Summary of Significant Accounting Policies

9 Months Ended

Oct. 29, 2011

Summary of Significant Accounting Policies

Summary of Significant Accounting Policies

(2)Summary of Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, SPELL C. LLC, a Delaware limited liability corporation.  All significant intercompany accounts and transactions have been eliminated in consolidation.

Allowance for Doubtful Accounts

The Company records its allowance for doubtful accounts based upon its assessment of various factors, such as: historical experience, age of accounts receivable balances, credit quality of our customers, current economic conditions, bankruptcy, and other factors that may affect customers’ ability to pay.

Revenue Recognition

Revenues from royalty and brand representation agreements are recognized when earned by applying contractual royalty rates to quarterly point of sale data received from our licensees. Our royalty recognition policy provides for recognition of royalties in the quarter earned, although a large portion of such royalty payments are actually received during the month following the end of a quarter.  Revenues are not recognized unless collectability is reasonably assured. Certain royalty agreements that account for the majority of our historical revenues are structured to provide royalty rate reductions once certain cumulative levels of sales are achieved by our licensees.  Revenue is recognized by applying the reduced contractual royalty rates prospectively to point of sale data as required sales thresholds are exceeded.  The royalty rate reductions do not apply retroactively to sales since the beginning of the fiscal year, and as a consequence such royalty rate reductions do not impact previously recognized royalty revenue.

As a result, our royalty revenues from retail sales of branded products by our most significant licensee, Target, as well as certain of our other licensees, are highest at the beginning of each fiscal year and decrease in each fiscal quarter as licensees reach certain retail sales thresholds contained in their respective license agreements.  Therefore, the amount of royalty revenue we recognize in any quarter is dependent not only on the retail sales of branded products in such quarter but also the royalty rate in effect after considering the cumulative level of retail sales.  Historically, this has usually caused our first quarter to be our highest revenue and profitability quarter; our second quarter to be our next highest quarter, and our third and fourth quarters to be our lowest quarters.  However, such historical patterns may vary in the future, depending upon the product mix and retail sales volumes achieved in each quarter with our licensees.

Deferred Revenue

Deferred revenues represent licensee revenue royalties paid in advance, the majority of which are non-refundable to the licensee.  Historically, deferred revenue was combined with accounts payable; however, beginning with the Third Quarter deferred revenue will be presented separately as current and non-current items on our balance sheet.  The values and timing of recognition of deferred revenues are outlined in our license agreements.

Deferred revenues and reclassification to accounts payable consisted of the following:

	October 29, 2011		July 30, 2011		April 30, 2011		January 29, 2011
Accounts payable, previously reported	$	N/A	$	1,841,000	$	1,363,000	$	1,867,000
Deferred revenue, current (reclassified)	368,000		218,000		139,000		386,000
Deferred revenue, non-current (reclassified)	299,000		449,000		562,000		549,000
Accounts payable,  (reclassified)	826,000		1,174,000		662,000		932,000

Earnings Per Share Computation

The following table provides a reconciliation of the numerator and denominator of the basic and diluted per-share computations for the three and nine month periods ended October 29, 2011 and October 30, 2010:

	October 29, 2011				October 30, 2010
	3 Months		9 Months		3 Months		9 Months
Numerator:
Net income-numerator for net income per common share and net income per common share assuming dilution	$	1,049,000	$	5,972,000	$	2,280,000	$	7,675,000
Denominator:
Denominator for net income per common share — weighted average Shares	8,419,473		8,476,469		8,882,493		8,836,956
Effect of dilutive securities:
Stock options	1,913		3,369		32,390		34,339
Denominator for net income per common share, assuming dilution: Adjusted weighted average shares and assumed exercises	8,421,386		8,479,838		8,914,883		8,871,295

The diluted weighted average number of shares for the three month periods ended October 29, 2011 and October 30, 2010 excludes 1,043,000 and 337,019, respectively, shares of common stock issuable on the exercise of stock options that have an exercise price above the average market price (“anti-dilutive”) for the period because such stock options outstanding were anti-dilutive. The diluted weighted average number of shares for the nine month periods ended October 29, 2011 and October 30, 2010, respectively, excludes 619,163 and 197,982 shares, respectively, of common stock issuable on the exercise of stock options because such options were anti-dilutive.

Significant Contracts

Our most significant contract is our retail direct licensing agreements with Target Stores, a subsidiary of Target Corp. (“Target”) for the Cherokee brand in the United States

In 1997, we entered into an agreement with Target that grants Target the exclusive right in the United States to use the Cherokee trademarks in certain categories of merchandise. The current terms of our relationship with Target are set forth in a restated license agreement with Target, which was entered into effective as of February 1, 2008 (the “Restated Target Agreement”).  The Restated Target Agreement grants Target the exclusive right in the United States to use the Cherokee trademarks in various specified categories of merchandise.  The term of the Restated Target Agreement continues through January 31, 2013.  However, the Restated Target Agreement provides that if Target remains current in its payments of the minimum guaranteed royalty of $9.0 million for the preceding fiscal year, then the term of the Restated Target Agreement will continue to automatically renew for successive fiscal year terms provided that Target does not give notice of its intention to terminate the Restated Target Agreement during February of the calendar year prior to termination.  Under the Restated Target Agreement, Target has agreed to pay royalties based on a percentage of Target’s net sales of Cherokee branded merchandise during each fiscal year ended January 31st, which percentage varies according to the volume of sales of merchandise.

We also have other licensing agreements regarding our brands, including with:  (i) Tesco for our Cherokee brand in the United Kingdom, Ireland, the Czech Republic, Slovakia, Poland, Hungary and Turkey; (ii) Zellers for our Cherokee brand in Canada; (iii) Nishimatsuya for our Cherokee brand in Japan; (iv) RT Mart for our Cherokee brand in China; (v) Arvind for our Cherokee brand in India; (vi) Magnit for our Cherokee brand in Russia; (vii) TJX Companies for our Carole Little and St. Tropez-West brands in the U.S. and other select countries; and (viii) a number of other international license agreements for our Cherokee brand.   For a more complete description of our license agreements and other commercial agreements, please see our Annual Report on Form 10-K for Fiscal 2011, which was filed with the Securities and Exchange Commission (the “Commission) on April 14, 2011.

Stock-Based Compensation

We currently maintain two equity-based compensation plans:  (i) the 2003 Incentive Award Plan as amended in 2006 with the adoption of the 2006 Incentive Award Plan (the “2003 Plan”); and (ii) the 2006 Incentive Award Plan (the “2006 Plan”).  Each of these equity based compensation plans provide for the issuance of equity-based awards to officers and other employees and directors, and they have previously been approved by our stockholders.  Stock options issued to employees are granted at the market price on the date of grant, generally vest over a three-year period, and generally expire seven to ten years from the date of grant.  We issue new shares of common stock upon exercise of stock options.

The 2003 Plan was approved at the June 9, 2003 Annual Meeting of Stockholders, and amended at the June 13, 2006 with the adoption of the 2006 Plan by the Company’s Stockholders at the June 2006 Annual Meeting of Stockholders.  Under the 2003 Plan, the Company is authorized to grant up to 250,000 shares of common stock in the form of incentive and nonqualified options and restricted stock awards.  The maximum number of shares which may be subject to granted under the 2003 Plan to any individual in any calendar year cannot exceed 100,000.  The principal purposes of the 2003 Plan are to provide an additional incentive for our directors, employees and consultants to further our growth, development and financial success and to enable us to obtain and retain their services.  The Compensation Committee of the Board of Directors or another committee thereof (the “Committee”) administers the 2003 Plan with respect to grants to our employees or consultants and the full Board of Directors (the “Board”) administers the 2003 Plan with respect to grants to independent directors.  Awards under the 2003 Plan may be granted to individuals who are then officers or other employees of Cherokee or any of our present or future subsidiaries.  Such awards also may be granted to our consultants selected by the Committee for participation in the 2003 Plan.  The 2003 Plan provides that the Committee may grant or issue stock options and restricted stock awards, or any combination thereof.  Two types of stock options may be granted under the plan:  incentive and non-qualified stock options.  In addition, restricted stock may be sold to participants at various prices (but not below par value) and made subject to such restrictions as may be determined by the Board or the Committee.  The vesting period and term for options granted under the 2003 Plan shall be set by the Committee, with the term being no greater than 10 years, and the options generally will vest over a specific time period as designated by the Committee upon the awarding of such options.  During the First Quarter, we granted to non-employee directors and certain employees stock options with a seven-year term to purchase 30,000 shares of our common stock at an exercise price of $17.21 per share (the closing price on the date of grant) pursuant to the 2003 Plan.  We did not make any grants under the 2003 Plan during either the Second Quarter or the Third Quarter.  As of October 29, 2011, there were 45,315 shares available for issuance under the 2003 Plan.  In the event that any outstanding option under the 2003 Plan expires or is terminated, the shares of common stock allocable to the unexercised portion of the option shall then become available for grant in the future, until the 2003 Plan expires on April 28, 2016.

The 2006 Plan was approved at the June 2006 Annual Meeting of Stockholders and amended at the June 2010 Annual Meeting of Stockholders, under which the Company is authorized to grant up to 750,000 shares of common stock in the form of incentive and nonqualified options and restricted stock awards.  The maximum number of shares that may be subject to grant under the 2006 Plan to any individual in any calendar year cannot exceed 100,000.  The principal purposes of the 2006 Plan is to provide an additional incentive for our directors, employees and consultants and its subsidiaries to further our growth development and financial success and to enable us to obtain and retain their services.  The Committee administers the 2006 Plan with respect to grants to our employees or consultants and the full Board administers the 2006 Plan with respect to grants to independent directors.  Under the 2006 Plan, restricted stock may be sold to participants at various prices (but not below par value) and made subject to such restrictions as may be determined by the Board or Committee.  The vesting period and term for options granted under the 2006 Plan shall be set by the Committee, with the term being no greater than 10 years, and the options generally will vest over a specific time period as designated by the Committee upon the awarding of such options During the First Quarter, we granted to certain employees stock options with a seven-year term to purchase 256,000 shares of our common stock at an exercise price of $17.21 per share (the closing price on the date of grant) pursuant to the 2006 Plan.  We did not make any grants under the 2006 Plan during the Second Quarter.  During the Third Quarter, we granted to certain employees stock options with a seven-year term to purchase 30,000 shares of our common stock at an exercise price of $11.99 per share (the closing price on the date of grant) pursuant to the 2006 Plan.  As of October 29, 2011, there were 195,500 shares available for issuance under the 2006 Plan.  In the event that any outstanding option granted under the 2006 Plan expires or is terminated, the shares of common stock allocable to the unexercised portion of the option shall then become available for grant in the future, until the 2006 Plan expires on April 28, 2016.

Stock-based compensation expense recognized for the Nine Months was $544,000, as compared to $506,000 for the comparable period in the prior year.

The estimated fair value of options granted during Fiscal 2012 and Fiscal 2011 was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Fiscal 2012		Fiscal 2011
Expected Dividend Yield	4.65% to 6.67	%	7.2	%
Expected Volatility	49.28% to 51.21	%	58.8	%
Avg. Risk-Free Rate	1.1	%	2.1	%
Expected Life (in years)	4.5 to 5.0		4.8

The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar options, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior.  The expected stock price volatility is based on the historical volatility of our stock price.  The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of grant with an equivalent remaining term.  The dividend yield is based on the past dividends paid and the current dividend yield at the time of grant.

A summary of activity for the Company’s stock options for the Nine Months is as follows:

					Weighted
					Average
					Remaining
			Weighted		Contractual	Aggregate
			Average		Term	Intrinsic
	Shares		Price		(in years)	Value
Outstanding, at January 29, 2011	949,444		$	18.76
Granted	316,000		$	16.71
Exercised	(10,000	)	$	16.08
Canceled/forfeited	(182,444	)	$	19.84
Outstanding, at October 29, 2011	1,073,000		$	18.18	4.69	$	35,100
Vested and Exercisable at October 29, 2011	375,994		$	19.73	3.01	$	—
Non-vested and not exercisable at October 29, 2011	697,006		$	17.34	5.25	$	35,100

As of October 29, 2011, total unrecognized stock-based compensation expense related to non-vested stock options was approximately $2,095,000, which is expected to be recognized over a weighted average period of approximately 3.30 years.  The total fair value of all options which vested during the Nine Months was $538,000.

Trademarks

During the Third Quarter and Nine Months, the Company did not acquire any trademarks, nor were there any trademark acquisitions during the comparable period last year.  Trademark registration and renewal fees which were capitalized during the Third Quarter and Nine Months totaled $27,000 and $201,000, respectively.  In comparison, for the third quarter and nine months of last year, the total trademark registration and renewal fees capitalized totaled $47,000 and $218,000, respectively.

Income Taxes

Income tax expense recognized for the Third Quarter was $709,000, resulting in an effective tax rate of 40.3%, as compared to 40.4% in the third quarter of last year and compared to 40.2% for the full year of Fiscal 2011. The tax provision in the First Quarter was offset by a tax benefit of $1.2 million that resulted from the payment to us of a refund from the California Franchise Tax Board of $2.0 million plus interest.  The refund related to fiscal 2004 through fiscal 2008 tax years.  Additionally, for tax years beginning in 2011, California provides for the election of a single factor apportionment formula.  The effect of this election resulted in a tax provision decrease of approximately $187,000 during the Nine Months.

The Company files U.S. federal and state income tax returns.  For our federal income tax returns, the Company is generally no longer subject to tax examinations for fiscal years prior to Fiscal 2011.   With limited exception, our significant state tax jurisdictions are no longer subject to examinations by the various tax authorities for fiscal years prior to 2008.  Although the outcome of tax audits is always uncertain, we believe that adequate amounts of tax, interest and penalties, if any, have been provided for in our income tax reserve for any adjustments that may result from future tax audits. We recognize interest and penalties, if any, related to unrecognized tax benefits within the provision for income taxes in our consolidated statement of income.  As of January 29, 2011 and October 29, 2011, respectively, accrued interest on a gross basis was $110,000 and $127,000.

As of January 29, 2011 and October 29, 2011, respectively, the total amount of gross unrecognized tax benefits was approximately $1.1 million and $0.9 million, of which approximately $0.9 and $0.9 million represents the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate.  It is reasonably possible that $0.7 million of unrecognized tax benefits may decrease within the next 12 months as a result of settling certain positions. The expected net impact of the changes would not have a significant impact on the results of operations or the financial position of the Company.

Recent Accounting Pronouncements

There have been no recent accounting pronouncements that will have a material impact on the Company’s financial statements.