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Build-A-Bear Workshop, Inc.—Leases

EXCERPTED WITH PERMISSION FROM

CASES IN FINANCIAL REPORTING

EIGHTH EDITION ISBN: 978-1-61853-122-3

MICHAEL DRAKE

ELLEN ENGEL

D. ERIC HIRST

MARY LEA MCANALLY

This document is authorized for use by Natalie Jagsaran, from 1/1/2015 to 6/30/2015, in the course: iMBA 515 - Accounting for External Reporting - Ketz (Spring 2015), Pennsylvania State University - University Park.

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Build-A-Bear Workshop, Inc.—Leases 1

Build-A-Bear Workshop, Inc.—Leases

Build-A-Bear Workshop, Inc., (NYSE: BBW), is the leading and only global company that offers an interactive make-your-own stuffed animal retail-entertainment experience. Founded in 1997, the company and its franchisees currently operate more than 400 Build-A-Bear Workshop® stores worldwide, including company-owned stores in the United States, Puerto Rico, Canada, the United Kingdom, Ireland, and France, and franchise stores in Europe, Asia, Australia and Africa. In 2007, the interactive experience was enhanced - all the way to CyBEAR™ space - with the launch of buildabearville.com®, the company’s virtual world, stuffed with fun. Source: Company website.

Learning Objectives • Understand the economic incentives of leasing versus buying assets. • Interpret lease footnotes and discussion of commitments and contingencies. • Relate lease footnote disclosures to balance sheet data. • Understand the balance sheet and income statement effects of lease accounting. • Perform present value calculations relating to lease obligations. • Create pro-forma financial statements to capitalize leases previously treated as operating. • Understand the economic consequences and quality of earnings issues related to lease accounting.

Refer to the fiscal 2009 financial statements of Build-A-Bear Workshop, Inc. ! Concepts !

a. Why do companies lease assets rather than buy them?

b. What is an operating lease? What is a capital lease? What is a direct-financing lease? What is a sales- type lease? (Hint: If your textbook does not cover these lease complexities, use your favorite Internet search engine to find definitions and examples.)

c. Why do accountants distinguish between different types of leases?

! Process !

d. Consider the following hypothetical lease for a Build-A-Bear Workshop retail location.

• The lease term is five years.

• Lease payments of $100,000 are due the last day of each year.

• At the end of the lease, title to the location does not transfer to Build-A-Bear nor is there a bargain purchase option.

• The expected useful life of the location is 25 years. The fair value of the location is estimated to be $1,500,000.

i. Will this lease be treated as an operating lease or a capital lease under current U.S. GAAP? Explain.

ii. Provide the journal entry that Build-A-Bear Workshop will record when it makes the first lease payment.

iii. Assume that a second lease is identical to this lease except that Build-A-Bear Workshop is offered a “first year rent-free.” That is, the company will make no cash payment at the end of year one, but will make payments of $125,000 at the end of each of years 2 through 5. Provide the journal entries that the company will make over the term of this lease.

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Build-A-Bear Workshop, Inc.—Leases 2

e. Consider Build-A-Bear Workshop’s operating lease payments and the information in Note 10, Commitments and Contingencies. Further information about their operating leases is reported in Note 1, Description of Business and Basis of Preparation (k) Deferred Rent.

i. What was the amount of rent expense on operating leases in fiscal 2009?

ii. Where did that expense appear on the company’s income statement?

! Analysis !

f. Recent proposals by the Financial Accounting Standards Board and the International Accounting Standards Board would largely eliminate the option to use operating lease accounting. Most leases would be accounted for as capital leases (which are called “finance” leases under IFRS). The present value of the expected lease payments would be treated as a “right to use the leased asset.” A corresponding capital lease obligation would be recorded, representing the liability incurred when the right-to-use asset was acquired. The asset would be amortized over a period not to exceed the lease term. The obligation would be accounted for as an interest-bearing obligation.

Consider the future minimum lease payments made under the operating leases disclosed in Note 10, Commitments and Contingencies. Assume that all lease payments are made on the final day of each fiscal year. Also assume that payments made subsequent to 2014 are made evenly over three years.

i. Calculate the present value of the future minimum lease payments at January 2, 2010. Assume that the implicit interest rate in these leases is 7%.

ii. Had Build-A-Bear Workshop entered into all of these leases on January 2, 2010 (the final day of fiscal 2009), what journal entry would the company have recorded if the leases were considered capital leases?

iii. What would the company have reported as the cost of “Property and equipment, net” at January 2, 2010? As “Total assets”?

iv. What would the company have reported as “Long-term obligations under capital leases” at January 2, 2010? As “Total current liabilities”? (Note that the current portion of the obligation under capital leases is the principal portion of the obligation that will be repaid in fiscal 2010.) As Total liabilities?

v. What journal entries would the company record in fiscal 2010 for these leases, if they were considered capital leases? There are two: one to record interest expense and the lease payment and one to record amortization of the leased asset.

vi. The FASB is considering an alternative approach to account for certain leases of property. Under the alternative approach, the pattern of expenses would result in straight-line expensing of the total lease cost (i.e., equal total expense each year). In particular, the lessee would record interest expense based on the unwinding of the discount included in the calculation of the lease liability and add to that the amortization of the leased asset in an amount that results in a total periodic lease expense that is the same over the term of the lease.

If Build-A-Bear Workshop adopted this alternative approach, what journal entry would they record in fiscal 2010? Hint: The total annual expense will equal the total lease payments divided by the term of the lease. Comment on the economic logic of this approach relative to the approach in f. v.

g. Under current U.S. GAAP, what incentives does Build-A-Bear Workshop, Inc.’s management have to structure its leases as operating leases? Comment on the effect of leasing on the quality of the company’s financial reporting.

h. If Build-A-Bear had capitalized their operating leases as the FASB and IASB propose, key financial ratios would have been affected.

i. Refer to your solution to part f, above to compute the potential impact on the current ratio, debt-to-equity ratio (defined as total liabilities divided by stockholders’ equity) and long-term

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Build-A-Bear Workshop, Inc.—Leases 3

debt-to-assets ratio (defined as long-term debt divided by total assets) at January 2, 2010. Is it true that the decision to capitalize leases will always yield weaker liquidity and solvency ratios?

ii. Refer to the Build-A-Bear income statement for the 13-week quarter ended April 3, 2010. Compute the potential impact of lease capitalization on return on equity and return on assets for the quarter. Assume that lease payments and the amortization and interest expenses you computed for fiscal 2010 in part f.v, above, were incurred evenly over fiscal 2010. Also, assume a marginal tax rate of 35%. For simplicity, use the balance sheet numbers at January 2, 2010 in the denominator of both return ratios, rather than averages. Is it true that the decision to capitalize leases will always yield weaker performance ratios?

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BUILD-A-BEAR WORKSHOP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except share data)

January 2, 2010

January 3, 2009

ASSETS Current assets:

Cash and cash equivalents $ 60,399 $ 47,000 Inventories 44,384 50,586 Receivables 5,337 8,288 Prepaid expenses and other current assets 19,329 16,151 Deferred tax assets 6,306 3,839

Total current assets 135,755 125,864 Property and equipment, net 101,044 123,193 Goodwill 33,780 30,480 Other intangible assets, net 3,601 3,903 Investment in affiliate — 7,721 Other assets, net 10,093 8,991

Total Assets $ 284,273 $ 300,152

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities: Accounts payable $ 32,822 $ 37,547 Accrued expenses 11,185 12,593 Gift cards and customer deposits 29,301 29,210 Deferred revenue 8,582 7,634

Total current liabilities 81,890 86,984

Deferred franchise revenue 2,027 2,033 Deferred rent 34,760 41,714 Other liabilities 816 1,696 Commitments and contingencies Stockholders' equity:

Preferred stock, par value $0.01, Shares authorized: 15,000,000; No shares issued or outstanding at January 2, 2010 and January 3, 2009 — — Common stock, par value $0.01, Shares authorized: 50,000,000;

Issued and outstanding: 20,447,343 and 19,478,750 shares, respectively 204 195 Additional paid-in capital 80,122 76,852 Accumulated other comprehensive loss (6,336 ) (12,585 ) Retained earnings 90,790 103,263

Total stockholders' equity 164,780 167,725

Total Liabilities and Stockholders' Equity $ 284,273 $ 300,152

See accompanying notes to consolidated financial statements.

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BUILD-A-BEAR WORKSHOP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except share and per share data)

Fiscal Year 2009 2008 2007

Revenues: Net retail sales $ 388,552 $ 460,963 $ 468,168 Franchise fees 3,353 4,157 3,577 Licensing revenue 2,470 2,741 2,616

Total revenues 394,375 467,861 474,361

Costs and expenses:

Cost of merchandise sold 245,980 270,463 259,078 Selling, general, and administrative 161,692 185,608 177,375 Store preopening 90 2,410 4,416 Store closing 981 2,952 — Losses from investment in affiliate 9,615 — — Interest expense (income), net (143 ) (799 ) (1,531 )

Total costs and expenses 418,215 460,634 439,338

Income (loss) before income taxes (23,840 ) 7,227 35,023

Income tax expense (benefit) (11,367 ) 2,663 12,514

Net income (loss) $ (12,473 ) $ 4,564 $ 22,509

Earnings (loss) per common share: Basic $ (0.66 ) $ 0.24 $ 1.11

Diluted $ (0.66 ) $ 0.24 $ 1.10

Shares used in computing per common share amounts:

Basic 18,874,352 19,153,123 20,256,847 Diluted 18,874,352 19,224,273 20,448,793

See accompanying notes to consolidated financial statements.

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BUILD-A-BEAR WORKSHOP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands)

Fiscal Year 2009 2008 2007

Cash flows from operating activities: Net income (loss) $ (12,473 ) $ 4,564 $ 22,509 Adjustments to reconcile net income (loss) to net cash provided by operating activities:

Depreciation and amortization 28,487 28,883 26,292 Losses from investment in affiliate 9,615 — — Impairment of Friends 2B Made assets — 2,867 — Impairment of store assets 5,321 1,825 — Deferred taxes (5,090 ) (847 ) (2,844 ) Loss on disposal of property and equipment 175 273 515 Tax benefit from stock option exercises — — (538 ) Stock-based compensation 4,335 3,638 3,078 Change in assets and liabilities:

Inventories 6,628 (3,795 ) 1,738 Receivables 1,885 (1,639 ) 350 Prepaid expenses and other assets (3,852 ) (3,980 ) (3,445 ) Accounts payable (4,923 ) (4,330 ) (1,025 ) Accrued expenses and other liabilities (6,118 ) (3,844 ) 9,744

Net cash provided by operating activities 23,990 23,615 56,374

Cash flows from investing activities:

Purchases of property and equipment, net (5,727 ) (21,620 ) (32,101 ) Purchases of other assets and other intangible assets (2,421 ) (1,595 ) (5,134 ) Investment in unconsolidated affiliate (750 ) (3,414 ) (3,703 )

Cash flow used in investing activities (8,898 ) (26,629 ) (40,938 )

Cash flows from financing activities:

Exercise of employee stock options and employee stock purchases — 322 1,080 Purchases of Company's common stock — (14,346 ) (4,670 ) Tax benefit from stock option exercises — — 538

Cash flow used in financing activities — (14,024 ) (3,052 )

Effect of exchange rates on cash (1,693 ) (2,223 ) 768

Net increase (decrease) in cash and cash equivalents 13,399 (19,261 ) 13,152 Cash and cash equivalents, beginning of period 47,000 66,261 53,109 Cash and cash equivalents, end of period $ 60,399 $ 47,000 $ 66,261

Supplemental disclosure of cash flow information: Cash (received) paid during the period for: Income taxes $ (1,105 ) $ 7,348 $ 20,593

Noncash Transactions: Return of common stock in lieu of tax withholdings and option exercises $ 318 $ 313 $ 501

See accompanying notes to consolidated financial statements.

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(1) Description of Business and Basis of Preparation (k) Deferred Rent Certain of the Company's operating leases contain predetermined fixed escalations of minimum rentals during the original lease terms. For these leases, the Company recognizes the related rental expense on a straight-line basis over the life of the lease and records the difference between the amounts charged to operations and amounts paid as deferred rent. The Company also receives certain lease incentives in conjunction with entering into operating leases. These lease incentives are recorded as deferred rent at the beginning of the lease term and recognized as a reduction of rent expense over the lease term. In addition, certain of the Company's leases contain future contingent increases in rentals. Such increases in rental expense are recorded in the period that it is probable that store sales will meet or exceed the specified target that triggers contingent rental expense. (10) Commitments and Contingencies (a) Operating Leases The Company leases its retail stores and corporate offices under agreements which expire at various dates through 2030. The majority of leases contain provisions for base rent plus contingent payments based on defined sales as well as scheduled escalations. Total office and retail store base rent expense was $45.9 million, $49.8 million and $45.8 million, and contingent rents were $0.9 million, $1.2 million and $1.8 million for 2009, 2008 and 2007, respectively. Future minimum lease payments at January 2, 2010, were as follows (in thousands):

2010 $ 50,651 2011 47,107 2012 42,345 2013 35,469 2014 31,319 Subsequent to 2014 75,686

$ 282,577

(b) Litigation In the normal course of business, the Company is subject to certain claims or lawsuits. Management is not aware of any claims or lawsuits that will have a material adverse effect on the consolidated financial position or results of operations of the Company.

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Thirteen weeks ended

Revenues: Net retail sales $ 99,786 Franchise fees 683 Licensing revenue 967

Total revenues 101,436

Costs and expenses: Cost of merchandise sold 59,106 Selling, general and administrative 39,533 Store preopening 11 Store closing — Interest expense (income), net (32)

Total costs and expenses 98,618

Income (loss) before income taxes 2,818 Income tax expense (benefit) 1,139

Net income (loss) $ 1,679

2010

BUILD-A-BEAR WORKSHOP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited) (Dollars in thousands, except share and per share data)

April 3,

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