. Depending on the structure of the leasing arrangement, accounting standards allow a company to treat a lease transaction as an operating or capital lease. The key difference between the two leasing arrangements is that, under a capital lease, the company must record its future payment obligations on the balance sheet but not so under an operating lease. Many companies like Walmart prefer operating lease over a capital lease because it is able to keep its obligations off the balance sheet. As of Jan 31, 2015, based on some modest assumptions, Walmart’s operating lease obligations are around $12.8 billion, while its capital lease obligations are $2.9 billion.
What were the leasing-related accounting errors?
1. In a number of its leases, Walmart made payments for certain structural improvements in the lessor’s construction of the leased assets. Under ASC 840, regardless of the significance of the payments, a company must capitalize its lease obligations when lease payments include specific structural improvements to the construction of the leased asset because it indicates ownership. Instead of treating such lease transactions as a capital lease for accounting purposes, Walmart was incorrectly treating such leases as an operating lease. Strike 1.
2. When a company performs a sale-leaseback (sells its asset and leases it back), it is precluded from derecognizing the asset/obligation from its balance sheet if it has “continuing involvement” with the asset. For example, a company makes construction improvements to an asset and then capitalizes those costs. At a certain point during this construction period, the company decides to sell the asset and then leases it back from a third-party. During the sale-leaseback, if the lessor allows the lessee (the company) to reduce its lease payments because of the continued construction improvements to the leased asset, the company cannot derecognize the asset/obligation from its balance sheet following the sale. Walmart was dereognizing asset/obligations from its balance sheet in these types of sale-leaseback transactions. Strike 2.
Because of the lease-related accounting errors, Walmart’s CEO and CFO concluded that the company’s disclosure controls and procedures were not effective as of the second quarter of 2015. To remediate the material weakness, the company initiated compensating controls in the near term. Walmart expects that the remediation of this material weakness to be completed prior to the end of fiscal year 2015.
How Did Walmart’s Investors respond?
Walmart stock price has declined from $72 around the beginning of August to about $64 as of last week, which translates to a 13% erosion in shareholder value.
Wal-Mart 10-Q ending July 31, 2015
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