Walmart Reports Material Weakness

In a 10-Q filed yesterday, September 9th, Walmart disclosed a significant deficiency that rose to the level of material weakness in its SOX Section 302 Disclosure Controls and Procedures assessment. The deficiency related to the company’s application of lease accounting. According to the filing, the material weakness resulted in a misapplication and misrepresentation of ASC 840 – Leases.

During the second quarter of fiscal 2016, we identified a material weakness in our controls over accounting for leases, as described below. Based upon that discovery, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are not effective at a level that provides reasonable assurance as of the last day of the period covered by this report.

The material weakness in internal control over financial reporting resulted from the lack of controls which allowed for the misinterpretation and historical misapplication of Accounting Standards Codification (“ASC”) 840, Leases, regarding sale-leaseback accounting, including lessee involvement in the construction of leased assets. Specifically, we did not have adequate controls in place to properly identify and account for leases that were subject to the sale-leaseback accounting guidance, including leases in which we made payments for certain structural components included in the lessor’s construction of the leased assets, which should have resulted in the Company being deemed the owner of the leased assets for accounting purposes.

Shares of WMT are below retail averages and the S&P 500 for the day. Were there early signs that lease accounting might be a weak spot in Walmart’s accounting? We noticed a few things that might have suggested the need for further investigation.

In its 2014 annual report filed on March 21, 2014, the company corrected some store lease expenses in China and Mexico that did not conform to Walmart’s global accounting policies. The description of the error was short, and did not provide much insight into potential impact of the errors:

In fiscal 2014, the Company corrected certain amounts pertaining to previous fiscal years as management determined they were not material, individually or in the aggregate, to any of the periods presented in the Company’s Consolidated Financial Statements.

A comment letter from the SEC released to the public on December 15, 2014 provided additional insight into the materiality of the error.

According to the materiality analysis provided by Walmart, the correction of the error increased SG&A expenses in 2014 by $277 million and decreased Diluted EPS by $0.08 (or about 1.6%). Interestingly, while immaterial to Walmart’s overall performance, this was the largest of 312 such catch-up error corrections in 2014. (Out of period adjustments are errors that are immaterial to prior and current financial statements and therefore corrected in the current period on a cumulative and prospective basis.)

In a follow up letter, the SEC requested clarification regarding the specific control deficiencies related to lease accounting.

1. We note your prior response and your conclusions that a) control design deficiencies exist in your Mexico and China subsidiaries’ lease processes related to the determination and application of lease terms, and b) you did not identify any systemic instances of not complying with your other global accounting policies. Further, we note from your Item 9A disclosures that you are implementing material internal control changes on a global scale, i.e. global shared services functions and as disclosed on page 50, have had significant changes in policies, practices, and internal controls related to your compliance programs. Please address the following:

• Tell us the specific control(s) that were deficient in the lease process. In doing so, tell us whether these deficiencies related to missing controls or inadequately designed controls, and what you have done to remediate the deficiencies.
• Describe what you have identified to be the cause(s) of these control design deficiencies, and tell us how you considered whether it was reasonably possible that such cause(s) could have resulted in non-compliance with other global accounting policies.

The response, however, was not very informative – Walmart requested that the information remain confidential based on FOIA. Confidentiality requests are filed for a variety of reasons; most common perhaps is to avoid disclosing sensitive business information to competitors. Yet, as we have discussed more than once (for example, here and here), there is good reason to pay closer attention to the confidential sections.

An additional adjustment is expected to be recorded in Q3 of 2016. According to the most recent 10-Q (that also references a previously-filed 8-K):

As previously disclosed in the Company’s Form 8-K furnished on August 18, 2015, we have been engaged in a review of the accounting treatment of leases. As part of this ongoing global review, we are assessing our historical application of Accounting Standards Codification (“ASC”) 840, Leases, regarding lessee involvement in the construction of leased assets. While we are in the final stages of management’s assessment and review of the impact of the related errors, management believes that the maximum cumulative adjustment to the accompanying Balance Sheets, Statements of Income and Statements of Cash Flows is immaterial for all periods. We anticipate recording the immaterial cumulative adjustment in the third quarter of fiscal 2016. These immaterial errors resulted from the failure to appropriately consider the implications of ASC 840 with respect to lessee involvement in the construction of leased assets. In a number of our leases, payments we have made for certain structural components included in the lessor’s construction of the leased assets will result in the Company being deemed the owner of the leased assets for accounting purposes. As a result, regardless of the significance of the payments, ASC 840 defines those payments as automatic indicators of ownership and requires the Company to capitalize the lessor’s total project cost on the balance sheet with a corresponding financing obligation. Generally, in these situations, the Company has not historically accounted for the total project costs of the lessor as owned assets. Additionally, upon completion of the lessor’s project, the Company must perform a sale-leaseback analysis pursuant to ASC 840 to determine if the Company can derecognize these assets and the related financing obligation from its Balance Sheet. In a substantial number of our leases, due to many of the same factors that required the Company to originally account for the total project costs as owned assets (for example, a portion of the construction costs is reimbursed to the Company via lowered rental payments), we are deemed to have “continuing involvement,” which precludes the Company from derecognizing these leased assets when construction is complete. In such cases, the leased assets and the related financing obligation remain on the Balance Sheet and are amortized over the lease term.

It is not clear whether the material weakness identified in yesterday’s 10-Q was related to these previously disclosed deficiencies in China and Mexico, or whether to other, unrelated lease accounting issues discovered after the completion of the SEC’s review.

Nevertheless, in this latest instance Walmart provides another example of the important role comment letters and irregular accounting adjustments can play in identifying  areas of increased accounting and regulatory risk.