NOTE 1 — DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of business. The primary business of Fred's, Inc. and its subsidiaries ("Fred's", “We”, “Our”, “Us” or “Company”) is the sale of general merchandise through its retail discount stores and full-service pharmacies. In addition, the Company sells general merchandise to its 11 franchisees. As of February 2, 2019, the Company had 557 retail stores, 169 of which had pharmacies and 11 franchised stores located in 15 states mainly in the Southeastern United States. We are licensed to dispense pharmaceuticals in 14 states.

Basis of Presentation. The Consolidated Financial Statements include the accounts of Fred's, Inc. and its subsidiaries. These financial statements have been prepared in accordance with U.S. generally accepted accounting principles. All significant intercompany accounts and transactions are eliminated. Amounts are in thousands unless otherwise noted.

During the second quarter of 2018, the Company completed the sale of its specialty pharmacy business for a cash purchase price of $40.0 million (plus an additional $5.5 million for inventory).

During the fourth quarter of 2018, the Company completed its sale of certain prescription files and the related data and records, retail pharmaceutical inventory and certain other assets from 179 of the Company’s retail pharmacy stores for an aggregate cash consideration of approximately $176.7 million. The results of operations for both businesses have been presented as discontinued operations in accordance with Accounting Standards Codification (“ASC” Topic 205-20) Results of Operations – Discontinued operations for all periods presented.

In addition, during the fourth quarter of 2018, the Company’s Board of Directors (the “Board”) approved a plan to actively market its headquarters building located in Memphis, TN. The building has been reflected as assets held for sale on the consolidated balance sheets in accordance with ASC 360 – Property Plant & Equipment.

Excluding the Assets Held for Sale and Discontinued Operations subsections amounts and percentages, all periods discussed below reflect the results of operations and financial conditions from Fred’s continuing operations. Refer to Note 2 for additional information on discontinued operations.

Subsequent Events. The Company has evaluated subsequent events through the financial statement issue date. See Note 15: Subsequent Events for additional discussion of the subsequent events through financial statement issuance date. See Note 4. Indebtedness

The Company has experienced significant net losses and negative cash flows from operating activities in recent years, and cannot offer assurance that such losses and negative cash flows will not continue for the foreseeable future. For the fiscal years ended February 2, 2019 and February 3, 2018, we incurred net losses of $136.2 million and $144.5 million, respectively, and our net cash flows used in operating activities were $91.7 million and $44.7 million, respectively. Furthermore, the Company has limited availability under its Revolving Credit Agreement, which along with cash from operations has traditionally been the Company’s primary source of working capital. As of April 30, 2019, the Company had outstanding borrowings of $78.4 million under our Revolving Credit Agreement and excess availability of $37.1 million. Under our Revolving Credit Agreement, we have a financial covenant to maintain at all times excess availability of at least the greater of $21,000,000 and 10% of the commitments, and if excess availability falls below such threshold, it would constitute an event of default under the Revolving Credit Agreement. The Company’s failure to comply with the financial covenants and other obligations under the Revolving Credit Agreement would result in an event of default, which if not cured or waived, may permit acceleration of our indebtedness and other remedies. If our indebtedness is accelerated, whether due to the Revolver EODs described in Note 4 or otherwise, the Company cannot be certain that we will have sufficient funds available to pay the accelerated indebtedness or that we will have the ability to refinance the accelerated indebtedness on terms favorable to us or at all, which could have a material adverse effect on the Company’s business, results of operations and financial condition and could impact our ability to continue as a going concern. Furthermore, our Revolving Credit Agreement has a maturity date of April 9, 2020, and we can provide no assurance that we will be able to renew or refinance such facility on terms acceptable to us or at all. The foregoing conditions raise substantial doubt about the Company’s ability to continue as a going concern.

The Company has evaluated its plans to alleviate this doubt, including engaging PJ Solomon in April 2019 to assist the Company in evaluating its strategic alternatives. In addition, while we analyze these strategic alternatives, the Company is also assessing potential alternative financing arrangements and undertaking a number of operational measures that we believe will enhance our cash position and improve our profitability, including, among other things:

The Company can provide no assurance, however, regarding the outcome of its evaluation of strategic alternatives, that alternative financing will be on terms acceptable to us or at all, or that the operational measures being undertaken by the Company will be successful in improving the Company’s financial performance, in which case the Company may be unable to continue as a going concern.

The accompanying consolidated financial statements have been prepared assuming the Company will continue to operate as a going concern, which contemplates the realization of assets and settlement of liabilities in the normal course of business, and do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classifications of liabilities that may result from uncertainty related to its ability to continue as a going concern.

The Company utilizes a 52-53-week accounting period which ends on the Saturday closest to January 31. Fiscal years 2018 and 2017, as used herein, refer to the years ended February 2, 2019 and February 3, 2018, respectively. Fiscal year 2018 had 52 weeks and fiscal year 2017 had 53 weeks.

Use of estimates. The preparation of financial statements in accordance with U.S. Generally Accepted Accounting Principles ("U.S. GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates and such differences could be material to the financial statements.

Cash and cash equivalents. Cash on hand and in banks, together with other highly liquid investments which are subject to market fluctuations and having original maturities of three months or less, are classified as cash and cash equivalents.

Allowance for doubtful accounts. The Company is reimbursed for drugs sold by its pharmacies by many different payors including insurance companies, Medicare and various state Medicaid programs. The Company estimates the allowance for doubtful accounts based on the aging of receivables and additionally uses payor-specific information to assess collection risk, given its interpretation of the contract terms or applicable regulations. However, the reimbursement rates are often subject to interpretations that could result in payments that differ from the Company’s estimates. Additionally, updated regulations and contract negotiations occur frequently, necessitating the Company’s continual review and assessment of the estimation process. Senior management reviews account receivable on a quarterly basis to determine if any receivables are potentially uncollectible. The Company includes any accounts receivable balances that are determined to be uncollectible in its overall allowance for doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance account.

Inventories. Merchandise inventories are stated at the lower of cost or net realizable value (NRV) using the retail first-in, first-out method for goods in our stores and the cost first-in, first-out method for goods in our distribution centers. The retail inventory method is a reverse mark-up, averaging method which has been widely used in the retail industry for many years. This method calculates a cost-to-retail ratio that is applied to the retail value of inventory to determine the cost value of inventory and the resulting cost of goods sold and gross margin. The assumption that the retail inventory method provides for valuation at lower of cost or NRV and the inherent uncertainties therein are discussed in the following paragraphs.

In order to assure valuation at the lower of cost or NRV, the retail value of our inventory is adjusted on a consistent basis to reflect current market conditions. These adjustments include increases to the retail value of inventory for initial markups to set the selling price of goods or additional markups to adjust pricing for inflation and decreases to the retail value of inventory for markdowns associated with promotional, seasonal or other declines in the market value. Because these adjustments are made on a consistent basis and are based on current prevailing market conditions, they approximate the carrying value of the inventory at NRV. Therefore, after applying the cost to retail ratio, the cost value of our inventory is stated at the lower of cost or NRV as is prescribed by U.S. GAAP.

Because the approximation of net realizable value under the retail inventory method is based on estimates such as markups, markdowns and inventory losses (shrink), there exists an inherent uncertainty in the final determination of inventory cost and gross margin. In order to mitigate that uncertainty, the Company has a formal review by product class which considers such variables as current market trends, seasonality, weather patterns and age of merchandise to ensure that markdowns are taken currently, or a markdown reserve is established to cover future anticipated markdowns. This review also considers current pricing trends and inflation to ensure that markups are taken if necessary. The estimation of inventory losses (shrink) is a significant element in approximating the carrying value of inventory at net realizable value, and as such, the following paragraph describes our estimation method as well as the steps we take to mitigate the risk of this estimate in the determination of the cost value of inventory.

The Company calculates inventory losses (shrink) based on actual inventory losses occurring as a result of physical inventory counts during each fiscal period and estimated inventory losses occurring between yearly physical inventory counts. The estimate for shrink occurring in the interim period between physical counts is calculated on a store-specific basis and is based on history, as well as performance on the most recent physical count. It is calculated by multiplying each store’s shrink rate, which is based on the previously mentioned factors, by the interim period’s sales for each store. Additionally, the overall estimate for shrink is adjusted at the corporate level to a three-year historical average to ensure that the overall shrink estimate is the most accurate approximation of shrink based on the Company’s overall history of shrink. The three-year historical estimate is calculated by dividing the “book to physical” inventory adjustments for the trailing 36 months by the related sales for the same period. In order to reduce the uncertainty inherent in the shrink calculation, the Company first performs the calculation at the lowest practical level (by store) using the most current performance indicators. This ensures a more reliable number, as opposed to using a higher-level aggregation or percentage method. The second portion of the calculation ensures that the extreme negative or positive performance of any particular store or group of stores does not skew the overall estimation of shrink. This portion of the calculation removes additional uncertainty by eliminating short-term peaks and valleys that could otherwise cause the underlying carrying cost of inventory to fluctuate unnecessarily. The methodology that we have applied in estimating shrink has resulted in variability that is not material to our financial statements.

Management believes that the Company’s retail inventory method provides an inventory valuation which reasonably approximates cost and results in valuing inventory at the lower of cost or NRV. For pharmacy department inventories, which were approximately $13.2 million, and $11.5 million at February 2, 2019 and February 3, 2018, respectively, cost was determined using the retail LIFO ("last-in, first-out") method in which inventory cost is maintained using the retail inventory method, then adjusted by application of the highly inflationary Producer Price Index published by the U.S. Department of Labor for the cumulative annual periods. The current cost of inventories was less than the LIFO cost by approximately $28.8 million at February 2, 2019 and $28.8 million at February 3, 2018 respectively. The LIFO reserve remained flat for the year ended February 2, 2019 and increased by $1.4 million for the year ended February 3, 2018.

The Company has historically included an estimate of inbound freight and certain general and administrative costs in merchandise inventory as prescribed by U.S. GAAP. These costs include activities surrounding the procurement and storage of merchandise inventory such as merchandise planning and buying, warehousing, accounting, information technology and human resources, as well as inbound freight. The total amount of procurement and storage costs and inbound freight included in merchandise inventory at February 2, 2019 is $21.3 million compared to $17.3 million at February 3, 2018.

The Company records inventory charges for the clearance of products that management identifies as low-productive and those that do not fit the Company’s go-forward model. In accordance with ASC 330, Inventory, during fiscal year 2017, the Company recorded a below-cost inventory adjustment of approximately $16.4 million (including $2.1 million for the accelerated recognition of freight capitalization expense), leaving $4.3 million in the reserve related to 2017 strategic initiatives. The inventory adjustment was recorded in cost of goods sold to value inventory at the lower of cost or net realizable value on inventory identified as low-productive. As of February 2, 2019, the Company had utilized the remaining $6.1 million (including $1.1 million for the accelerated recognition of freight capitalization expense) of the 2016 and 2017 strategic initiatives. During the fiscal year of 2018, $0.4 million was recorded as inventory charges for inventory clearance of products that management identified as low-productive and did not fit the go-forward model, however, the $0.4 million was utilized during 2018. No additional charges were recorded during 2018 related to the low productive products.

The following table illustrates the inventory charges related to the inventory clearance initiatives discussed in the previous paragraph (in millions):

	Balance at February 3, 2018		Additions		Utilization			Ending Balance February 2, 2019
Inventory markdown on low-productive inventory (2016 initiatives)	$	1.7	$	0.4	$	(2.1	)	$	—
Inventory provision for freight capitalization expense (2016 initiatives)		0.1		—		(0.1	)		—
Inventory markdown on low-productive inventory (2017 initiatives)		3.3		—		(3.3	)		—
Inventory provision for freight capitalization expense (2017 initiatives)		1.0				(1.0	)		—
Total	$	6.1	$	0.4	$	(6.5	)	$	—

Property and equipment. Property and equipment are carried at cost. Depreciation is recorded using the straight-line method over the estimated useful lives of the assets and presented in depreciation and amortization. Improvements to leased premises are amortized using the straight-line method over the shorter of the initial term of the lease or the useful life of the improvement. Leasehold improvements added late in the lease term are amortized over the lesser of the remaining term of the lease (including the upcoming renewal option, if the renewal is reasonably assured) or the estimated useful life of the improvement. Gains or losses on the sale of assets are recorded at disposal.

Assets under capital lease are amortized in accordance with the Company’s normal depreciation policy for owned assets or over the lease term (regardless of renewal options), if shorter, and the charge to earnings is included in depreciation expense in the Consolidated Financial Statements. There was no amortization expense on assets under capital lease for 2018.

Leases. Certain operating leases include rent increases during the initial lease term. For these leases, the Company recognizes the related rental expense on a straight-line basis over the term of the lease (which includes the pre-opening period of construction, renovation, fixturing and merchandise placement) and records the difference between the amounts charged to operations and amounts paid as a rent liability. Rent expense is recognized on a straight-line basis over the lease term, which includes any rent holiday period.

The Company recognizes contingent rental expense when the achievement of specified sales targets are considered probable in accordance with ASC 840, Leases. The amount expensed but not paid was $0.4 million and $0.5 million at February 2, 2019 and February 3, 2018, respectively, and is included in “Accrued expenses and other” in the consolidated balance sheet. See Note 3: Detail of Certain Balance Sheet Accounts for additional information.

The Company occasionally receives reimbursements from landlords to be used towards construction of the store the Company intends to lease. The reimbursement is primarily for the purpose of performing work required to divide a much larger location into smaller segments, one of which the Company will use for its store. This work could include the addition or demolition of walls, separation of plumbing, utilities, electrical work, entrances (front and back) and other work as required. Leasehold improvements are recorded at their gross costs including items reimbursed by landlords. The reimbursements are initially recorded as a deferred credit and then amortized as a reduction of rent expense over the initial lease term.

Based upon an overall analysis of store performance and expected trends, we periodically evaluate the need to close underperforming stores. When we determine that an underperforming store should be closed, and a lease obligation still exists, we record the estimated future liability associated with the rental obligation on the date the store is closed in accordance with ASC 420, Exit or Disposal Cost Obligations. Liabilities are computed based at the point of closure for the present value of any remaining operating lease obligations, net of estimated sublease income, and at the communication date for severance and other exit costs, as prescribed by ASC 420. The assumptions in calculating the liability include the timeframe expected to terminate the lease agreement, estimates related to the sublease of potential closed locations, and estimation of other related exit costs. If the actual timing and the potential termination costs or realization of sublease income differ from our estimates, the resulting liabilities could vary from recorded amounts. We periodically review the liability for closed stores and make adjustments when necessary.

Impairment of long-lived assets. The Company’s policy is to review the carrying value of all property and equipment as well as purchased intangible assets subject to amortization for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In accordance with ASC 360, Impairment or Disposal of Long-Lived Assets, we review for impairment all stores open at least 3 years or remodeled more than 2 years ago. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease, or 10 years for owned stores. Our estimate of undiscounted future cash flows over the lease term is based upon historical operations of the stores and estimates of future store profitability which encompasses many factors that are subject to management’s judgment and are difficult to predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s fair value. The fair value is based on estimated market values for similar assets or other reasonable estimates of fair market value based upon using a discounted cash flow model.

During the fiscal year 2018, the Company continued to incur significant operating losses which further yielded net losses within the consolidated statement of operations. During 2017, current economic conditions indicated strength in the retail market, however; during the fiscal year 2018, the Company continued to incur declines in sales and gross profits, as consumer demand continued to shrink, indicating softness in the retail market. The Company witnessed other companies within the market filing for bankruptcy and/or shutting down operations. Given the outlook on the retail market, and the change of in the Company’s management, the decision was made to re-evaluate the standing forecast for operating results and cash flows for the upcoming year and for multiple subsequent years and adjusted the forecast to align with the demands of the market and thus providing for a triggering event, which caused the Company to reassess the carrying value of its current long-lived assets, including intangibles. The Company determined that the long-lived assets failed Step 1 of the two step process and determined an impairment expense may be necessary for the difference between the carrying value and fair value of the assets.

The Company compared the fair value to carrying value or net book value of the long-lived assets, including intangibles, for both open and closed stores to determine if the carrying value of the asset exceeded the calculated fair value. The impairment test yielded a difference between carrying value and the fair value and an impairment charge of $27.8 million was recorded as the carrying value of the assets were deemed not to be recoverable.

Additionally, during fiscal year 2018, the Company recorded an impairment charge of $4.0 million related to fixed assets in accordance with ASC 360 Impairment or Disposal of Long-Lived Assets. The assets impaired were not included as a part of the Walgreens sale, however; they were identified as a part of the disposal group. The carrying value of the assets were evaluated and it was determined the carrying value of the assets exceeded the fair market value of as of February 2, 2019. The impairment charge is recorded within impairment expense on the Consolidated Statement of Operations.

During fiscal year 2017, in association with planned closure of underperforming stores and pharmacies and based on the review of the carrying value of assets and the undiscounted future cash flows for these stores, the Company recorded impairment charges in the amount of $2.5 million. The impairment charge was recorded within impairment expense on the consolidated statement of operations.

Impairment of goodwill and other intangibles. Goodwill and intangibles with indefinite lives must be tested for impairment annually or more frequently if events or changes in circumstances indicate that the related asset might be impaired in accordance with ASC 350, Intangibles – Goodwill and Other . An impairment of an investment in an unconsolidated affiliate is recognized when circumstances indicate that a decline in the investment value is other than temporary. An impairment loss should be recognized only if the carrying amount of the asset/goodwill is not recoverable and exceeds its fair value.

Estimated fair values could change if, for example, there are changes in the business climate, changes in the competitive environment, adverse legal or regulatory actions or developments, changes in capital structure, cost of debt, interest rates, capital expenditure levels, operating cash flows or market capitalization. While we believe we have made reasonable assumptions to calculate the fair value, if future results are not consistent with our estimates, we could be exposed to future impairment losses that could be material to our results of operations.

The analysis was broken down into two reporting units: the continuing operations and the discontinued specialty pharmacy (refer to Note 2 for more discussion surrounding discontinued operations). As of November 1, 2017, the estimated fair value of the business enterprise of the continuing operations was below the carrying value. As a result of the analysis, management recorded an impairment to goodwill of $87 thousand in the fourth quarter of 2017, the entire balance of goodwill for the continuing operations. The estimated fair value of the business enterprise for the discontinued specialty pharmacy exceeded the carrying value by approximately 10 percent and as a result did not have any impairment to goodwill.

On February 3, 2018, the Company assessed the discontinued specialty pharmacy’s goodwill for impairment as a result of the plan to actively market it for sale and the deterioration in the price of our common stock and the resulting reduced market capitalization. As a result of the interim impairment test, the Company recognized a goodwill impairment charge of $10.8 million to its discontinued specialty pharmacy business.

The Company determined the fair value of the reporting units using a weighted combination of the discounted cash flow method and the guideline company method. Determining the fair value of a reporting unit requires judgment and the use of significant estimates and assumptions. Such estimates and assumptions include revenue growth rates, operating margins, weighted average costs of capital and future market conditions, among others. The Company believes the estimates and assumptions used in our impairment assessments are reasonable and based on available market information, but variations in any of the assumptions could result in a materially different calculations of fair value and determinations of whether or not an impairment is indicated. Under the discounted cash flow method, the Company determined fair value based on estimated future cash flows of each reporting unit including estimates for capital expenditures, discounted to present value using the risk-adjusted rate, which reflect the overall level of inherent risk of the reporting unit. Cash flow projections are derived from one-year budgeted amounts and five-year operating forecasts plus an estimate of later period cash flows, all of which are evaluated by management. Subsequent period cash flows are developed for each reporting unit using growth rates that management believes are reasonably likely to occur. Under the guideline company method, the Company determined the estimated fair value of each of our reporting units by applying valuation multiples of comparable publicly-traded companies to each reporting unit’s projected revenue and EBITDA to determine the preliminary enterprise value. From that preliminary enterprise value, it is further adjusted by adding cash and cash equivalents and subtracting interest-bearing debt to determine the cash-adjusted equity value. In addition, the Company estimated a reasonable control premium representing the incremental value that accrues to the majority owner from the opportunity to dictate the strategic and operational actions of the business.

One key assumption for the measurement of an impairment is management’s estimate of future cash flows and EBITDA. These estimates are based on the annual budget for the upcoming year and forecasted amounts for multiple subsequent years. The annual budget process is typically completed near the annual goodwill impairment testing date, and management uses the most recent information for the annual impairment tests. The forecast is also subjected to a comprehensive update annually in conjunction with the annual budget process and is revised periodically to reflect new information and/or revised expectations. The estimates of future cash flows and EBITDA are subjective in nature and are subject to impacts from the business risks described in “Item 1A. Risk Factors.” Therefore, the actual results could differ significantly from the amounts used for goodwill impairment testing, and significant changes in fair value estimates could occur in a given period. Such changes in fair value estimates could result in additional impairments in future periods. Therefore, the actual results could differ significantly from the amounts used for goodwill impairment testing, and significant changes in fair value estimates could occur in a given period, resulting in additional impairments. As of February 2, 2019, there was no goodwill presented within the consolidated balance sheet.

During 2017, the Company recorded $1.1 million for the accelerated recognition of amortization of intangible assets associated with the closing pharmacies. Additionally, during the fourth quarter 2017 the Company recorded a $628 thousand impairment related to the trade name for the specialty pharmacy. Refer to Note 2 Assets held for sale and Discontinued Operations for additional discussion on discontinued operations.

During the fourth quarter of 2018, the Company recorded an impairment charge of $1.5 million related to the non-compete agreements associated with the Retail Pharmacy sale. The non-compete agreements were all associated with the related Retail Pharmacy sale.

Intangible assets. Other identifiable intangible assets primarily represent customer lists associated with acquired pharmacies and are being amortized on a straight-line basis over seven years. Based on the Company's historical experience, seven years approximates the actual lives of these assets.

(in thousands)	February 2, 2019		February 3, 2018		Estimated Useful Lives (years)
Customer prescription files	$	18,743	$	27,828		7
Non-compete agreements		2,334		5,356	3 - 15
Software		386		1,048		3
Other		—		115		—
	$	21,463	$	34,347

Amortization expense for 2018 and 2017, was $9.8 million and $10.6 million, respectively.

Estimated amortization expense for the assets recognized as of February 2, 2019, in millions for each of the next 7 years is as follows:

(in millions)		2019				2020				2021				2022				2023				Thereafter
Estimated amortization expense		$	7.4			$	6.2			$	4.7			$	2.3			$	0.8			$	0.1

Goodwill. The Company records goodwill when the purchase price exceeds the fair value of assets acquired and liabilities assumed. The Company accounts for goodwill and intangibles under ASC 350, Intangibles – Goodwill and Other, which does not permit amortization, but requires the Company to test goodwill and other indefinite-lived assets for impairment annually or whenever events or circumstances indicate that impairment may exist. On a continuing basis, the company no longer has goodwill.

Revenue recognition. The Company markets goods and services through 557 Company-owned stores and 11 franchised stores. Net sales include sales of merchandise from Company-owned stores, net of returns and exclusive of sales taxes. Sales to franchised stores are recorded when the merchandise is shipped from the Company’s warehouse. The vast majority of Fred’s contracts with customers are made at the point of sale (POS) in the retail stores, and the performance obligation is the transfer of merchandise which is satisfied at POS when customer pays for merchandise and title transfers to them.

We evaluated principal versus agent considerations with regards to the 340B Direct program under ASC 606, Revenue from Contracts with Customers. Because Fred’s is primarily responsible for fulfilling the promise to provide the 340B Direct prescription drugs and assumes control of and risk for inventory prior to transfer of goods to the customer, including pricing apart from when determined by federal mandate, Fred’s recognizes revenue on a gross basis as principal for the 340B Direct program.

Revenue from sales of pharmaceutical products is recognized at the time the prescription is filled. This approximates when a customer picks up the prescription or when the prescription has been delivered and is recorded net of an allowance for prescriptions that were filled but not picked up by the customer. For all periods presented, there is no material difference between the revenue recognized at the time the prescription is filled and that which would be recognized when the customer picks up the prescription. Prescriptions are generally not returnable.

When customers purchase gift cards, the sale is not recognized until the card is redeemed. The gift cards are not always fully redeemed and as such, the Company recognizes breakage. The Company will recognize aged liabilities as revenue when the likelihood of the gift card being redeemed is remote. Based on the results from the historical breakage model, the Company defines the likelihood of redemption as remote after three years of no activity.

The Company records a gift card liability on the date the gift card is issued to the customer. Revenue is recognized, and the gift card liability is reduced as the customer redeems the gift card. During 2018, we recognized no gift card breakage revenue. During 2017 we recognized $0.3 million of gift breakage revenue, or less than $0.01 per share.

Store layaways are agreements with our customers to provide or deliver goods for a specified price at a future date. Layaway programs run annually for a duration of less than one year and are most popular during the Christmas seasons. Under the Company’s layaway plan, the customer is obligated to pay only the amount equivalent to the value of the good plus sales tax. The Company does not assess a layaway fee or interest but requires an upfront deposit. The customer does not take delivery of the merchandise until the full value is collected.

Our performance obligation is the transfer of merchandise which is satisfied at the point of customer pick-up, not at transaction initiation. Any payments received prior to customer pick-up are considered advance payments and deferred and recognized when the performance obligation is satisfied. Layaway sales are deferred when the customer transaction is initiated and are recognized as revenue when the layaway merchandise is transferred.

In addition, the Company charges its franchised stores a fee based on a percentage of their purchases from the Company. These fees represent a reimbursement for use of the Fred's name and other administrative costs incurred on behalf of the franchised stores. Total franchise income for 2018 and 2017 was $0.6 million, $0.7 million, respectively.

In the following table, consolidated sales are disaggregated by major merchandising category.

	For the Years Ended
	February 2, 2019		February 3, 2018
Pharmacy	$	406,559	$	414,753
Consumables		494,515		527,641
Household Goods and Softlines		357,639		438,355
Franchise		13,033		15,096
Total Sales Mix	$	1,271,746	$	1,395,845

Cost of goods sold. Cost of goods sold includes the purchase cost of inventory and the freight costs to the Company’s distribution centers. Warehouse and occupancy costs are not included in cost of goods sold, but are included as a component of selling, general and administrative expenses. Depreciation and amortization related to warehouse and occupancy costs are included in depreciation and amortization.

Vendor rebates and allowances. The Company receives rebates for a variety of merchandising activities, such as volume commitment rebates, relief for temporary and permanent price reductions, cooperative advertising programs, and for the introduction of new products in our stores. ASC 606, Revenue from Contracts with Customers addresses the accounting and income statement classification for consideration given by a vendor to a retailer in connection with the sale of the vendor’s products or for the promotion of sales of the vendor’s products. Such consideration received from vendors is reflected as a decrease in prices paid for inventory and recognized in cost of sales as the related inventory is sold, unless specific criteria are met qualifying the consideration for treatment as reimbursement of specific, identifiable incremental costs.

Selling, general and administrative expenses. The Company includes buying, warehousing, distribution, advertising, depreciation and amortization and occupancy costs in selling, general and administrative expenses.

Advertising. In accordance with ASC 720-35, Advertising Costs, the Company charges advertising, including production costs, to selling, general and administrative expense on the first day of the advertising period. Gross advertising expenses for 2018 and 2017 $14.5 million and $23.2 million, respectively. Gross advertising expenses were reduced by vendor cooperative advertising allowances of $14.0 million and $20.9 million for 2018 and 2017, respectively.

Pre-opening costs. The Company charges to expense the pre-opening costs of new stores as incurred. These costs are primarily labor to stock the store, rent, pre-opening advertising, store supplies and other expendable items.

Fair value of financial instruments. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy, as defined below, gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.

At February 2, 2019, the Company did not have any outstanding derivative instruments. The recorded value of the Company’s financial instruments, which include cash and cash equivalents, receivables, accounts payable and indebtedness, approximates fair value. The following methods and assumptions were used to estimate fair value of each class of financial instrument: (1) the carrying amounts of current assets and liabilities approximate fair value because of the short maturity of those instruments and (2) the fair value of the Company’s indebtedness is estimated based on the current borrowing rates available to the Company for bank loans with similar terms and average maturities. Most of our indebtedness is under variable interest rates.

Insurance reserves. The Company is largely self-insured for workers compensation, general liability and employee medical insurance. The Company’s liability for self-insurance is determined based on claims known at the time of determination of the reserve and estimates for future payments against incurred losses and claims that have been incurred but not reported. Estimates for future claims costs include uncertainty because of the variability of the factors involved, such as the type of injury or claim, required services by the providers, healing time, age of claimant, case management costs, location of the claimant, and governmental regulations. These uncertainties or a deviation in future claims trends from recent historical patterns could result in the Company recording additional expenses or expense reductions that might be material to the Company’s results of operations. The Company’s worker's compensation and general liability insurance policy coverages run August 1 through July 31 of each fiscal year. Our employee medical insurance policy coverage runs from January 1 through December 31. The Company purchases excess insurance coverage for certain of its self-insured liabilities, or stop loss coverage. The stop loss limits for excessive or catastrophic claims for general liability remained at $350,000, worker’s compensation remained at $500,000 and employee medical changed to $250,000 effective January 1, 2017. The Company’s insurance reserve was $8.4 million and $11.3 million as of February 2, 2019 and February 3, 2018, respectively. Changes in the reserve for the year ended February 2, 2019, were attributable to additional reserve requirements of $70.4 million netted with payments of $68.3million.

Stock-based compensation. The Company uses the fair value recognition provisions of ASC 718, Compensation – Stock Compensation, whereby the Company recognizes share-based payments to employees and directors in the Consolidated Statements of Operations on a straight-line basis for shares that cliff vest and under the graded vesting attribution method for those shares that have graded vesting.

The Company calculates the income tax effects of stock-based compensation in accordance with ASC 718, Compensation - Stock Compensation, which provides for the use of the alternative transition method. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in-capital pool (“APIC Pool”) related to the income tax effects of stock-based compensation, and for determining the subsequent impact on the APIC pool and consolidated statements of cash flows of the income tax effects of stock-based compensation awards that are outstanding.

ASC 718 also requires the benefits of income tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow. ASC 718 results depends on, among other things, levels of share-based payments granted, actual forfeiture rates and the timing of option exercises.

Stock-based compensation expense is based on awards ultimately expected to vest, and therefore has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant based on the Company’s historical forfeiture experience and will be revised in subsequent periods if actual forfeitures differ from those estimates.

The Company adopted the provisions of ASU 2016-09 beginning with its fiscal 2017 first quarter. The ASU provisions did not have a material impact on the Company’s income tax expense as a result of the valuation allowance position eliminating the tax effects on the income statement.

Income Taxes. The Company reports income taxes in accordance with ASC 740, Income Taxes. Under ASC 740, the asset and liability method are used for computing future income tax consequences of events, which have been recognized in the Company’s Consolidated Financial Statements or income tax returns. Deferred income tax expense or benefit is the net change during the year in the Company’s deferred income tax assets and liabilities See Note 6: Income Taxes for additional information.

ASC 740 prescribes a minimum recognition threshold of more-likely-than-not to be sustained upon examination that a tax position must meet before being recognized in the financial statements. The impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. The Company recognizes and measures tax benefits from uncertain tax positions if it is "more likely than not" that the position is sustainable, based on its technical merits. The tax benefit of a qualifying position is the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon final settlement with a taxing authority fully knowing all relevant information. Additionally, ASC 740 provides guidance on de-recognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. See Note 6: Income Taxes for additional information.

ASC 740 also requires that interest and penalties required to be paid on the underpayment of taxes should be accrued on the difference between the amount claimed or expected to be claimed on the tax return and the tax benefit recognized in the financial statements. The Company includes potential interest and penalties recognized in accordance with ASC 740 in the financial statements as a component of income tax expense. Accrued interest and penalties related to our unrecognized tax benefits are recorded in the consolidated balance sheet within “Other non-current liabilities.”

The Company records valuation allowances to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and magnitude of appropriate valuation allowances against deferred tax assets. The realization of these assets is dependent on generating future taxable income, as well as successful implementation of various tax planning strategies. Valuation allowances against the deferred tax assets totaled $63.0 million and $59.3 million on February 2, 2019 and February 3, 2018, respectively.

Business segments. The Company is organized around individual stores. The Company stores have similar economic characteristics, offer pharmaceuticals or general merchandise consistent with all other locations, and have discrete financial information. Each store therefore represents an operating segment that is aggregated into one reportable segment.

Comprehensive income. Comprehensive income consists of two components, net income and other comprehensive income (loss). Other comprehensive income (loss) refers to gains and losses that under generally accepted accounting principles are recorded as an element of shareholders’ equity but are excluded from net income. The Company applies the guidance of ASC 715, Compensation – Retirement Benefits to the accounting and disclosure requirements of accumulated other comprehensive income. See Note 11: Commitments and Contingencies for additional information.

Reclassifications. Certain prior year amounts have been reclassified to conform to the 2018 presentation.

In February 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2018-02, Income Statement – Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASU provides companies with the option to reclassify tax effects resulting from the Tax Cuts and Jobs Act (“TCJA”) within Accumulated Other Comprehensive Income into Retained Earnings. This ASU is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The Company is currently evaluating the effect this ASU will have on its financial position, results of operations and cash flows.

In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other than Inventory. ASU 2016-16 requires that an entity recognize the income tax consequences of an intra-entity transfer of assets other than inventory when the transfer occurs. The guidance must be applied using the modified retrospective basis. This update is effective for the Company at the beginning of fiscal 2018. The Company has adopted the provisions of ASU 2016-16 and it has had no impact on its financial statements.

In February 2016, the FASB established ASU No. 2016-02 Leases (Topic 842), which requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements. Topic 842 was subsequently amended by ASU No. 2018-01, Land Easement Practical Expedient for Transition to Topic 842; ASU No. 2018-10, Codification Improvements to Topic 842, Leases; and ASU No. 2018-11, Targeted Improvements. The new standard establishes a right-of-the Company model (ROU) that requires a lessee to recognize a ROU asset and lease liability on the balance sheet for all leases with a term longer than 12 months. Leases will be classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the income statement. We will adopt the new standard effective February 3, 2019 on a modified retrospective basis and will not restate comparative periods. We elected to accept all of the practical expedients permitted under the guidance, with the exception of the use-of-hindsight or the practical expedient pertaining to land easements; the latter not being applicable to us.

The Company has selected a lease accounting and administration software to maintain all leases in compliance with this pronouncement and is currently working on the software implementation and testing, as well as accounting process development to ensure compliance with this standard upon adoption in 2019. We are evaluating the necessary changes to our controls and processes to address the lease standard. Adoption of the standard is expected to have a material impact on our consolidated statement of financial position for the addition of lease assets and liabilities, primarily related to real estate operating leases. ASU 2016-02 also requires expanded disclosure regarding the amounts, timing and uncertainties of cash flows related to a company’s lease portfolio. We are evaluating these disclosure requirements and are incorporating the collection of relevant data into our processes in preparation for disclosure in our first 10-Q filing for fiscal 2019. We do not expect ASU 2016-02 to have a material impact on our annual results of operations and/or cash flows.

In August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606), an update to ASU 2014-09. This ASU amends ASU 2014-09 to defer the effective date by one year for annual reporting periods beginning after December 15, 2017. Subsequently, the FASB has also issued accounting standards updates which clarify the guidance. This ASU removes inconsistencies, complexities and allows transparency and comparability of revenue transactions across entities, industries, jurisdictions and capital markets by providing a single comprehensive principles-based model with additional disclosures regarding uncertainties. The principles-based revenue recognition model has a five-step analysis of transactions to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Early adoption is permitted for annual reporting periods beginning after December 15, 2016. In transition, the ASU could have been applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company evaluated all contracts and implemented this standard and there was no material impact to the Company’s statement of position, results of operations, or statement of cash flow. No retrospectively application was required.

On December 19, 2016, Fred’s and its wholly-owned subsidiary, AFAE, LLC (“Buyer”), entered into an Asset Purchase Agreement (the “Asset Purchase Agreement”) with Rite Aid Corporation (“Rite Aid”) and Walgreens Boots Alliance, Inc. (“Walgreens”), pursuant to which Buyer agreed to purchase 865 stores, certain intellectual property and other tangible assets (collectively, the “Assets”) and to assume certain liabilities for a cash purchase price of $950 million (the “Rite Aid Transaction”). Pursuant to Section 8.01(g) of the Asset Purchase Agreement, each of Buyer, Walgreens or Rite Aid was permitted to terminate the Asset Purchase Agreement upon the termination of that certain Agreement and Plan of Merger, dated as of October 27, 2015, among Walgreens, Rite Aid and the other parties thereto (as amended, the “Merger Agreement”).

On June 29, 2017, the Merger Agreement was terminated and, accordingly, the Asset Purchase Agreement was also terminated, effective immediately. In connection with the termination of the Asset Purchase Agreement, the Company received a termination fee payment of $25 million on June 30, 2017 from Walgreens.