Summary of Significant Accounting Policies

9 Months Ended

Oct. 27, 2012

Summary of Significant Accounting Policies

Summary of Significant Accounting Policies

(3)   Summary of Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, SPELL C. LLC and Cherokee Brands LLC, both Delaware limited liability corporations.  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 licensees, current economic conditions, bankruptcy, and other factors that may affect our licensees’ ability to pay.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and revenues and expenses during the reporting periods. Actual results could differ from those estimates.

Cash and Cash Equivalents

We consider all highly liquid debt instruments purchased and money market funds purchased with an original maturity date of three months or less to be cash equivalents.

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. Our agreement with Target for the Cherokee brand in the U.S. accounts for the majority of our historical revenues and is structured to provide royalty rate reductions once certain cumulative levels of sales are achieved. With respect to Target’s sales in the U.S., revenue is recognized by applying the reduced contractual royalty rates prospectively to point of sale data as defined sales thresholds are exceeded. The royalty rate reductions do not apply retroactively to sales since the beginning of the fiscal year. As a result, our royalty revenues as a percentage of Target’s retail sales in the U.S. are highest at the beginning of each fiscal year and decrease during the fiscal year as Target exceeds sales thresholds as set forth in our agreement with Target. The amount of royalty revenue earned by us from Target in any quarter is dependent not only on Target’s retail sales of Cherokee branded products in the U.S. in each quarter, but also on the royalty rate then in effect after considering Target’s cumulative level of retail sales for Cherokee branded products in the U.S. for the fiscal year. Historically this has 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 execution of new license agreements and retail sales volumes achieved in each quarter from Target and also on the revenues we receive from other licensees that do not pay us reduced royalty rates based upon cumulative sales.

Deferred Revenue

Deferred revenues represent minimum licensee revenue royalties paid in advance, the majority of which are non-refundable to the licensee.

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 27, 2012 and October 29, 2011:

	Three Months Ended				Nine Months Ended
	October 27, 2012		October 29, 2011		October 27, 2012		October 29, 2011
Numerator:
Net income-numerator for net income per common share and net income per common share assuming dilution	$	2,077,000	$	1,049,000	$	5,756,000	$	5,972,000
Denominator:
Denominator for net income per common share — weighted average Shares	8,397,416		8,419,473		8,391,666		8,476,469
Effect of dilutive securities:
Stock options	38,173		1,912		12,996		3,369
Denominator for net income per common share, assuming dilution:
Adjusted weighted average shares and assumed exercises	8,435,589		8,421,385		8,404,662		8,479,838

The computation for diluted number of shares excludes unexercised stock options which are anti-dilutive. There were 772,500 and 1,043,000 of anti-dilutive shares for the three months ended October 27, 2012 and October 29, 2011, respectively. There were 772,500 and 619,163 of anti-dilutive shares for the nine month periods ended October 27, 2012 and October 29, 2011, respectively.

Significant Contracts

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 and amended on December 1, 2011 (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. In addition, pursuant to a Canada Affiliate Agreement between Cherokee and Target Canada Co., dated December 1, 2011 (the “Target Canada Agreement”), and subject to our agreement with Zellers, the terms of the Restated Target Agreement will apply to the territory of Canada effective as of February 1, 2013 and Target will have exclusive rights to the Cherokee brand within the territory of Canada effective as of January 31, 2014 (or earlier if our agreement with Zellers terminates before such date).  

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 Fiscal 2013, then the term of the Restated Target Agreement will continue to renew automatically 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. In addition, effective as of February 1, 2013, the minimum guaranteed royalty for Target will increase to $10.5 million and will apply to all sales made by Target in the United States or in Canada as contemplated by the Target Canada Agreement. Under the Restated Target Agreement, Target has agreed to pay royalties based on a percentage of Target’s net sales of Cherokee branded merchandise in the U.S. during each fiscal year ended January 31st, which percentage varies according to the volume of sales of merchandise. Under the Target Canada Agreement, Target has agreed to pay a fixed royalty rate based on a percentage of Target’s net sales of Cherokee branded merchandise in Canada during each fiscal quarter. Royalty revenues from Target totaled $13.8 million in Fiscal 2012, $13.0 million in Fiscal 2011 and $13.2 million in Fiscal 2010.

We also have other licensing agreements regarding our brands, including with Tesco for our Cherokee brand in the United Kingdom, Ireland, the Czech Republic, Slovakia, Poland, Hungary and Turkey. For a more complete description of certain of our license agreements and other commercial agreements, please see our Annual Report on Form 10-K for Fiscal 2012, which was filed with the Securities and Exchange Commission (the “Commission”) on April 12, 2012.

On September 4, 2012, Cherokee and LLM Management Co., LLC entered into an Asset Purchase Agreement pursuant to which Cherokee acquired assets related to the “Liz Lange” and “Completely Me by Liz Lange” brands. See Note 2 (“Acquisitions and Transactions”) above.

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.

2003 Plan—The 2003 Plan was approved at the June 9, 2003 Annual Meeting of Stockholders, and amended on 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 grants under the 2003 Plan to any individual in any calendar year cannot exceed 100,000.  During the First Quarter, we granted to certain employees stock options with a seven-year term to purchase a total of 70,000 shares of our common stock at an exercise price of $10.92 per share (the closing price on the date of grant) pursuant to the 2003 Plan. During the Second and Third Quarter, we did not make any grants pursuant to the 2003 Plan. As of October 27, 2012, there were 55,315 shares available for issuance under the 2003 Plan.

2006 Plan—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. During the First Quarter, we granted to certain employees stock options with a seven-year term to purchase 10,000 shares of our common stock at an exercise price of $10.92 per share (the closing price on the date of grant) pursuant to the 2006 Plan. During the Second Quarter, we granted to certain employees and non-employee directors stock options with a seven-year term to purchase a total of 213,000 shares of our common stock at exercise prices of $13.06 and $14.12 per share (which were the closing prices on the date of each applicable grant) pursuant to the 2006 Plan.   In addition, during the Second Quarter, we granted to each of our non-employee directors restricted stock awards for 1,500 shares, or 7,500 shares in total, of our common stock pursuant to the 2006 Plan.  During the Third Quarter, we did not make any grants pursuant to the 2006 Plan. During the Third Quarter, 5,500 stock options were exercised at $13.06 per share. As of October 27, 2012, there were 52,500 shares available for issuance under the 2006 Plan.

Following the approval by Cherokee’s stockholders, on June 4, 2010, we issued to Robert Margolis, our former Executive Chairman, a non-qualified stock option to purchase 100,000 shares of our Common Stock (the “Margolis Option”) at an exercise price of $18.49, which was the closing price of our Common Stock on June 4, 2010. The Margolis Option was not issued pursuant to any of Cherokee’s existing equity incentive plans. Pursuant to its original terms, the Margolis Option was to vest contingent on Mr. Margolis’ continued service as a member of our Board of Directors in two equal installments of 50,000, on January 31, 2011 and January 31, 2012; however, pursuant to our separation with Mr. Margolis, the vesting applicable to the Margolis Option was accelerated in full. The Margolis Option is exercisable until June 4, 2015.

In addition, in connection with the appointment of Mr. Stupp as our Chief Executive Officer, on August 26, 2010, we granted to Mr. Stupp an option to purchase shares (the “Stupp Option”) of Cherokee’s common stock as an inducement grant outside of the 2006 Plan, subject to vesting requirements and other terms. The Stupp Option was originally exercisable for up to a total of 300,000 shares and the maximum number of shares for which the Stupp Option may exercise is 187,500 as of the date of this report (subject to applicable vesting conditions set forth in the Stupp Option). This grant of stock options was entered into as an inducement material for Mr. Stupp to enter into employment with Cherokee. While the grant of the Stupp Option was made outside of the 2006 Plan, the grant is consistent with applicable terms of the 2006 Plan. See the description of the Stupp Option in Note 5. (“Related Party Transactions”) below.

Stock-based compensation expense recognized for the Nine Months was $647,000, as compared to $544,000 for the comparable period in the prior year.

The estimated fair value of options granted during Fiscal 2013 and Fiscal 2012 as of each grant date was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Fiscal 2013	Fiscal 2012
Expected Dividend Yield	5.67% to 7.33%	4.65% to 6.67%
Expected Volatility	51.63 to 53.33	49.28 to 51.21
Avg. Risk-Free Rate	0.57% to 1.01%	1.1%
Expected Life (in years)	4.5	4.5 to 5.0
Estimated Forfeiture Rate	17%	30%

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. 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. Our 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 28, 2012	973,833		$	17.92
Granted	293,000		11.75
Exercised	(5,500	)	13.06
Canceled/forfeited	(186,333	)	18.44
Outstanding, at October 27, 2012	1,075,000		16.37		4.67	662,870
Vested and Exercisable at October 27, 2012	458,831		17.66		3.42	67,870
Non-vested and not exercisable at October 27, 2012	616,169		15.42		5.38	595,000

As of October 27, 2012, total unrecognized stock-based compensation expense related to non-vested stock options was approximately $1,969,929 and $91,127 for restricted stock awards, which is expected to be recognized over a weighted average period of approximately 2.65 and 2.65 years, respectively.  The total fair value of all options which vested during the Nine Months was $820,659.

Trademarks

Trademark acquisition, registration, and renewal fees which were capitalized during the Third Quarter and Nine Months totaled $13,181,000 and $13,334,000, respectively, predominantly due to the acquisition of assets related to the “Liz Lange” and “Completely Me by Liz Lange” brands.  In comparison, for the Third Quarter and Nine months of last year, the total trademark registration and renewal fees capitalized totaled $27,000 and $200,000, respectively.

Income Taxes

Income tax expense recognized for the Third Quarter was $1,187,000, resulting in an effective tax rate of 36.4%, as compared with 40.3% in the third quarter of last year and compared with 28.0% for the full year of Fiscal 2012. Our lower effective tax rate in Fiscal 2012 was primarily the result of settling income tax examinations with the California Franchise Tax Board related to our apportionment of income.

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 2009. 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 28, 2012 and October 27, 2012, respectively, accrued interest on a gross basis was $130,000 and $171,000.

As of January 28, 2012 and October 27, 2012, respectively, the total amount of gross unrecognized tax benefits was approximately $900,000 and $928,000, of which approximately $603,000 represents the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate.

Recent Accounting Pronouncements

In May 2011, the FASB issued an update to ASC Topic 820, Fair Value Measurements and Disclosures (“ASC 820”). ASC 820 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. ASC 820 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years, with early adoption permitted. We adopted ASC 820 on the first day of Fiscal 2009, and this adoption did not have a material impact on our consolidated financial statements.