NOTE 1. Organization and Summary of Significant Accounting Policies

Organization and Business Activities We are a mall and web-based specialty retailer of apparel, accessories, music and gift items for young men and women whose lifestyles reflect a passion for music, fashion and pop culture. We operate under two concepts: Hot Topic and Torrid. Music is the overriding inspiration at Hot Topic and Torrid is focused on providing the best in fashion to young plus-size women. We generate revenues primarily through our retail stores in the United States of America, Puerto Rico and Canada, and online through our websites. We were incorporated in California in 1988. We currently have one reportable segment given the similarities of the economic characteristics among the Hot Topic and Torrid concepts. During the second quarter of fiscal 2011, the operations of ShockHound, our online digital music website launched in fiscal 2008, were discontinued. Refer to “NOTE 2 – Recent Business Events” contained in these consolidated financial statements and notes for more information concerning the discontinuation of ShockHound’s operations.

Principles of Consolidation Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The consolidated financial statements include the accounts of Hot Topic, Inc. and our wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.

Fiscal Year Our fiscal year ends on the Saturday nearest to January 31. References to fiscal 2012 refer to the 53-week period ending February 2, 2013. References to fiscal 2011, 2010, 2009, 2008 and 2007 refer to the 52-week periods ended January 28, 2012, January 29, 2011, January 30, 2010, January 31, 2009 and February 2, 2008.

Use of Estimates We are required to make certain estimates and assumptions in order to prepare consolidated financial statements in conformity with generally accepted accounting principles. Such estimates and assumptions affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities in the financial statements and accompanying notes. Our most significant estimates relate to the valuation of inventory balances, the valuation of our auction rate securities, the determination of sales returns, the assessment of expected cash flows used in evaluating long-lived assets for impairment, the determination of gift card breakage and estimates related to certain strategic business changes made during the year. The estimation process required to prepare our consolidated financial statements requires assumptions to be made about future events and conditions, and as such, is inherently subjective and uncertain. Our actual results could differ materially from those estimates.

Cash and Cash Equivalents We consider all highly liquid investments with maturities of less than three months when purchased to be cash equivalents. All credit and debit card transactions that process in less than seven days are classified as cash and cash equivalents. The amounts due from third party financial institutions for these transactions classified as cash totaled $2.9 million and $3.0 million as of the end of fiscal 2011 and 2010, respectively. Cash used primarily for working capital purposes is maintained with various major financial institutions in amounts which are in excess of the Federal Deposit Insurance Corporation, or FDIC, insurance limits. We are potentially exposed to a concentration of credit risk when cash deposits in banks are in excess of FDIC limits. Excess cash and cash equivalents, which represent the majority of our cash and cash equivalents balance, are held primarily in diversified money market funds.

Fair Value of Financial Instruments We consider carrying amounts of cash and cash equivalents, receivables and accounts payable to approximate fair value because of the short maturity of these financial instruments.

Short-Term and Long-Term Investments Our short-term investments consist of highly-rated interest-bearing municipal bonds that have maturities that are less than one year and are accounted for as available for sale. As of the end of fiscal 2011, short-term investments consisted of municipal bonds of $16.5 million. As of the end of fiscal 2010, short-term investments consisted of $5.0 million of certificates of deposit that were guaranteed by the Federal Deposit Insurance Corporation, classified as held to maturity and had maturities that were less than one year, and municipal bonds of $20.2 million. Refer to “NOTE 7 – Fair Value Measurements” contained in these consolidated financial statements and notes for further discussion on how we determined the fair value of our short-term investments. The associated unrealized net losses and gains in fiscal 2011 and 2010, respectively, were immaterial and have been recorded in accumulated other comprehensive loss, or OCL, reflected in the shareholders’ equity section of the consolidated balance sheet.

As of the end of fiscal 2011, our long-term investments were comprised of auction rate securities. As of the end of fiscal 2010, our long-term investments were comprised of auction rate securities and highly-rated interest-bearing municipal bonds that had maturities that were more than one year and were accounted for as available for sale. As of the end of fiscal 2010, the fair value of our long-term municipal bonds was $0.5 million and the associated unrealized losses were immaterial and recorded in OCL reflected in the shareholders’ equity section of the consolidated balance sheet.

Our auction rate securities are AAA/A3-rated debt instruments with maturities of 26 years. They are accounted for as available for sale and backed by pools of student loans guaranteed by the U.S. Department of Education. Their interest rates are reset through an auction process, most commonly at intervals of approximately 4 weeks. This same auction process is designed to provide a means by which these securities can be sold and prior to 2008 had provided a liquid market for them. There continues to be uncertainty in the global credit and capital markets, which has resulted in the failure of auctions representing the auction rate securities we hold as the amount of securities submitted for sale in those auctions exceed the amount of bids. While we have continued to earn and receive interest on our auction rate securities through the date of this report, we concluded that their estimated fair value no longer approximates par value. Due to the lack of availability of observable market quotes on our auction rate securities, the fair market value of these securities has been based on a valuation model using current assumptions. Refer to “NOTE 7 – Fair Value Measurements” contained in these consolidated financial statements and notes for further discussion on how we determined the fair value of our investment in auction rate securities.

As of the end of fiscal 2011 and 2010, the fair value of our auction rate securities was $1.7 million and $2.5 million, respectively. The $0.8 million decline in fair value from the beginning of the fiscal year represents a $0.1 million, $0.7 million and a $50,000 redemption of certain auction rate securities at par during the first, second and third quarters of fiscal 2011, respectively, as well as a decrease in fair value of the remaining auction rate securities of $50,000. The decrease is offset by the recovery in fair value of $0.1 million which was previously temporarily impaired. The fair value of our remaining auction rate securities as of the end of fiscal 2011 reflects a cumulative decline of $0.4 million from the par value. This cumulative $0.4 million decline ($0.2 million net of tax) is deemed temporary as we have the ability to hold these securities and we do not have the intent to sell them below par value. Furthermore, it is not likely that we will be required to sell the securities before the recovery of their amortized cost basis. If uncertainties in the credit and capital markets continue, we may incur additional losses, some of which may be other-than-temporary, which could negatively affect our financial condition or results of operations. In addition, in the event that we decide to sell these securities and it becomes likely that we will be required to sell the securities before the recovery of their amortized cost basis, we may be required to recognize impairment charges against income. We have classified all auction rate securities as non-current assets on our consolidated balance sheet, as we do not expect them to successfully auction and recover their full or par value within the next 12 months.

In fiscal 2011 and 2010, we recorded unrealized gains of $0.1 million ($0.1 million net of tax) and $0.2 million ($0.1 million net of tax), respectively, for our auction rate securities in accumulated OCL reflected in the shareholders’ equity section of the consolidated balance sheet. The $0.1 million unrealized gain in fiscal 2011 primarily represents a $149,000 recovery in fair value which was previously temporarily impaired, offset by a $52,000 decrease in fair value of the remaining auction rate securities.

Accumulated OCL is comprised of unrealized gains and losses from short-term and long-term investments, net of all related taxes, as well as foreign currency translation adjustments and are reflected in the shareholders’ equity section of the consolidated financial statements.

Inventories Inventories are valued at the lower of average cost or market, on a weighted average cost basis, using the retail method. Under the retail method, inventory is stated at its current retail selling value and then is converted to a cost basis by applying an average cost factor that represents the average cost-to-retail ratio based on beginning inventory and the purchase activity for the month. Throughout the year, we review our inventory levels in order to identify slow-moving merchandise and use permanent markdowns to sell through selected merchandise. We record a charge to cost of goods sold for permanent markdowns. Inherent in the retail method are certain significant management judgments and estimates including initial merchandise markup, future sales, markdowns and shrinkage, which significantly impact the ending inventory valuation at cost and the resulting gross margins. To the extent our estimated markdowns at period-end prove to be insufficient, additional future markdowns will need to be recorded. Physical inventories are conducted during the year to determine actual inventory on hand and shrinkage. We accrue our estimated inventory shrinkage for the period between the last physical count and current balance sheet date. Thus, the difference between actual and estimated shrink amounts may cause fluctuations in quarterly results, but not for the full fiscal year results.

Property and Equipment Property and equipment are recorded at cost less accumulated depreciation, or in the case of capitalized leases, at the present value of future minimum lease payments. Major renewals and improvements are capitalized, while routine maintenance and repairs are expensed as incurred. Application and development costs associated with internally developed software such as salaries of employees and payments made to third parties and consultants working on the software development are capitalized. Subsequent additions, modifications or upgrades to internal-use software are capitalized only to the extent that they allow the software to perform a task it previously did not perform. Capitalized internal use software costs are amortized using the straight-line method over their estimated useful lives, generally three years. In fiscal 2011, 2010 and 2009, we amortized approximately $1.5 million, $1.8 million and $1.1 million, respectively. Additionally, as of the end of fiscal 2011 and 2010, the net book value of capitalized internal use software totaled approximately $2.5 million and $3.5 million, respectively.

Depreciation expense is calculated using the straight-line method over the estimated useful lives of the related assets (3 to 20 years).

Leasehold improvements are amortized using the straight-line method over the shorter of the respective lease terms or the 10 year estimated useful life of the assets.

We assess property and equipment for impairment whenever events or changes in circumstances indicate that an asset’s carrying value may not be recoverable.

Valuation of Long-Lived Assets We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. For our Hot Topic and Torrid concepts, we group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be identified. Factors we consider important that could trigger an impairment review of our stores or online operations include a significant underperformance relative to expected historical or projected future operating results, a significant change in the manner of the use of the asset or a significant negative industry or economic trend. When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the aforementioned factors, impairment is measured based on a projected discounted cash flow method using a discount rate determined by management. These cash flows are calculated by netting future estimated sales against associated merchandise costs and other related expenses such as payroll, occupancy and marketing. The estimated sales, net of the aforementioned costs and expenses, used for this nonrecurring fair value measurement is considered a Level 3 input as defined in “NOTE 7 – Fair Value Measurements” contained in these consolidated financial statements and notes. In the event future store performance is lower than forecasted results, future cash flows may be lower than expected, which could result in future impairment charges. While we believe recently opened stores will provide sufficient cash flow, material changes in results could result in future impairment charges.

In fiscal 2011, 2010 and 2009, we recorded store impairment charges of $2.4 million (of which $0.9 million related to the cost reduction plan described in “NOTE 2 – Recent Business Events” contained in these consolidated financial statements and notes), $3.1 million (of which $1.2 million related to the cost reduction plan described in “NOTE 2 – Recent Business Events” contained in these consolidated financial statements and notes) and $0.9 million, respectively, which are included in selling, general and administrative expenses in our consolidated statements of operations. During the third quarter of fiscal 2010, we concluded that ShockHound’s assets had become impaired due to its slower than expected revenue growth. Revenues from partnerships entered into in the earlier part of fiscal 2010, as well as other revenues, did not build as much as we had anticipated. In the third quarter of fiscal 2010, we recorded an impairment charge of $3.0 million to selling, general and administrative expenses in our consolidated statements of operations. We did not record an impairment charge for ShockHound in fiscal 2011 or 2009.

Self-Insurance We are self-insured for certain losses related to medical and workers compensation claims although we maintain stop loss coverage with third party insurers to limit our total liability exposure. The estimate of our self-insurance liability involves uncertainty since we must use judgment to estimate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not reported as of the balance sheet date. When estimating our self-insurance liability, we consider a number of factors, which include historical claim experience and valuations provided by independent third party actuaries. As claims develop, the actual ultimate losses may differ from actuarial estimates. Therefore, an analysis is performed quarterly to determine if modifications to the accrual are required.

Revenue Recognition Revenue is generally recognized at our retail store locations at the point at which the customer receives and pays for the merchandise at the register. For online sales, revenue is recognized upon delivery to the customer. Sales are recognized net of merchandise returns, which are reserved for based on historical experience. As of the end of fiscal 2011, 2010 and 2009, net merchandise returns were $22.8 million, $22.4 million and $24.0 million, respectively. Revenue from gift cards, gift certificates and store merchandise credits is recognized at the time of redemption. Shipping and handling revenues from our websites are included as a component of net sales.

We recognize estimated gift card breakage as a component of net sales in proportion to actual gift card redemptions over the period that remaining gift card values are redeemed. Gift card breakage is income recognized due to the non-redemption of a portion of gift cards sold by us for which liability was recorded in prior periods. While customer redemption patterns result in estimated gift card breakage, which approximates 5 to 6%, changes in our customers’ behavior could impact the amount that ultimately is unused and could affect the amount recognized as a component of net sales. In fiscal 2011, 2010 and 2009, we recognized $0.9 million, $1.1 million and $1.1 million, respectively, as a component of sales in proportion to actual gift card redemptions over the period that remaining gift card values are redeemed.

Cost of Goods Sold, Including Buying, Distribution and Occupancy Costs Cost of goods sold, including buying, distribution and occupancy costs includes: merchandise costs; freight; inventory shrink; payroll expenses associated with the merchandising and distribution departments; distribution center expenses including rent, common area maintenance charges, real estate taxes, depreciation, utilities, supplies and maintenance; and store expenses including rents, common area maintenance charges, real estate taxes and depreciation.

Vendor Allowances We receive certain allowances from our vendors primarily related to damaged merchandise, markdowns and pricing. Allowances received from vendors related to damaged merchandise and pricing are reflected as a reduction of inventory in the period they are received and allocated to cost of sales during the period in which the items are sold. Markdown allowances received from vendors are reflected as reductions to cost of sales in the period they are received as these allowances are received after goods have been sold or marked down. In fiscal 2011, 2010 and 2009, we received vendor allowances of $8.3 million, $8.5 million and $8.3 million, respectively, of which $8.3 million, $8.4 million and $8.2 million, respectively, were accounted for as a reduction of cost of goods sold. Most of the vendor allowances that we receive are based on on-going agreements and negotiations with vendors. We receive vendor allowances from substantially all of our vendors.

Selling, General and Administrative Expenses Selling, general and administrative expenses include: payroll expenses associated with stores; store operating expenses; store pre-opening costs; marketing expenses; and payroll and other expenses associated with headquarters and administrative functions.

Store Pre-Opening Costs These are costs incurred in connection with the opening of a new store and are expensed as incurred.

Shipping and Handling Costs We classify shipping and handling costs in costs of goods sold, including buying, distribution and occupancy costs in the accompanying consolidate statements of operations.

Rent Expense Rent expense under our operating leases typically provides for fixed non-contingent rent escalations. We recognize rent expense on a straight-line basis over the non-cancelable term of the lease, commencing when we take possession of the property. Construction allowances are recorded as a deferred rent liability, which we amortize as a reduction of rent expense over the non-cancelable term of each lease. Our leases are discussed in more detail in “NOTE 9 – Commitments and Contingencies” contained in these consolidated financial statements and notes.

Advertising Costs Advertising costs are expensed the first time the event occurs or as incurred. During fiscal 2011, 2010 and 2009, advertising expenses were $7.4 million, $8.5 million and $7.3 million, respectively, and advertising reimbursements from vendors for these years were immaterial. As of the end of fiscal 2011 and 2010, the amount of advertising costs reported as prepaid advertising was immaterial.

Income Taxes We account for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting bases and tax bases of assets and liabilities and are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled. Deferred tax assets are reduced by valuation allowances if we believe it is more likely than not that some portion or the entire asset will not be realized.

We prescribe a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. We include interest and penalties related to uncertain tax positions in income tax expense.

Stock-Based Payments We account for stock-based compensation expense by estimating the fair value of stock options granted, except for certain stock options granted in March 2011 that are subject to the vesting determination described in “NOTE 3– Stock-Based Compensation” contained in these consolidated financial statements and notes, using the Black-Scholes option-pricing formula and a single option award approach. We estimated the fair value of the stock options granted in March 2011 that are subject to the vesting determination using a Monte Carlo simulation valuation model. Both of the option-pricing models used require the input of highly subjective assumptions, including the option’s expected life, price volatility of the underlying stock, risk free interest rate, early exercise behavior and expected dividend rate. As stock-based compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.

(Loss) Earnings Per Share Basic earnings or loss per share is computed by dividing net income or net loss, respectively, by the weighted average number of common shares outstanding for the period. Diluted earnings per share is applicable only in periods of net income and is computed by dividing net income by the weighted average number of common shares outstanding for the period and potentially dilutive common stock equivalents outstanding for the period. Periods of net loss require the diluted computation to be the same as the basic computation.

Comprehensive (Loss) Income Comprehensive (loss) income includes all changes in equity during a period except those that resulted from investments by or distributions to shareholders. Other comprehensive (loss) income refers to revenues, expenses, gains and losses that, under generally accepted accounting principles, are included in comprehensive (loss) income, but excluded from net (loss) income as these amounts are recorded directly as an adjustment to shareholders’ equity. Components of our comprehensive (loss) income include net (loss) income and gains/losses associated with our short-term and long-term investments.

Comprehensive (loss) income as of the end of fiscal 2011, 2010 and 2009 is as follows (in thousands):

	Fiscal Year
	2011			2010			2009
Comprehensive (loss) income
Net (loss) income	$	(1,818	)	$	(8,235	)	$	11,880
Foreign currency translation adjustment		(23	)		71			-
Unrealized gain on short- and long-term
investments, net		24			121			929
Total comprehensive (loss) income	$	(1,817	)	$	(8,043	)	$	12,809

During fiscal 2011, we recognized a $30,000 tax expense for the $97,000 unrealized gain on auction rate securities. The resulting $67,000 net gain is recorded in other comprehensive loss. Unrealized loss on short-term and long-term marketable securities during fiscal 2011 was $43,000 and the related tax expense on this activity was not material. During fiscal 2011, we also recognized a loss on foreign currency translation adjustments in connection with our stores in Canada. During fiscal 2010, we recognized an $85,000 tax expense for the $155,000 unrealized gain on auction rate securities. The resulting $70,000 net gain is recorded in other comprehensive loss. Unrealized gain on short-term marketable securities during fiscal 2010 was $51,000 and the related tax expense on this activity was not material. During fiscal 2010, we also recognized a gain on foreign currency translation adjustments in connection with our stores in Canada. During fiscal 2009, we recognized a $0.5 million tax expense for the $1.3 million unrealized gain on auction rate securities resulting in a $0.8 million net gain. Unrealized gain on short-term marketable securities during fiscal 2009 was $132,000 and the related tax expense on this activity was not material. We did not have any foreign currency translation adjustments in fiscal 2009.

Impact of Recently Issued Accounting Pronouncements

In May 2011, the FASB issued new guidance that results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between U.S. GAAP and International Financial Reporting Standards, or IFRS. The new guidance changes some fair value measurement principles and disclosure requirements under U.S. GAAP. Among the changes, the new guidance states that the concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets (that is, it does not apply to financial assets or any liabilities). Additionally, the new guidance extends the prohibition of applying a blockage factor (that is, premium or discount related to size of the entity’s holdings) to all fair value measurements. A fair value measurement that is not a Level 1 measurement may include premiums or discounts other than blockage factors. The new guidance is effective for interim or fiscal years beginning on or after December 15, 2011, with early adoption prohibited. The adoption of this new guidance is not expected to have a material impact on our financial condition or results of operations.

In June 2011, the FASB issued a final standard requiring entities to present net (loss) income and other comprehensive (loss) income in either a single continuous statement or in two separate, but consecutive, statements of net (loss) income and other comprehensive (loss) income. The new standard eliminates the option to present items of other comprehensive (loss) income in the statement of changes in equity. The new requirements do not change which components of comprehensive (loss) income are recognized in net (loss) income or other comprehensive (loss) income, or when an item of other comprehensive (loss) income must be reclassified to net (loss) income. Also, (loss) earnings per share computations do not change. The new requirements are effective for interim and fiscal years beginning after December 15, 2011, with early adoption permitted. Full retrospective application is required. As this standard relates only to the presentation of other comprehensive (loss) income, the adoption of this new guidance is not expected to have a material impact on our financial condition or results of operations.