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Summary of Significant Accounting Policies (Policies)

9 Months Ended

Nov. 01, 2014

Summary of Significant Accounting Policies

Receivables are reported at amounts the Company expects to be collected, net of 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 the Company’s licensees, current economic conditions, bankruptcy, and other factors that may affect the Company’s licensees’ ability to pay. There was no allowance for doubtful accounts as of November 1, 2014 or February 1, 2014.

Recent Accounting Pronouncements

In May 2014, the FASB issued new guidance surrounding revenue from contracts with customers noting that an entity 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. This guidance is effective for fiscal periods beginning after December 15, 2016. The anticipated impact of the adoption of this guidance on the Company is still being evaluated.

Reclassifications

The Company has reclassified certain prior year amounts within the operating activities on the Company’s consolidated statements of cash flows, and within the selling, general and administrative expenses on the Company’s consolidated statements of income, to conform to the Company’s current year presentation.

Use of Estimates

On an ongoing basis, the Company evaluates its estimates and assumptions, including those related to revenue recognition, allowance for doubtful accounts, valuation of long-lived assets, stock based compensation and income taxes. The Company bases its estimates on historical and anticipated results, trends and on various other assumptions that it believes are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making assumptions about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results could differ materially from these estimates.

Cash and Cash Equivalents

The Company considers 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. At November 1, 2014 and February 1, 2014, the Company’s cash and cash equivalents exceeded FDIC limits.

Revenue Recognition and Deferred Revenue

The Company recognizes revenue when persuasive evidence of a sale arrangement exists, delivery has occurred or services have been rendered, the buyer’s price is fixed or determinable and collection is reasonably assured. Revenues from arrangements involving license fees, up-front payments and milestone payments, which are received or billable by the Company in connection with other rights and services that represent continuing obligations of the Company, are deferred and recognized in accordance with the license agreement. Deferred revenues represent minimum licensee revenue royalties paid in advance of the culmination of the earnings process, the majority of which are non-refundable to the licensee. Deferred revenues will be recognized as revenue in future periods in accordance with the license agreement. Revenues from royalty and brand representation agreements are recognized when earned by applying contractual royalty rates to quarterly point of sale data received from the Company’s licensees.

The Company’s royalty revenue recognition policy provides for recognition of royalties in the quarter earned. The Company’s agreement with Target for the Cherokee brand in the U.S. accounts for the majority of the Company’s historical revenues and is structured to provide royalty rate reductions once certain cumulative levels of retail sales are achieved. With respect to Target’s sales in the U.S. of Cherokee branded products other than in the school uniforms category and adult products sold on Target dotcom, 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, the Company’s 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 the Company’s agreement with Target. The amount of Cherokee brand royalty revenue earned by the Company 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, with Target, this has caused the Company’s first quarter to be the Company’s highest revenue and profitability quarter and the Company’s fourth quarter to be the Company’s lowest quarter. 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 the Company receives from Target or other licensees that are not subject to reduced royalty rates based upon cumulative sales, including with respect to the Company’s Liz Lange brands, the recently acquired Tony Hawk brand, as well as Cherokee brand in the school uniforms category and Cherokee adult products sold on Target dotcom.

In order to ensure that Cherokee’s licensees are appropriately reporting and calculating royalties owed to Cherokee, all of Cherokee’s license agreements include audit rights to allow Cherokee to validate the royalties paid. Any revenue resulting from these audits, or other audits, is recognized in the financial statement of the current reporting period.

Deferred Financing Costs and Debt Discount

Deferred financing costs and debt discounts are capitalized and amortized into interest expense over the life of the debt.

Foreign Withholding Taxes

Licensing revenue is recognized gross of withholding taxes that are remitted by the Company’s licensees directly to their local tax authorities.

Property and Equipment

Property and equipment consist of the following:

	November 1, 2014			February 1, 2014
Computer Equipment	$	417		$	349
Software	62			49
Furniture and Store Fixtures	1,457			1,141
Leasehold Improvements	409			317
Less: Accumulated depreciation	(990		)	(634		)
Property and Equipment, net	$	1,355		$	1,222

Property and equipment are stated at cost, less accumulated depreciation. Maintenance and repairs are expensed as incurred. The cost and related accumulated depreciation of property and equipment sold or retired are written off, and the resulting gains or losses are included in current operations. Depreciation is provided on a straight line basis over the estimated useful life of the related asset.

Computers and related equipment and software are depreciated over three years. Furniture and store fixtures are depreciated over the shorter of seven years, or the remaining term of the licensee agreement. Leasehold improvements are depreciated over the shorter of five years, or the remaining life of the lease term. Depreciation expense was $152 and $361 for the three and nine month periods ended November 1, 2014, respectively, and $89 and $257 for the three and nine month periods ended November 2, 2013, respectively.

Earnings Per Share Computation

Earnings Per Share Computation (amounts in thousands, including share amounts)

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 November 1, 2014 and November 2, 2013:

	Three Months Ended				Nine Months Ended
	November 1, 2014		November 2, 2013		November 1, 2014		November 2, 2013
Numerator:
Net income-numerator for net income per common share and net income per common share assuming dilution	$	2,316	$	1,563	$	8,160	$	5,123

Denominator:
Denominator for net income per common share — weighted average Shares	8,424		8,396		8,411		8,394
Effect of dilutive securities:
Stock options	142		12		79		12

Denominator for net income per common share, assuming dilution:
Adjusted weighted average shares and assumed exercises	8,566		8,408		8,490		8,406

The computation for diluted number of shares excludes unexercised stock options which are anti-dilutive. There were 502 and 917 anti-dilutive shares for the three and nine month periods ended November 1, 2014, respectively, and 1,033 and 974 anti-dilutive shares for each of the three and nine months periods ended November 2, 2013.

Basic earnings per share (“EPS”) is computed by dividing the net income attributable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is similar to the computation for basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. However, nonvested restricted stock awards (referred to as participating securities) are excluded from the dilutive impact of common equivalent shares outstanding in accordance with authoritative guidance under the two-class method since the nonvested restricted stockholders are entitled to participate in dividends declared on common stock as if the shares were fully vested and hence are deemed to be participating securities. Under the two-class method, earnings attributable to nonvested restricted stockholders are excluded from net earnings attributable to common stockholders for purposes of calculating basic and diluted earnings per common share. There is no material impact on the calculation under the two-class method.

Significant Contracts

The current terms of the Company’s relationship with Target are set forth in a restated license agreement with Target, which was entered into effective as of February 1, 2008 and recently amended (i) on January 31, 2013 to add the category of school uniforms; (ii) on April 3, 2013 to provide for a fixed royalty rate of 2% for sales of Cherokee-branded products in the category of adult merchandise sold on Target’s website (target.com) in Fiscal 2015 and in future periods; and (iii) on January 6, 2014 to reflect Target’s election to renew the agreement through January 31, 2017 and to provide that Target can renew the agreement for successive two (2) year periods, provided that it satisfied the minimum guaranteed royalty payment of $10,500 for the preceding fiscal year (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”), the terms of the Restated Target Agreement apply to the territory of Canada effective as of February 1, 2013. The current term of the Restated Target Agreement continues through January 31, 2017; however, the Restated Target Agreement may be renewed by Target for additional two year terms by providing written notice of renewal at least one year prior to the end of the then current extended restated term.

The minimum guaranteed royalty for Target is $10,500 and applies to all sales of Cherokee-branded products made by Target in the United States and in Canada, specifically excluding the sales of Cherokee-branded products in the school uniforms category (which products are subject to a separate minimum guaranteed royalty of $800). Under the Restated Target Agreement, Target has agreed to pay royalties based on a percentage of Target’s net sales of Cherokee branded merchandise during each fiscal year ended January 31, which percentage varies according to the volume of sales of merchandise specifically excluding the sales of Cherokee-branded products in the school uniforms category and, beginning in Fiscal 2015, specifically excluding the sales of Cherokee-branded products in the adult merchandise category that are sold on Target’s website.

The Company assumed a separate license agreement with Target for the Liz Lange brands in connection with the Company’s acquisition of the assets in September 2012.

In connection with the Hawk acquisition, Cherokee and Kohl’s entered into an amended license agreement. Pursuant to such amendment, Kohl’s is granted the exclusive right to sell Tony Hawk and Hawk-branded apparel and related products in the United States and has agreed to pay Cherokee an annual royalty rate for its sales of Hawk-branded signature apparel and related products in the United States subject to a minimum royalty guarantee of $4,800 per year, or $19,200 over the initial contract term of four years.

On October 7, 2014 Cherokee and Tesco entered into a termination agreement whereby the license agreement for the Cherokee brand in the UK, Ireland and certain territories in Central Europe will terminate as of January 31, 2015.

Stock-Based Compensation

Effective July 16, 2013, the Company’s stockholders approved the 2013 Stock Incentive Award Plan, or the 2013 Plan. The 2013 Plan serves as the successor to the 2006 Incentive Award Plan, or the 2006 Plan (which includes the 2003 Incentive Award Plan as amended by the adoption of the 2006 Incentive Award Plan). The 2013 plan authorized to be issued (i) 700,000 additional shares of Common Stock, and (ii) 102,483 shares of Common Stock previously reserved but unissued under the 2006 Plan. No future grants will be awarded under the 2006 Plan, but outstanding awards granted under the 2006 Plan continue to be governed by its terms. Any such shares of Common Stock that are subject to outstanding awards under the 2006 Plan which are forfeited, terminate or expire unexercised and would otherwise have been returned to the share reserve under the 2006 Plan will be available for issuance under the 2013 Plan. The 2013 Plan provides for the issuance of equity-based awards to officers, other employees, and directors. 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. The Company issues new shares of Common Stock upon exercise of stock options. The Company has also granted non-plan options to certain executives as a material inducement for employment.

The Company accounts for stock options under authoritative guidance, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors for employee stock options based on estimated fair values.

The Company estimates the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as an expense over the requisite service periods in the consolidated statements of income. The compensation expense recognized for all stock-based awards is net of estimated forfeitures over the award’s service period.

Stock-based compensation expense recognized for the Nine Months was $780, as compared to $817 for the comparable period in the prior year.

A summary of all 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 February 1, 2014	1,156,834		$	16.02	3.85	$	436,415
Granted	188,000		$	13.82
Exercised	(29,733	)	11.88
Canceled/forfeited	(19,334	)	$	12.00

Outstanding, at November 1, 2014	1,295,767		$	15.85	3.56	$	2,629,616

Vested and Exercisable at November 1, 2014	834,429		$	16.59	2.71	$	1,201,041

As of November 1, 2014, total unrecognized stock-based compensation expense related to non-vested stock options was approximately $1,332, which is expected to be recognized over a weighted average period of approximately 1.87 years. The total fair value of all options which vested during the Nine Months was $596.

Restricted Stock and Restricted Stock Units

The Compensation Committee of the Company’s Board of Directors granted certain performance-based equity awards to executives under the Company’s 2006 Stock Plan.

The performance metric applicable to such awards is compound stock price growth, using the closing price of the Company’s Common Stock on February 1, 2013, or $13.95, as the benchmark. The target growth rate is 10% annually, which results in an average share price target of (i) $15.35 for Fiscal 2014, (ii) $16.88 for Fiscal 2015 and (iii) $18.57 for the Company’s fiscal year ending in 2016. The average share price will be calculated as the average of all market closing prices during the January preceding fiscal year end. If a target is met at the end of a fiscal year, one third of the shares subject to the award will vest. If the stock price target is not met, the relevant portion of the shares subject to the award will not vest but will roll over to the following fiscal year. The executive must continue to be employed by the Company through the relevant vesting dates to be eligible for vesting.

Since the vesting of these performance-based equity awards are subject to market based performance conditions, the fair value of these awards were measured on the date of grant using the Monte Carlo simulation model for each vesting tranche. The Monte Carlo simulation model utilizes multiple input variables that determine the probability of satisfying the performance conditions stipulated in the award grant and calculates the fair market value for the performance units granted. The Monte Carlo simulation model also uses stock price volatility and other variables to estimate the probability of satisfying the performance conditions and the resulting fair value of the award.

Pursuant to a compensation program for non-employee directors adopted by the Compensation Committee, at the June Board meeting each year, every non-employee member of the Board of Directors must make an election regarding the percentage, up to 100%, of his annual Board compensation to be paid in equity, in the form of Restricted Stock Units (“RSU’s”). All of the RSU’s issuable under this program in June 2014 were approved and granted on July 28, 2014. The fair value of these awards was measured on the effective date of grant using the stock price.

The RSU’s awarded to the non-employee directors are subject to the terms of the Cherokee, Inc. 2013 Stock incentive Plan and RSU agreement which provides for quarterly vesting over a one year service period of August 4, 2014 through August 3, 2015, subject to acceleration of vesting upon the earlier to occur of the following: (i) a change in control of the Company, (ii) the death of the recipient or (iii) the recipient’s failure to be re-elected to the Board of Directors in any election in which the recipient stands for re-election.

Separately, the Compensation Committee of the Company’s Board of Directors granted certain sales based performance-based equity awards to an employee under the Company’s 2013 Stock Plan all of which vest in five increments dependent upon achievement of certain annual sales targets. The fair value of this award was measured on the effective date of grant, August 29, 2014, using the stock price.

Compensation expense on shares of restricted stock and performance stock units for the Nine Months was $244 compared to $100 for the comparable period in the prior year.

	Number of Shares		Weighted Average Grant-Date Fair Value
Unvested stock at February 1, 2014	87,000		$	5.70
Granted	51,576		$	15.78
Vested	—		—
Forfeited	(12,000	)	3.80
Unvested stock at November 1, 2014	126,576		$	9.99

As of November 1, 2014, total unrecognized stock-based compensation expense related to restricted stock and performance stock units was approximately $409, which is expected to be recognized over a weighted average period of approximately 2.51 years.

Trademarks

The Company holds various trademarks including Cherokee®, Liz Lange®, Completely Me by Liz Lange®, Hawk®, Tony Hawk®, Sideout®, Sideout Sport®, Carole Little®, Saint Tropez-West®, Chorus Line, All That Jazz®, and others, in connection with numerous categories of apparel and other goods. These trademarks are registered with the United States Patent and Trademark Office and in a number of other countries. The Company also holds trademark applications for Cherokee, Liz Lange, Completely Me by Liz Lange, Hawk, Tony Hawk, Sideout, Sideout Sport, Carole Little, Chorus Line, Saint Tropez-West, All That Jazz, and others in numerous countries. The Company intends to renew these registrations, as appropriate, prior to expiration. The Company monitors on an ongoing basis unauthorized uses of the Company’s trademarks, and relies primarily upon a combination of trademark, copyright, know-how, trade secrets, and contractual restrictions to protect the Company’s intellectual property rights both domestically and internationally.

Trademark registration and renewal fees are capitalized and are amortized on a straight-line basis over the estimated useful lives of the assets. Trademark acquisitions are capitalized and are either amortized on a straight-line basis over the estimated useful lives of the assets, or are capitalized as indefinite-lived assets, if no legal, regulatory, contractual, competitive, economic, or other factors limit its useful life to Cherokee. Trademarks are evaluated for the possibility of impairment and are tested, at least annually.

Trademarks consist of the following:

	November 1, 2014			February 1, 2014
Acquired Trademarks	$	47,994		$	47,994
Other Trademarks	8,609			8,551
Accumulated amortization	(16,560		)	(15,862		)
Total	$	40,043		$	40,683

Fair Value of Financial Instruments

Authoritative guidance defines fair value 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 guidance establishes a fair value hierarchy, which prioritizes the inputs used in measuring fair value into three broad levels as follows:

Level 1: Observable inputs such as quoted prices for identical assets or liabilities in active markets.

Level 2: Other inputs that are observable directly or indirectly, such as quoted prices for similar assets or liabilities or market-corroborated inputs.

Level 3: Unobservable inputs for which there is little or no market data and which requires the owner of the assets or liabilities to develop its own assumptions about how market participants would price these assets or liabilities.

The carrying amounts of receivables, accounts payable and accrued liabilities approximate fair value due to the short-term nature of these instruments. Long-term debt approximates fair value due to the variable rate nature of the debt.

The realizability of long-lived assets is evaluated periodically as events or circumstances indicate a possible inability to recover the carrying amount. Long-lived assets that will no longer be used in business are written off in the period identified since they will no longer generate any positive cash flows for the Company. Periodically, long lived assets that will continue to be used by the Company need to be evaluated for recoverability. Such evaluation is based on various analyses, including cash flow and profitability projections. The analyses involve management judgment. In the event the projected undiscounted cash flows are less than net book value of the assets, the carrying value of the assets will be written down to their estimated fair value, in accordance with authoritative guidance.

The estimated undiscounted cash flows used for this nonrecurring fair value measurement is considered a Level 3 input, which consist of unobservable inputs that reflect assumptions about what market participants would use in pricing the asset or liability. These inputs would be based on the best information available, including the Company’s own data.

Income Taxes

Income tax expense of $1,291 was recognized for the Third Quarter, resulting in an effective tax rate of 35.8% in the Third Quarter, as compared to 37.6% in the third quarter of last year and compared to 35.9% for the full year of Fiscal 2014. The effective tax rate for the Third Quarter differs from the statutory rate due to permanent differences on certain expenses and the apportionment of income between state jurisdictions. Income tax expense of $3,874 was recognized for the Nine Months, resulting in an effective tax rate of 32.2% in the Nine Months, as compared to 37.5% in the nine months of last year. The effective tax rate for the Nine Months differs from the statutory rate due to the effect of certain permanent nondeductible expenses, the apportionment of income among state jurisdictions, and the recognition of previously unrecognized tax benefits upon the conclusion of income tax examinations.

The amount of unrecognized tax benefits was approximately $361 and $1,045, respectively, at November 1, 2014 and February 1, 2014. At November 1, 2014, approximately $235 of unrecognized tax benefits would, if recognized, affect the effective tax rate.

In accordance with authoritative guidance, interest and penalties related to unrecognized tax benefits are included within the provision for taxes in the consolidated statements of income. The total amount of interest and penalties recognized in the consolidated statements of income for the Third Quarter was $4 as compared with $14 in the third quarter of last year. As of November 1, 2014 and February 1, 2014, respectively, the total amount of accrued interest and penalties included in the liability for unrecognized tax benefits was $86 and $346.

Due to inherent uncertainties in estimating accruals for uncertain tax positions, amounts asserted by tax authorities could be greater or less than the amounts accrued by the Company. Accordingly, the Company’s provision on federal and state matters to be recorded in the future may change as revised estimates are made or the underlying matters are settled or otherwise resolved. As of November 1, 2014, the Company does not believe that its estimates, as otherwise provided for, on such tax positions will significantly increase or decrease within the next twelve months.

The Company files income tax returns in the U.S. federal and California and certain other state jurisdictions. For federal income tax purposes, the fiscal 2012 and later tax years remain open for examination by the tax authorities under the normal three year statute of limitations. The IRS commenced an examination of the Company’s fiscal 2012 federal tax return during the first quarter of the year. No material adjustments are anticipated to result from the examination. For state tax purposes, the fiscal 2011 and later tax years remain open for examination by the tax authorities under a four year statute of limitations.

Marketing and Advertising

Generally, the Company’s direct to retail licensees fund their own advertising programs. Cherokee’s marketing, advertising and promotional costs totaled $211 and $876 for the three and nine month periods ended November 1, 2014 and $149 and $580 for the three and nine month periods ended November 2, 2013, respectively. These costs are expensed as incurred and were accounted for as selling, general and administrative expenses.

The Company provides marketing expense money to certain large licensees based upon sales criteria to help them build the Company’s licensed brands in their respective territories; the amounts paid for the three and nine month periods ended November 1, 2014 were $50 and $168 and for the three and nine month periods ended November 2, 2013 were $19 and $38, respectively, and are included in the total marketing, advertising and promotional costs above.

Deferred Rent and Lease Incentives

When a lease includes lease incentives (such as a rent abatement) or requires fixed escalations of the minimum lease payments, rental expense is recognized on a straight-line basis over the term of the lease and the difference between the average rental amount charged to expense and amounts payable under the lease is included in deferred rent and lease incentives in the accompanying consolidated balance sheets. For leasehold allowances, the Company records a deferred lease credit on the consolidated balance sheets and amortizes the deferred lease credit as a reduction of rent expense in the consolidated statements of income over the term of the leases.

Comprehensive Income

Authoritative guidance establishes standards for reporting comprehensive income and its components in financial statements. Comprehensive income, as defined, includes all changes in equity (net assets) during a period from non-owner sources. For the three and nine months ended November 1, 2014 and November 2, 2013, the Company has no comprehensive income components and accordingly, net income equals comprehensive income.

Treasury Stock

Repurchased shares of the Company’s common stock are held as treasury shares until they are reissued or retired. When the Company reissues treasury stock, and the proceeds from the sale exceed the average price that was paid by the Company to acquire the shares, the Company records such excess as an increase in additional paid-in capital.

Conversely, if the proceeds from the sale are less than the average price the Company paid to acquire the shares, the Company records such difference as a decrease in additional paid-in capital to the extent of increases previously recorded, with the balance recorded as a decrease in retained earnings.