Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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The following discussion and analysis of our financial condition, results of operations, and liquidity and capital resources for the 52 weeks ended February 2, 2020 (“fiscal 2019”), and the 53 weeks ended February 3, 2019 (“fiscal 2018”) should be read in conjunction with our Consolidated Financial Statements and notes thereto. Fiscal 2018 was a

53-week

year and includes approximately $85,000,000 of net revenues and $0.10 of diluted earnings per share associated with the additional week. All explanations of changes in operational results are discussed in order of magnitude.

A discussion and analysis of our financial condition, results of operations, and liquidity and capital resources for the

53-weeks

ended February 3, 2019 (“fiscal 2018”), compared to the

52-weeks

ended January 28, 2018 (“fiscal 2017”), can be found under Item 7 in our Annual Report on Form

10-K

for fiscal 2018, filed with the SEC on April 4, 2019, which is available on the SEC’s website at www.sec.gov and under the Financial Reports section of our Investor Relations website.

OVERVIEW

Williams-Sonoma, Inc. is a specialty retailer of high-quality sustainable products for the home. These products, representing distinct merchandise strategies — Williams Sonoma, Pottery Barn, Pottery Barn Kids, West Elm, Pottery Barn Teen, Williams Sonoma Home, Rejuvenation, and Mark and Graham — are marketed through

e-commerce

websites, direct-mail catalogs and 614 stores. These brands are also part of The Key Rewards, our

free-to-join

loyalty program that offers members exclusive benefits across the Williams-Sonoma family of brands. We operate in the U.S., Puerto Rico, Canada, Australia and the United Kingdom, offer international shipping to customers worldwide, and have unaffiliated franchisees that operate stores in the Middle East, the Philippines, Mexico and South Korea, as well as

e-commerce

websites in certain locations. In December 2017, we acquired Outward, Inc., a

3-D

imaging and augmented reality platform for the home furnishings and décor industry.

Fiscal 2019 Financial Results

Net revenues in fiscal 2019 increased by $226,415,000 or 4.0%, with comparable brand revenue growth of 6.0%. This increase in net revenues was primarily driven by West Elm and Pottery Barn, partially offset by the loss of the additional week of net revenues in fiscal 2018, a fifty-three week year. Total fiscal 2019 net revenue growth included a 5.4% increase in international revenues primarily related to our franchise operations and strength in our Canadian

e-commerce

business and company-owned United Kingdom operations.

All brands delivered positive comparable brand revenue growth in fiscal 2019. Growth in Pottery Barn accelerated from last year, driven by strength in

e-commerce

and growth in new businesses: Marketplace and Pottery Barn Apartment, as well as our digital transformation and brand revitalization strategies. The Pottery Barn Kids and Teen business delivered combined comparable brand revenue growth of 4.5% — its strongest performance in recent years. Our expansion across life stages and aesthetics continued to be key drivers of growth and customer acquisition. West Elm had another year of double-digit net revenue growth and comparable brand revenue growth of 14.4%, on top of 9.5% in fiscal 2018, led by furniture, with strength in dining and bedroom categories, as well as new product introductions. The Williams Sonoma brand delivered comparable brand revenue growth of 0.4%. And, our emerging brands, Rejuvenation and Mark and Graham, combined delivered another year of double-digit revenue growth as they continue to scale and attract new customers.

Gross profit in fiscal 2019 decreased to 36.3% of revenues versus 37.0% in fiscal 2018, primarily driven by lower year-over-year occupancy leverage resulting from one less week of sales in fiscal 2019, increased shipping costs due to a larger mix of furniture and drop-ship sales that are more expensive to ship, as well as the incremental impact from the China tariffs. We have been executing against an aggressive tariff mitigation plan which includes cost reductions from vendors, moving production out of China to South East Asia and to the United States, cost savings in other areas of the business, as well as select price increases. Our approach towards mitigating the financial impact of these tariffs all year enabled us to deliver operating income growth, operating margin expansion, and diluted earnings per share growth.

In fiscal 2019, diluted earnings per share was $4.49 (which included a $0.30 impact related to operations and acquisition-related expenses of Outward, Inc., $0.11 related to certain employment-related expenses, and an $0.08 benefit related to a deferred tax liability adjustment) versus $4.05 in fiscal 2018 (which included a $0.25 impact related to Outward, Inc., a $0.12 impact related to impairment and early lease termination charges, a $0.07 impact from employment-related expenses, a $0.05 net tax benefit from the Tax Cuts and Jobs Act and a $0.01 impact of equity accounting rules).

During fiscal 2019, our cross-brand programs also continued to scale. Our cross-brand loyalty program, The Key, continues to be an impactful driver of revenues and customer acquisition as total membership continued to grow during the year, while our complimentary design service, Design Crew, continued to be a significant revenue driver of sales in store. Fiscal 2019 was also a strong start for our new cross-brand Business to Business (B2B) division as we delivered several key wins, which establish an important foundation for our future growth and demonstrate the appeal of our differentiated value proposition to B2B clients.

Critical to the success of our growth initiatives in fiscal 2019 has been our continued focus on improving the customer experience. We enhanced our digital experience with new functionalities and content that enable us to deliver a faster and more personalized experience for our customers. During the year, we launched a machine-learning search engine that allows us to provide more relevant and personalized search results. We added more storytelling and selling content on our product information pages and further optimized our site navigation. We also improved our mobile site speed within search and product information pages through enhancements to our Progressive Web App platform. In addition, we implemented more functional improvements to our Outward-powered Design Crew room planner. In our supply chain, we continued to drive operational improvements which contributed to another year of strong growth and better customer service. Within our

in-home

furniture delivery network in fiscal 2019, we migrated our order management and fulfillment capabilities to a new platform, which allows us to enhance our furniture delivery scheduling capabilities. We also made important strides in increasing customer visibility with the installation of an order tracking program, which provides real-time updates on the day of delivery. Our West Elm West Coast distribution center in Fontana, California is now fully operational, facilitating growth for our West Elm brand on the West Coast, and finally, our

in-house

manufacturing operation continues to be a strategic advantage, attracting demand for our

made-to-order

upholstered furniture across all our brands, and enabling more domestic production, which helps to mitigate the impact of the China tariffs.

Sustainability continues to be a cornerstone of our business and a key differentiator for our brands. During fiscal 2019, we expanded on our commitment to responsibly sourced cotton and wood across our brands and made further progress in our social impact supply chain programs, including Fair Trade, HERproject and VisionSpring. We also transitioned a reporting framework that incorporates environmental, social and governance (ESG) goals to provide greater transparency into our purpose and progress. Furthermore, we were recognized for the third consecutive year as one of Barron’s 100 Most Sustainable Companies.

In summary, in fiscal 2019, our strong topline performance, along with the operational efficiencies we drove across the business all year, enabled us to generate operating margin expansion to 7.9% from 7.7% last year. We also delivered another year of robust operating cash flow, which allowed us to return approximately $299,474,000 to our stockholders through dividends and share repurchases.

Looking Ahead to 2020

Despite our strong start to fiscal 2020, we have been making changes to our operations as we navigate the challenges in the wake of the coronavirus outbreak. We have been preparing all aspects of our business to continue to support our associates and customers during this time. We believe we have adequate liquidity and strong financial discipline to address the near-term challenges. However, the extent of the recent

COVID-19

outbreak and its impact on our operations, including our recently announced temporary closure of our U.S. and Canadian retail stores, and the markets served by us is uncertain. A prolonged outbreak could further interrupt our operations, our vendors’ operations, and impact consumer spending, which would have a material impact on our revenues, results of operations, cash flows and liquidity position. For more information on risks associated with the

COVID-19

outbreak, please see “Risk Factors” in Item 1A.

Results of Operations

NET REVENUES

Net revenues consist of sales of merchandise to our customers through our

e-commerce

websites, direct-mail catalogs, and at our retail stores and include shipping fees received from customers for delivery of merchandise to their homes. Our revenues also include sales to our franchisees and wholesale customers, breakage income related to our store-value cards, and incentives received from credit card issuers in connection with our private label and

co-branded

credit cards.

Net revenues in fiscal 2019 increased by $226,415,000 or 4.0%, with comparable brand revenue growth of 6.0%. This increase in net revenues was primarily driven by West Elm and Pottery Barn, partially offset by the loss of the additional week of net revenues in fiscal 2018, a fifty-three week year. Total fiscal 2019 net revenue growth included a 5.4% increase in international revenues, primarily related to our franchise operations, and strength in our Canadian

e-commerce

business and company-owned United Kingdom operations.

The following table summarizes our net revenues by brand for fiscal 2019 and fiscal 2018:

In thousands		Fiscal 2019 (52 Weeks)				Fiscal 2018 (53 Weeks)
Pottery Barn		$	2,214,397			$	2,177,344
West Elm			1,466,537				1,292,928
Williams Sonoma			1,032,368				1,056,125
Pottery Barn Kids and Teen			908,561				895,762
Other 1			276,145				249,434
Total		$	5,898,008			$	5,671,593

1	Primarily consists of net revenues from our international franchise operations, Rejuvenation and Mark and Graham.

Comparable Brand Revenue

Comparable brand revenue includes comparable store sales and

e-commerce

sales, including through our direct-mail catalog, as well as shipping fees, sales returns and other discounts associated with current period sales. Comparable stores are defined as permanent stores where gross square footage did not change by more than 20% in the previous 12 months and which have been open for at least 12 consecutive months without closure for seven or more consecutive days. Outlet comparable store net revenues are included in their respective brands. Sales to our international franchisees are excluded from comparable brand revenue as their stores and

e-commerce

websites are not operated by us. Sales from certain operations are also excluded until such time that we believe those sales are meaningful to evaluating their performance. Additionally, comparable brand revenue growth for newer concepts is not separately disclosed until such time that we believe those sales are meaningful to evaluating the performance of the brand.

Comparable brand revenue growth 1		Fiscal 2019 (52 Weeks)				Fiscal 2018 (53 Weeks)
Pottery Barn			4.1%				1.2%
West Elm			14.4%				9.5%
Williams Sonoma			0.4%				1.7%
Pottery Barn Kids and Teen			4.5%				2.8%
Total 2			6.0%				3.7%

1	Comparable brand revenue is calculated on a 52-week to 52-week basis for fiscal 2019 and on a 53-week to 53-week basis for fiscal 2018 .

2	Total comparable brand revenue growth includes the results of Rejuvenation and Mark and Graham.

RETAIL STORE DATA

In thousands		Fiscal 2019 (52 Weeks)				Fiscal 2018 (53 Weeks)
Store count – beginning of year			625				631
Store openings			14				23
Store closings			(25	)			(29	)
Store count – end of year			614				625
Store selling square footage at year-end			4,129,000				4,105,000
Store leased square footage (“LSF”) at year-end			6,558,000				6,557,000

		Fiscal 2019								Fiscal 2018
		Store Count				Avg. LSF Per Store				Store Count				Avg. LSF Per Store
Williams Sonoma			211				6,900				220				6,900
Pottery Barn			201				14,400				205				14,200
West Elm			118				13,100				112				13,100
Pottery Barn Kids			74				7,700				78				7,500
Rejuvenation			10				8,500				10				8,500
Total			614				10,700				625				10,500

COST OF GOODS SOLD

In thousands		Fiscal 2019 (52 Weeks)				% Net Revenues				Fiscal 2018 (53 Weeks)				% Net Revenues
Cost of goods sold 1		$	3,758,916				63.7%			$	3,570,580				63.0%

1	Includes occupancy expenses of $710,523 and $702,537 in fiscal 2019 and fiscal 2018, respectively.

Cost of goods sold includes cost of goods, occupancy expenses and shipping costs. Cost of goods consists of cost of merchandise, inbound freight expenses,

freight-to-store

expenses and other inventory related costs such as shrinkage, damages and replacements. Occupancy expenses consist of rent, depreciation and other occupancy costs, including common area maintenance, property taxes and utilities. Shipping costs consist of third-party delivery services and shipping materials.

Our classification of expenses in cost of goods sold may not be comparable to other public companies, as we do not include

non-occupancy-related

costs associated with our distribution network in cost of goods sold. These costs, which include distribution network employment, third-party warehouse management and other distribution-related administrative expenses, are recorded in selling, general and administrative expenses.

Fiscal 2019 vs. Fiscal 2018

Cost of goods sold increased by $188,336,000, or 5.3%, in fiscal 2019 compared to fiscal 2018. Cost of goods sold as a percentage of net revenues increased to 63.7% in fiscal 2019 from 63.0% in fiscal 2018. This increase was primarily driven by lower year-over-year occupancy leverage resulting from one less week of sales in fiscal 2019, increased shipping costs due to a larger mix of furniture and drop-ship sales that are more expensive to ship, as well as the incremental impact from the China tariffs.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

In thousands		Fiscal 2019 (52 weeks)				% Net Revenues				Fiscal 2018 (53 weeks)				% Net Revenues
Selling, general and administrative expenses		$	1,673,218				28.4%			$	1,665,060				29.4%

Selling, general and administrative expenses consist of

non-occupancy-related

costs associated with our retail stores, distribution and manufacturing facilities, customer care centers, supply chain operations (buying, receiving and inspection) and corporate administrative functions. These costs include employment, advertising, third-party credit card processing and other general expenses.

Fiscal 2019 vs. Fiscal 2018

Selling, general and administrative expenses increased by $8,158,000, or 0.5%, in fiscal 2019 compared to fiscal 2018. Selling, general and administrative expenses as a percentage of net revenues decreased to 28.4% in fiscal 2019 from 29.4% in fiscal 2018. This decrease as a percentage of net revenues was driven by the leverage of employment and advertising costs from higher sales and the continued cost savings initiatives across the business, as well as our overall expense discipline.

INCOME TAXES

The effective income tax rate was 22.1% for fiscal 2019 and 22.3% for fiscal 2018.

LIQUIDITY AND CAPITAL RESOURCES

As of February 2, 2020, we held $432,162,000 in cash and cash equivalents, the majority of which was held in interest-bearing demand deposit accounts and money market funds, and of which $201,909,000 was held by our foreign subsidiaries. As is consistent within our industry, our cash balances are seasonal in nature, with the fourth quarter historically representing a significantly higher level of cash than other periods.

Throughout the fiscal year, we utilize our cash balances to build our inventory levels in preparation for our fourth quarter holiday sales. In fiscal 2020, we plan to use our cash resources to fund our inventory and inventory-related purchases, advertising and marketing initiatives, stock repurchases and dividend payments, and property and equipment purchases. In addition to our cash balances on hand, we have a credit facility, which provides for a $500,000,000 unsecured revolving line of credit (“revolver”), and a $300,000,000 unsecured term loan facility (“term loan”). The revolver may be used to borrow revolving loans or to request the issuance of letters of credit. We may, upon notice to the administrative agent, request existing or new lenders to increase the revolver by up to $250,000,000, at such lenders’ option, to provide for a total of $750,000,000 of unsecured revolving credit. During fiscal 2019, we had borrowings under the revolver of $100,000,000, all of which were repaid in the fourth quarter of fiscal 2019. During fiscal 2018, we had borrowings under the revolver of $60,000,000, all of which were repaid in the fourth quarter of fiscal 2018. As of February 2, 2020, we had $300,000,000 outstanding under our term loan. The term loan matures on January 8, 2021, at which point all outstanding principal and any accrued interest must be repaid. Prior to maturity in fiscal 2020, we intend to renew and extend our $300,000,000 term loan. See Note P: Subsequent Events to our Consolidated Financial Statements. Additionally, as of February 2, 2020, a total of $12,187,000 in issued but undrawn standby letters of credit were outstanding under the credit facility. The standby letters of credit were issued to secure the liabilities associated with workers’ compensation and other insurance programs.

Additionally, we have three unsecured letter of credit reimbursement facilities, which were amended during the year, for a total of $70,000,000, of which an aggregate of $6,462,000 was outstanding as of February 2, 2020. These letter of credit facilities represent only a future commitment to fund inventory purchases to which we had not taken legal title.

We are currently in compliance with all of our financial covenants under the credit facility. We believe our cash on hand, in addition to our available credit facilities, will provide adequate liquidity for our business operations over the next 12 months. see “Risk Factors” in Item 1A and Note P: Subsequent Events to our Consolidated Financial Statements.

Cash Flows from Operating Activities

For fiscal 2019, net cash provided by operating activities was $607,294,000 compared to $585,986,000 in fiscal 2018. For fiscal 2019, net cash provided by operating activities was primarily attributable to net earnings adjusted for

non-cash

items, a decrease in merchandise inventories, and an increase in accrued expenses and other liabilities, partially offset by a decrease in accounts payable. This represents an increase in net cash provided by operating activities compared to fiscal 2018 primarily due to a decrease in merchandise inventories and a decrease in prepaid expenses, partially offset by an increase in payments for accounts payable and accrued expenses, and a decrease in gift card and other deferred revenue.

Cash Flows from Investing Activities

For fiscal 2019, net cash used in investing activities was $185,548,000 compared to $187,899,000 in fiscal 2018, and was primarily attributable to purchases of property and equipment.

Cash Flows from Financing Activities

For fiscal 2019, net cash used in financing activities was $327,226,000 compared to $450,066,000 in fiscal 2018. For fiscal 2019, net cash used in financing activities was primarily attributable to the payment of dividends and repurchases of common stock. Net cash used in financing activities compared to fiscal 2018 decreased primarily due to a decrease in repurchases of common stock.

Dividends

In fiscal 2019 and fiscal 2018, total cash dividends declared were approximately $156,103,000, or $1.92 per common share, and $144,609,000, or $1.72 per common share, respectively. Our quarterly cash dividend may be limited or terminated at any time.

Stock Repurchase Programs

See section titled “Stock Repurchase Programs” within Part II, Item 5 of this Annual Report on Form

10-K

for further information.

Contractual Obligations

The following table provides summary information concerning our future contractual obligations as of February 2, 2020:

		Payments Due by Period 1
In thousands		Fiscal 2020				Fiscal 2021 to Fiscal 2023				Fiscal 2024 to Fiscal 2025				Thereafter				Total
Current debt 2		$	300,000			$	—			$	—			$	—			$	300,000
Interest			9,634				—				—				—				9,634
Operating leases 3			281,995				637,867				284,461				333,413				1,537,736
Purchase obligations 4			857,106				28,420				83				—				885,609
Total		$	1,448,735			$	666,287			$	284,544			$	333,413			$	2,732,979

1	This table excludes $43.9 million of liabilities for unrecognized tax benefits associated with uncertain tax positions as we are not able to reasonably estimate when and if cash payments for these liabilities will occur. This amount, however, has been recorded as a liability in our accompanying Consolidated Balance Sheet as of February 2, 2020.

	2 Current debt consists of term loan borrowings under our credit facility. See Note C to our Consolidated Financial Statements for discussion of our borrowing arrangements.

3	Projected undiscounted payments include only those amounts that are fixed and determinable as of the reporting date. See Note E to our Consolidated Financial Statements for discussion of our operating leases.

4	Represents estimated commitments at year-end to purchase inventory and other goods and services in the normal course of business to meet operational requirements.

Other Contractual Obligations

We have other liabilities reflected in our Consolidated Balance Sheet. The payment obligations associated with these liabilities are not reflected in the table above due to the absence of scheduled maturities. The timing of these payments cannot be determined, except for amounts estimated to be payable in fiscal 2020, which are included in our current liabilities as of February 2, 2020.

In connection with our acquisition of Outward Inc., we have agreed to pay certain additional amounts to former stockholders of Outward, contingent upon their continued service or the achievement of certain financial performance targets. These contingent obligations are not reflected in the table above. See Note O to Our Consolidated Financial Statements.

We are party to a variety of contractual agreements under which we may be obligated to indemnify the other party for certain matters. These contracts primarily relate to commercial matters, operating leases, trademarks, intellectual property and financial matters. Under these contracts, we may provide certain routine indemnification relating to representations and warranties or personal injury matters. The terms of these indemnifications range in duration and may not be explicitly defined. Historically, we have not made significant payments for these indemnifications. We believe that if we were to incur a loss in any of these matters, the loss would not have a material effect on our financial condition or results of operations.

Commercial Commitments

The following table provides summary information concerning our outstanding commercial commitments as of February 2, 2020:

		Amount of Outstanding Commitment Expiration by Period 1
In thousands		Fiscal 2020				Fiscal 2021 to Fiscal 2023				Fiscal 2024 to Fiscal 2025				Thereafter				Total
Standby letters of credit		$	12,187			$	—			$	—			$	—			$	12,187
Letter of credit facilities			6,462				—				—				—				6,462
Total		$	18,649			$	—			$	—			$	—			$	18,649

1 See Note C to our Consolidated Financial Statements for discussion of our borrowing arrangements.

IMPACT OF INFLATION

The impact of inflation (or deflation) on our results of operations for the past three fiscal years has not been significant. However, we cannot be certain of the effect inflation (or deflation) may have on our results of operations in the future.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these Consolidated Financial Statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. These estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ from these estimates.

We believe the following critical accounting policies used in the preparation of our Consolidated Financial Statements include the significant estimates and assumptions that we consider to be the most critical to an understanding of our financial statements because they involve significant judgments and uncertainties. See Note A to our Consolidated Financial Statements for further discussion of each policy.

Merchandise Inventories

Merchandise inventories, net of an allowance for shrinkage and obsolescence, are stated at the lower of cost (weighted average method) or market. To determine if the value of our inventory should be reduced below cost, we consider current and anticipated demand, customer preferences and age of the merchandise. The significant estimates used in inventory valuation are obsolescence (including excess and slow-moving inventory and lower of cost or market reserves) and estimates of inventory shrinkage. We reserve for obsolescence based on historical trends of inventory sold below cost and specific identification.

Reserves for shrinkage are estimated and recorded throughout the year as a percentage of net sales based on historical shrinkage results, cycle count results within our distribution centers, expectations of future shrinkage and current inventory levels. Actual shrinkage is recorded at

year-end

based on the results of our cycle counts and year end physical inventory counts, and can vary from our estimates due to such factors as changes in operations, the mix of our inventory (which ranges from large furniture to small tabletop items) and execution against loss prevention initiatives in our stores, distribution facilities and

off-site

storage locations, and with our third-party warehouse and transportation providers. Accordingly, there is no shrinkage reserve at

year-end,

with the exception of a cycle count reserve based on the historical cycle count results in our distribution centers. This reserve was not material to our Consolidated Financial Statements as of February 2, 2020. Historically, actual shrinkage has not differed materially from our estimates.

Our obsolescence and shrinkage reserve calculations contain estimates 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 our original estimate, we will adjust our reserves accordingly throughout the year. We have made no material changes to our assumptions included in the calculations of the obsolescence and shrinkage reserves throughout the year. In addition, we do not believe a 10% change in our inventory reserves would have a material effect on our net earnings. As of February 2, 2020 and February 3, 2019, our inventory obsolescence reserves were $13,424,000 and $13,580,000, respectively.

Long-lived Assets

Property and equipment is stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets.

We review the carrying value of all long-lived assets for impairment, primarily at an individual store level, whenever events or changes in circumstances indicate that the carrying value of an asset or asset group may not be recoverable. Our impairment analyses determine whether projected cash flows from operations are sufficient to recover the carrying value of these assets. The asset group is comprised of both property and equipment and operating lease right-of-use assets. Impairment may result when the carrying value of the asset or asset group exceeds the estimated undiscounted future cash flows over its remaining useful life. For store asset impairment, our estimate of undiscounted future cash flows over the store lease term is based upon our experience, the historical operations of the stores and estimates of future store profitability and economic conditions. The estimates of future store profitability and economic conditions require estimating such factors as sales growth, gross margin, employment costs, lease escalations, inflation and the overall economics of the retail industry, and are therefore subject to variability and difficult to predict. For right-of-use assets, we determine the fair value of the assets by using estimated market rental rates. These estimates can be affected by factors such as future store results, real estate demand, store closure plans, and economic conditions that can be difficult to predict. Actual future results may differ from those estimates. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the excess of the asset or asset group’s net carrying value over its estimated fair value. We measure property and equipment at fair value on a nonrecurring basis using Level 3 inputs as defined in the fair value hierarchy (see Note M to our Consolidated Financial Statements). We measure right-of-use assets at fair value on a nonrecurring basis using Level 2 inputs, primarily market rental rates, that are corroborated by market data. Where Level 2 inputs are not readily available, we use Level 3 inputs. Fair value of these long-lived assets is based on the present value of estimated future cash flows using a discount rate commensurate with the risk.

During fiscal 2019, we recorded an approximate $3,303,000, reduction, net of tax to the opening balance of retained earnings resulting from the impairment of certain long-lived assets upon adoption of ASU

2016-02,

Leases

(see Note A to our Consolidated Financial Statements). During fiscal 2018, we recorded asset impairment charges of approximately $9,639,000, related to property and equipment for our retail stores, which is recorded within selling, general and administrative expenses.

Leases

We lease store locations, distribution and manufacturing facilities, corporate facilities, customer care centers and certain equipment for our U.S. and foreign operations with initial terms generally ranging from 2 to 22 years. We determine whether an arrangement is or contains a lease at inception by evaluating potential lease agreements, including service and operating agreements, to determine whether an identified asset exists that we control over the term of the arrangement.

Lease commencement is determined to be when the lessor provides us access to, and the right to control, the identified asset.

Upon lease commencement, we recognize a

right-of-use

asset and a corresponding lease liability measured at the present value of the fixed future minimum lease payments. We record a

right-of-use

asset for an amount equal to the lease liability, increased for any prepaid lease costs and initial direct costs and reduced by any lease incentives. We remeasure the lease liability and

right-of-use

asset when a remeasurement event occurs. Many of our leases contain renewal and early termination options. The option periods are generally not included in the lease term used to measure our lease liabilities and

right-of-use

assets upon commencement, as we do not believe the exercise of these options to be reasonably certain. We remeasure the lease liability and

right-of-use

asset when we are reasonably certain to exercise a renewal or an early termination option.

Our leases generally do not provide information about the rate implicit in the lease. Therefore, we utilized an incremental borrowing rate to calculate the present value of our future lease obligations. The incremental borrowing rate represents the rate of interest we would have to pay on a collateralized borrowing, for an amount equal to the lease payments, over a similar term and in a similar economic environment. We use judgment in determining our incremental borrowing rate, which is applied to each lease based on the lease term. An increase or decrease in the incremental borrowing rate applied would impact the value of our

right-of-use

assets and lease liabilities.

We use judgment in determining lease classification, including our determination of the economic life and the fair market value of the identified asset. The fair market value of the identified asset is generally estimated based on comparable market data provided by third-party sources. All of our leases are currently classified as operating leases.

Business Combinations

We account for acquired businesses when we obtain control of the business using the acquisition method of accounting. Assets acquired and liabilities assumed are recorded based upon the estimated fair value as of the acquisition date. Estimated fair values represent the estimated price that would be paid by a third-party market participant based upon the highest and best use of the assets acquired or liabilities assumed. The determination of the fair value of assets acquired and liabilities assumed requires significant judgment and estimates. In making such judgments and estimates, we utilize inputs from independent third-party valuation specialists and other internal sources. Any excess of the purchase price over the estimated fair value of the identifiable net assets acquired is recorded as goodwill. Acquisition-related expenses are expensed as incurred. During fiscal 2017, we acquired Outward (see Note O to our Consolidated Financial Statements). During the second quarter of fiscal 2018, we finalized the valuation of intangible assets acquired, which primarily represent

3-D

imaging data and core intellectual property, which are being amortized over a useful life of four years.

Goodwill

Goodwill is initially recorded as of the acquisition date, and is measured as any excess of the purchase price over the estimated fair value of the identifiable net assets acquired. Goodwill is not amortized, but rather is subject to

impairment testing annually (on the first day of the fourth quarter), or between annual tests whenever events or changes in circumstances indicate that the fair value of a reporting unit may be below its carrying amount. We first perform a qualitative assessment to evaluate goodwill for potential impairment. If based on that assessment, it is more likely than not that the fair value of the reporting unit is below its carrying value, a quantitative impairment test is necessary. The quantitative impairment test requires determining the fair value of the reporting unit. We use the income approach, whereby we calculate the fair value based on the present value of estimated future cash flows using a discount rate that approximates our weighted average cost of capital. The process of evaluating the potential impairment of goodwill is subjective and requires significant estimates and assumptions about the future, such as sales growth, gross margins, employment costs, capital expenditures, inflation and future economic and market conditions. Actual future results may differ from those estimates. If the carrying value of the reporting unit’s assets and liabilities, including goodwill, exceeds its fair value, impairment is recorded for the excess, not to exceed the total amount of goodwill allocated to the reporting unit.

As of February 2, 2020 and February 3, 2019, we had goodwill of $85,343,000 and $85,382,000, respectively, primarily related to our fiscal 2017 acquisition of Outward and our fiscal 2011 acquisition of Rejuvenation, Inc. In fiscal 2019, fiscal 2018, and fiscal 2017, we performed a qualitative assessment of potential goodwill impairment and determined it was more likely than not that the fair value of each of our reporting units exceeded its carrying value. Accordingly, no further impairment testing of goodwill was performed. We did not recognize any goodwill impairment in fiscal 2019, fiscal 2018, or fiscal 2017.

Self-Insured Liabilities

We are primarily self-insured for workers’ compensation, employee health benefits, product and other general liability claims. We record self-insurance liability reserves based on claims filed, including the development of those claims, and an estimate of claims incurred but not yet reported, based on an actuarial analysis of historical claims data. Factors affecting these estimates include future inflation rates, changes in severity, benefit level changes, medical costs and claim settlement patterns. Should a different number of claims occur compared to what was estimated, or costs of the claims increase or decrease beyond what was anticipated, reserves may need to be adjusted accordingly. Self-insurance reserves for workers’ compensation, employee health benefits, product and other general liability claims were $27,000,000 and $28,542,000 as of February 2, 2020 and February 3, 2019, respectively.

Income Taxes

Income taxes are accounted for using the asset and liability method. Under this method, deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in our Consolidated Financial Statements. We record reserves for our estimates of the additional income tax liability that is more likely than not to result from the ultimate resolution of foreign and domestic tax examinations. At any one time, many tax years are subject to examination by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. We review and update the estimates used in the accrual for uncertain tax positions as more definitive information becomes available from taxing authorities, upon completion of tax examination, upon expiration of statutes of limitation, or upon occurrence of other events.

In order to compute income tax on an interim basis, we estimate what our effective tax rate will be for the full fiscal year and adjust these estimates throughout the year as necessary. Adjustments to our income tax provision due to changes in our estimated effective tax rate are recorded in the interim period in which the change occurs. The tax expense (or benefit) related to items other than ordinary income is individually computed and recognized when the items occur. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of our earnings in various taxing jurisdictions or changes in tax law.