(1) Business and Summary of Significant Accounting Policies

Business & Basis of Presentation

Select Comfort Corporation and our wholly-owned subsidiaries (“Select Comfort” or the “Company”) design, manufacture, market and distribute the proprietary SLEEP NUMBER® bed, a premium quality, adjustable-firmness mattress, and other sleep-related products. We sell through two distribution channels: (i) Company-Controlled which includes Retail, Direct and E-Commerce; and (ii) Wholesale. The consolidated financial statements include the accounts of Select Comfort Corporation and our subsidiaries. All significant intra-entity balances and transactions have been eliminated in consolidation.

Change in Accounting Principle - Cash and Cash Equivalents

At the beginning of 2011, we changed our accounting policy for payments due from financial services companies for credit card and debit card transactions. Historically, at each reporting period, we classified all credit card and debit card transactions that processed in less than seven days as cash and cash equivalents on our consolidated balance sheets. We now classify these credit card and debit card transactions as accounts receivable until the cash is received. We believe that our new policy is preferable because the presentation (i) more appropriately aligns with our view that these credit card and debit card transactions are not part of our cash management processes (i.e., these receivables are non-interest bearing and are not taken into consideration when making cash management decisions), and (ii) is more consistent with the nature of the credit card and debit card receivables, which are subject to the credit risk of the financial services companies. Our new policy resulted in the adjustment of certain amounts in our consolidated balance sheets and consolidated statements of cash flows. This change in accounting principle had no effect on our previously reported consolidated shareholders' equity or consolidated net income.

The change in accounting principle has been applied retrospectively by adjusting all previously reported amounts to conform to our new policy. A summary of the retrospective application is as follows for the periods presented in this Form 10-K (in thousands):

	Before Accounting Policy Change		Adjustment			As Reported
Consolidated balance sheet – December 31, 2011
Cash and cash equivalents	$	125,205	$	(8,950	)	$	116,255
Accounts receivable		4,894		8,950			13,844

	As Previously Reported		Adjustment			As Adjusted
Consolidated balance sheet – January 1, 2011
Cash and cash equivalents	$	81,361	$	(5,345	)	$	76,016
Accounts receivable		4,564		5,345			9,909

	Before Accounting Policy Change			Adjustment			As Reported
Consolidated statement of cash flow – Year ended December 31, 2011
Cash flows from operating activities:
Changes in operating assets and liabilities:
Accounts receivable	$	(330	)	$	(3,605	)	$	(3,935	)
Net cash provided by operating activities		94,651			(3,605	)		91,046

Net increase in cash and cash equivalents	$	43,844		$	(3,605	)	$	40,239
Cash and cash equivalents, at beginning of year		81,361			(5,345	)		76,016
Cash and cash equivalents, at end of year	$	125,205		$	(8,950	)	$	116,255

	As Previously Reported		Adjustment			As Adjusted
Consolidated statement of cash flow – Year ended January 1, 2011
Cash flows from operating activities:
Changes in operating assets and liabilities:
Accounts receivable	$	530	$	188		$	718
Net cash provided by operating activities		71,219		188			71,407

Net increase in cash and cash equivalents	$	63,644	$	188		$	63,832
Cash and cash equivalents, at beginning of year		17,717		(5,533	)		12,184
Cash and cash equivalents, at end of year	$	81,361	$	(5,345	)	$	76,016

	As Previously Reported			Adjustment			As Adjusted
Consolidated statement of cash flow – Year ended January 2, 2010
Cash flows from operating activities:
Changes in operating assets and liabilities:
Accounts receivable	$	(155	)	$	(3,463	)	$	(3,618	)
Net cash provided by operating activities		66,639			(3,463	)		63,176

Net increase in cash and cash equivalents	$	4,660		$	(3,463	)	$	1,197
Cash and cash equivalents, at beginning of year		13,057			(2,070	)		10,987
Cash and cash equivalents, at end of year	$	17,717		$	(5,533	)	$	12,184

Fiscal Year

Our fiscal year ends on the Saturday closest to December 31. Fiscal years and their respective fiscal year ends are as follows: fiscal 2011 ended December 31, 2011; fiscal 2010 ended January 1, 2011; and fiscal 2009 ended January 2, 2010. Fiscal years 2011, 2010 and 2009 each had 52 weeks.

Use of Estimates in the Preparation of Financial Statements

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires us to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of sales, expenses and income taxes during the reporting period. Predicting future events is inherently an imprecise activity and, as such, requires the use of judgment. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates will be reflected in the financial statements in future periods. Our critical accounting policies consist of asset impairment charges, stock-based compensation, self-insured liabilities, warranty liabilities and revenue recognition.

Cash and Cash Equivalents

Cash and cash equivalents include highly liquid investments with original maturities of three months or less. The carrying value of these investments approximates fair value due to their short-term maturity. Our banking arrangements allow us to fund outstanding checks when presented to the financial institution for payment, resulting in book overdrafts. Book overdrafts totaled $6.9 million and $7.2 million at December 31, 2011, and January 1, 2011, respectively. Book overdrafts are included in accounts payable in our consolidated balance sheets and in net decrease in short-term borrowings in the financing activities section of our consolidated statements of cash flows.

Investments

Our investment portfolio is currently comprised of U.S. Treasury securities. The value of these securities is subject to market and credit volatility during the period these investments are held. We classify marketable debt securities as available-for-sale investments and these securities are stated at their estimated fair value. Our investments with original maturities of greater than three months but current maturities of less than one year are recorded as marketable debt securities - current. Our investments with current maturities of more than one year are recorded as marketable debt securities – non-current. Unrealized gains and losses, net of taxes, are reported as a component of accumulated other comprehensive income in our consolidated balance sheets. Other-than-temporary declines in market value, if any, from original cost are charged to other expense, net in the consolidated statements of operations in the period in which the loss occurs, and a new cost basis for the security is established. In determining whether an other-than-temporary decline in the market value has occurred, we consider the duration and extent that the fair value of the investment is below its cost. There were no other-than-temporary declines in market value during 2011.

Realized gains and losses, if any, are calculated on the specific identification method and are measured and reclassified from accumulated other comprehensive income in our consolidated balance sheets to other expense, net in our consolidated statements of operations.

See Note 2, Fair Value Measurements, for more information on our fair value measurements.

Concentration of Credit Risk

Our investment policy's primary focus is to preserve principal and maintain adequate liquidity. Our investment policy addresses the concentration of credit risk by limiting the concentration in certain investment types. Our exposure to a concentration of credit risk consist primarily of cash, cash equivalents and investments. We place our cash with high-credit quality financial institutions. We currently hold investments solely in U.S. Treasury securities. We believe no significant concentration of credit risk exist with respect to our cash, cash equivalents and investments.

Accounts Receivable

Accounts receivable are recorded net of an allowance for expected losses and consist primarily of receivables from wholesale customers and receivables from third-party financiers for customer credit card purchases. The allowance is recognized in an amount equal to anticipated future write-offs. We estimate future write-offs based on delinquencies, aging trends, industry risk trends and our historical experience. Account balances are charged off against the allowance when we believe it is probable the receivable will not be recovered.

Inventories

Inventories include materials, labor and overhead and are stated at the lower of cost or market. Cost is determined by the first-in, first-out method.

Property and Equipment

Property and equipment, carried at cost, is depreciated using the straight-line method over the estimated useful lives of the assets. The cost and related accumulated depreciation of assets sold or retired is removed from the accounts with any resulting gain or loss included in net income in our consolidated statements of operations. Maintenance and repairs are charged to expense as incurred. Major renewals and betterments that extend useful life are capitalized.

Leasehold improvements are depreciated over the shorter of the estimated useful lives of the assets or the contractual term of the lease, with consideration of lease renewal options if renewal appears probable.

Property under capital lease is comprised of manufacturing equipment, computer equipment and computer software used in our retail operations and corporate support areas.

Estimated useful lives of our property and equipment by major asset category are as follows:

Leasehold improvements	5 to 10 years
Office furniture and equipment	5 to 7 years
Production machinery, computer equipment and software	3 to 7 years
Property under capital lease	3 to 4 years

Other Assets

Other assets include deposits, patents, trademarks and goodwill. Patents and trademarks are amortized using the straight-line method over periods ranging from 10 to 17 years. The carrying value of goodwill at both December 31, 2011, and January 1, 2011, was $2.9 million.

Asset Impairment Charges

We review our long-lived assets and finite-lived intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated fair value plus net proceeds expected from disposition of the asset (if any). When we recognize an impairment loss, the carrying amount of the asset is reduced to estimated fair value based on discounted cash flows, quoted market prices or other valuation techniques. Assets to be disposed of are reported at the lower of the carrying amount of the asset or fair value less costs to sell. We review store assets for potential impairment based on historical cash flows, lease termination provisions and expected future store operating results.

Asset impairment charges is one of our critical accounting estimates and requires management to make estimates about future events including sales growth rates, cash flows and asset fair values. Predicting future events is inherently an imprecise activity. If actual results are not consistent with the estimates and assumptions used in our asset impairment calculations, we may incur additional impairment charges. See Note 1, Business and Summary of Significant Accounting Policies – Fair Value Measurements, for a discussion of how we determine fair values.

Our test for goodwill impairment is performed at least annually. Beginning in the fourth quarter of fiscal 2011, we early adopted the Financial Accounting Standards Board's (“FASB's”) new guidance for goodwill impairment testing. The new guidance allows us to perform a qualitative assessment before calculating the fair value of a reporting unit. If we determine, based on our qualitative assessments, that the fair value of our reporting unit is “more likely than not” greater than the carrying amount, a quantitative calculation would not be needed. However, if there are any indications of impairment or if the fair value of our reporting unit is not “more likely than not” greater than the carrying amount, we would perform a quantitative analysis. The FASB's new guidance did not change the quantitative assessment of goodwill, if required. The quantitative goodwill impairment test is a two-step process. The first step is a comparison of the fair value of the reporting unit with its carrying amount, including goodwill. If this step reflects impairment, then the loss would be measured as the excess of recorded goodwill over its implied fair value. Implied fair value is the excess of fair value of the reporting unit over the fair value of all identified assets and liabilities. Fair value is determined using a market-based approach utilizing widely accepted valuation techniques, including quoted market prices and our market capitalization. During the fourth quarter of 2011, we elected to complete a quantitative analysis. Based on our quantitative assessment, we determined there was no impairment.

Warranty Liabilities

We provide a 20-year limited warranty on our beds. The customer participates over the last 18 years of the warranty period by paying a portion of the retail value of replacement parts. The estimated warranty costs, which are expensed at the time of sale and included in cost of sales, are based on historical claims rates incurred by us and are adjusted for any current trends as appropriate. Our warranty liability is one of our critical accounting policies and contains uncertainties because our warranty obligations cover an extended period of time. Actual warranty claim costs could differ from these estimates. We regularly assess and adjust the estimate of accrued warranty claims by updating claims rates for actual trends and projected claim costs.

We classify as noncurrent those estimated warranty costs expected to be paid out in greater than one year. The activity in the accrued warranty liabilities account was as follows (in thousands):

	2011			2010			2009
Balance at beginning of year	$	5,744		$	7,143		$	8,049
Additions charged to costs and expenses for current-year sales		4,232			3,630			5,114
Deductions from reserves		(4,750	)		(4,318	)		(5,822	)
Changes in liability for pre-existing warranties during the current year, including expirations(1)		1,084			(711	)		(198	)
Balance at end of period	$	6,310		$	5,744		$	7,143

(1)

Incudes $1.6 million adjustment for customer-service reserves during 2011.

Fair Value Measurements

The guidance for fair value measurements establishes the authoritative definition of fair value, sets out a framework for measuring fair value and outlines the required disclosures regarding fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. We use a three-tier fair value hierarchy based upon observable and non-observable inputs as follows:

-	Level 1 – observable inputs such as quoted prices in active markets;

-	Level 2 – inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and

-	Level 3 – unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

We generally estimate fair value of long-lived assets, including our retail stores, using the income approach, which we base on estimated future cash flows (discounted and with interest charges). The inputs used to determine fair value relate primarily to future assumptions regarding sales volumes, gross profit rates, store operating expenses and applicable probability weightings regarding future alternative uses. These inputs are categorized as Level 3 inputs under the fair value measurements guidance. The inputs used represent management's assumptions about what information market participants would use in pricing the assets and are based upon the best information available at the balance sheet date.

Our projected fair value calculations reflect recent consumer spending trends and assume no significant change in the macroeconomic environment for the foreseeable future. Our fair value calculations reflect the ongoing availability of consumer credit and our ability to provide cost-effective consumer credit options.

Revenue Recognition

Revenue is recognized when the sales price is fixed or determinable, collectability is reasonably assured and title passes. Amounts billed to customers for delivery and set up are included in net sales. Revenue is reported net of estimated sales returns and excludes sales taxes.

We accept sales returns after a 30-night trial period. The accrued sales returns estimate is based on historical return rates and is adjusted for any current trends as appropriate. If actual returns vary from expected rates, sales in future periods are adjusted.

Cost of Sales, Sales and Marketing, General and Administrative (“G&A”) and Research & Development (“R&D”) Expenses

The following tables summarize the primary costs classified in each major expense category (the classification of which may vary within our industry):

Cost of Sales		Sales & Marketing

• Costs associated with purchasing, manufacturing, shipping, handling and delivering our products to our stores and customers; • Physical inventory losses, scrap and obsolescence; • Related occupancy and depreciation expenses; and • Estimated costs to service warranty claims of customers.		• Advertising and media production; • Marketing and selling materials such as brochures, videos, customer mailings and in-store signage; • Payroll and benefits for sales and customer service staff; • Store occupancy costs; • Store depreciation expense; • Credit card processing fees; and • Promotional financing costs.
G&A		R&D(1)

• Payroll and benefit costs for corporate employees, including information technology, legal, human resources, finance, sales and marketing administration, investor relations and risk management; • Occupancy costs of corporate facilities; • Depreciation related to corporate assets; • Information hardware, software and maintenance; • Insurance; • Investor relations costs; and • Other overhead costs.		• Internal labor and benefits related to research and development activities; • Outside consulting services related to research and development activities; and • Testing equipment related to research and development activities. (1) Costs incurred in connection with R&D are charged to expense as incurred.

Operating Leases

We rent our retail, office and manufacturing space under operating leases which, in addition to the minimum lease payments, require payment of a proportionate share of the real estate taxes and certain building operating expenses. In addition, our mall store leases may require payment of contingent rents based upon sales levels.

Rent expense is recognized on a straight-line basis over the lease term, after consideration of rent escalations and rent holidays. We record any difference between the straight-line rent amounts and amounts payable under the leases as part of deferred rent, in other current liabilities or other long-term liabilities, as appropriate. The lease term for purposes of the calculation begins on the earlier of the lease commencement date or the date we take possession of the property. During lease renewal negotiations that extend beyond the original lease term, we estimate straight-line rent expense based on current market conditions. At December 31, 2011, and January 1, 2011, deferred rent included in other current liabilities in our consolidated balance sheets was $1.3 million and $1.5 million, respectively, and deferred rent included in other long-term liabilities in our consolidated balance sheets was $3.7 million and $3.9 million, respectively.

Leasehold improvements that are funded by landlord incentives or allowances under an operating lease are recorded as deferred lease incentives, in other current liabilities or other long-term liabilities, as appropriate and amortized as reductions to rent expense over the lease term. At December 31, 2011, and January 1, 2011, deferred lease incentives included in other current liabilities in our consolidated balance sheets were $1.2 million and $1.2 million, respectively, and deferred lease incentives included in other long-term liabilities in our consolidated balance sheets were $3.7 million and $3.6 million, respectively.

Lease payments that depend on factors that are not measurable at the inception of the lease, such as future sales levels, are contingent rents and are excluded from minimum lease payments and included in the determination of total rent expense when it is probable the expense has been incurred and the amount is reasonably estimable. Future payments for real estate taxes and certain building operating expenses for which we are obligated are not included in minimum lease payments.

We also lease delivery vehicles, which in addition to the minimum lease payments, require payment of a management fee and contain certain residual value guarantee provisions that would become due at the expiration of the operating agreement if the fair value of the leased vehicles is less than the guaranteed residual value. As of December 31, 2011, the maximum guaranteed residual value at lease expiration was $0.8 million. Historically, payments related to these guarantees have been insignificant. We believe the likelihood of funding the guarantee obligation is remote and thus, we have not recognized a liability.

Pre-opening Costs

Costs associated with the start up and promotion of new store openings are expensed as incurred.

Advertising Costs

We incur advertising costs associated with print and broadcast advertisements. Advertising costs are charged to expense when the ad first runs. Advertising expense was $91.6 million, $70.2 million and $61.4 million in 2011, 2010 and 2009, respectively. Advertising costs deferred and included in prepaid expenses in our consolidated balance sheets were $2.2 million and $1.8 million as of December 31, 2011, and January 1, 2011, respectively.

Insurance

We are self-insured for certain losses related to health and workers' compensation claims, although we obtain third-party insurance coverage to limit exposure to these claims. We estimate our self-insured liabilities using a number of factors including historical claims experience and analysis of incurred but not reported claims. Our self-insurance liability was $4.3 million and $4.4 million at December 31, 2011, and January 1, 2011, respectively. At December 31, 2011, and January 1, 2011, $2.0 million and $2.3 million, respectively, were included in other current liabilities and $2.3 million and $2.1 million, respectively, were included in other long-term liabilities in our consolidated balance sheets. At December 31, 2011, we had a restricted deposit of $2.7 million with our insurer that serves as collateral for our workers' compensation insurance obligations and was included in other current assets in our consolidated balance sheet.

Stock-Based Compensation

We record stock-based compensation expense based on the award's fair value at the date of grant and the awards that are expected to vest. We recognize stock-based compensation expense over the period during which an employee is required to provide services in exchange for the award, or to their eligible retirement date, if earlier. We use the Black-Scholes-Merton option-pricing model to estimate the fair value of stock options and resulting compensation expense. The most significant inputs into the Black-Scholes-Merton option-pricing model are exercise price, our estimate of expected stock price volatility and the weighted-average expected life of the options. We reduce compensation expense by estimated forfeitures. We include as part of cash flows from financing activities the benefit of tax deductions in excess of recognized compensation expense.

See Note 8, Shareholders' Equity, for additional information on stock-based compensation.

Income Taxes

We recognize deferred tax assets and liabilities for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established for any portion of deferred tax assets that are not considered more likely than not to be realized. We evaluate all available positive and negative evidence, including our forecast of future taxable income, to assess the need for a valuation allowance on our deferred tax assets.

We record a liability for unrecognized tax benefits from uncertain tax positions taken, or expected to be taken, in our tax returns. We follow a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately forecast actual outcomes.

We classify interest and penalties on tax uncertainties as a component of income tax expense (benefit) in our consolidated statements of operations.

Net Income Per Share

We calculated basic net income per share by dividing net income attributable to common shareholders by the weighted-average number of common shares outstanding during the period. We calculated diluted net income per share based on the weighted-average number of common shares outstanding adjusted by the number of potentially dilutive common shares as determined by the treasury stock method. Potentially dilutive shares consisted of stock options, restricted stock and warrants.

Sources of Supply

We currently obtain materials and components used to produce our beds from outside sources. As a result, we are dependent upon suppliers that in some instances, are our sole source of supply. We are continuing our efforts to dual-source key components. The failure of one or more of our suppliers to provide us with materials or components on a timely basis could significantly impact our consolidated results of operations and net income per share. We believe we can obtain these raw materials and components from other sources of supply in the ordinary course of business, although an unexpected loss of supply over a short period of time may not allow us to replace these sources in the ordinary course of business.

Subsequent Events

Events that have occurred subsequent to December 31, 2011 have been evaluated through the date the consolidated financial statements were issued. There have been no subsequent events that occurred during such period that would require recognition or disclosure in the consolidated financial statements as of or for the fiscal year ended December 31, 2011.

New Accounting Pronouncements

In May 2011, the FASB issued new guidance regarding fair value measurements. The new guidance changes the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements to ensure consistency between U.S. GAAP and International Financial Reporting Standards (“IFRS”). This guidance also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. As this is a financial statement presentation issue, we do not expect the adoption of this new guidance to have any impact on our consolidated results of operations, financial position or cash flows. This new guidance will be effective for us beginning in the first quarter of 2012 and is to be applied on a prospective basis.

In June 2011, the FASB issued new guidance regarding the presentation of other comprehensive income. The objective of the new guidance is to improve the comparability, consistency, and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. This guidance does not change the items that are required to be reported in other comprehensive income, but changes the presentation of those items in the consolidated financial statements. As this is a financial statement presentation issue, we do not expect the adoption of this new guidance to have any impact on our consolidated results of operations, financial position or cash flows. This new guidance will be effective for us beginning in the first quarter of 2012 and is to be applied on a retrospective basis.