K•Swiss Inc. (the “Company”) designs, develops and markets footwear, apparel and accessories for athletic, high performance sports and fitness activities and casual wear under the K•Swiss brand. Since July 2008, the Company also designs, develops and markets footwear for adventurers for all terrains under the Palladium brand. The Company operates in an industry dominated by a small number of very large competitors. The size of these competitors enables them to lead the product direction of the industry, and therefore, potentially diminish the value of the Company’s products. In addition to generally greater resources, these competitors spend substantially more money on advertising and promotion than the Company and therefore dominate market share. The Company’s market share is estimated at approximately one percent. Lastly, due to the recent global economic crisis, the retail environment has been particularly challenging during the last few several years, which could negatively impact the Company’s operations.

The Company purchases significantly all of its products from a small number of contract manufacturers in Asia. The concentration of suppliers in this location subjects the Company to the risk of interruptions of product flow for various reasons which could lead to possible loss of sales, which would adversely affect operating results. In addition, there are other risks associated with doing business in Asia, especially China, where the Company’s intellectual property rights may not be protected.

In November 2001, the Company acquired the worldwide rights and business of Royal Elastics, an Australian-based designer and manufacturer of elasticated footwear. On April 30, 2009, the Company sold certain Royal Elastics assets, consisting of its inventory located in Taiwan and its intangible trademarks to Royal Elastics Holdings Ltd., a third party, in an arm’s length transaction. Operations of the Royal Elastics brand have been accounted for and presented as a discontinued operation in the accompanying consolidated financial statements. See further discussion in Note R.

In July 2008, the Company purchased a 57% equity interest in Palladium SAS (“Palladium”) for a total purchase price of €5,350,000, or approximately $8,448,000 (including a loan of €3,650,000, or approximately $5,764,000). In June 2009, the Company purchased the remaining 43% equity interest in Palladium for €5,000,000 (or $7,034,000) plus a variable future price, i.e. the Contingent Purchase Price (“CPP”), the terms of which were amended in May 2010. In May 2010, the Company revised the terms of the remaining future purchase price to be equal to the net present value of €3,000,000 plus up to €500,000 based on an amount calculated in accordance with a formula driven by Palladium’s EBITDA for the twelve months ended December 31, 2012. The €500,000 CPP will be determined each quarter based on the current quarter’s projection of Palladium’s EBITDA for the twelve months ended December 31 of the current year. Excluding the initial recognition of the CPP, any change in CPP is based on the change in net present value of the €3,000,000 and the current quarter’s EBITDA projection, and will be recognized as interest income or interest expense during the current quarter. The fair value of the CPP at December 31, 2011 was $3,739,000 (or €2,886,000). See further discussion in Note P.

In July 2010, the Company entered into a Membership Interest Purchase Agreement with Form Athletics, LLC (“Form Athletics”) and its Members to purchase Form Athletics for $1,600,000 in cash and additional cash consideration to certain Members of Form Athletics in an amount equal to Form Athletics’ EBITDA for the twelve months ended December 31, 2012 (“Form CPP”). The acquisition of Form Athletics was recorded as a 100% purchase and the Form CPP liability was recognized. The purchase of Form Athletics was part of an overall strategy to enter the action sports market, however, during 2011, the Company decided to no longer pursue operating in this line of business and recognized impairment losses of $3,689,000 on the Form Athletics goodwill and trademark and reversed the Form CPP liability of $2,110,000. Operations of Form Athletics have been accounted for and presented as a discontinued operation in the accompanying consolidated financial statements. See further discussion in Note Q.

In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Actual results could differ from those estimates.

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated. Certain reclassifications have been made in the 2010 and 2009 presentation to conform to the 2011 presentation. These reclassifications had no impact on previously reported results of operations or stockholders’ equity and do not affect previously reported cash flows from operations, investing and financing activities or net change in cash and cash equivalents.

For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Included in cash and cash equivalents as of December 31, 2011 and 2010 is $17,232,000 and $26,503,000, respectively, of balances maintained in foreign bank accounts.

Inventories, consisting of merchandise held for resale as finished goods, are stated at the lower of cost or market. Cost is determined using a moving average cost method. Management continually evaluates its inventory position and implements promotional or other plans to reduce inventories to appropriate levels relative to its sales estimates for particular product styles or lines. Estimated losses are recorded when such plans are implemented. It is possible that management’s plans to reduce inventory levels will be less than fully successful, and that such an outcome would result in a change in the inventory reserve in the near-term.

Property, plant and equipment are carried at cost. For financial reporting and tax purposes, depreciation and amortization are calculated using straight-line and accelerated methods, respectively, over the estimated service lives of the depreciable assets. The service lives of the Company’s building and related improvements are 30 and 5 years, respectively. Information systems and equipment is depreciated from 3 to 10 years and leasehold improvements are amortized over the lives of the respective leases.

When events or circumstances indicate the carrying value of a long-lived asset may be impaired, the Company estimates the future undiscounted cash flows to be derived from the asset to assess whether or not a potential impairment exists. If the carrying value exceeds the Company’s estimate of future undiscounted cash flows, the Company then calculates the impairment as the excess of the carrying value of the asset over the Company’s estimate of its fair market value.

Events or changes in circumstances that may trigger impairment reviews include among other factors, significant changes in business climate, operating results, planned investments, or an expectation that the carrying amount may not be recoverable. The test for impairment involves the use of estimates relating to the fair values of business operations with which the goodwill is associated and the fair values of intangible assets with indefinite lives.

The Company reviews goodwill for impairment in a two-step process. The first step is to determine whether there is potential impairment by comparing the estimated fair value of a reporting unit to its carrying value (which includes goodwill). If the fair value exceeds the carrying value, then goodwill is not considered impaired, however, if the carrying amount exceeds the fair value, then step two is performed to measure the amount of impairment loss, if any. The second step compares the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined by allocating fair value to all assets and liabilities. The excess, if any, is the implied fair value of goodwill. If the implied fair value of goodwill is less than the carrying amount of goodwill, then impairment is recognized.

The Company reviews intangible assets related to trademarks for impairment, by determining fair value using a “relief from royalty payments” methodology. This approach involves two steps: (i) estimating reasonable royalty rates for each trademark and (ii) applying these royalty rates to a net sales stream and discounting the resulting cash flows to determine fair value. If the fair value is less than the carrying value then impairment is recognized.

In addition, facts and circumstances could change, including further deterioration of general economic conditions, customers reducing orders in response to such conditions and increased competition. These and/or other factors could result in changes to the calculation of the fair value which could result in future impairment of the Company’s remaining goodwill and other intangible assets. Changes in any one or more of these estimates and assumptions could produce different financial results.

The Company has not recorded United States income tax expense on earnings of selected foreign subsidiary companies as these are intended to be permanently invested, thus reducing the Company’s overall income tax expense. The amount of earnings designated as permanently invested is based upon the Company’s expectations of the future cash needs of its subsidiaries. Income tax considerations are also a factor in determining the amount of earnings to be permanently invested. Because the declaration involves the Company’s future plans and expectations of future events, the possibility exists that amounts declared as permanently invested may ultimately be repatriated. This would result in additional income tax expense in the year the Company determines that amounts were no longer permanently invested.

On a quarterly basis, the Company estimates what its effective tax rate will be for the full calendar year by estimating pre-tax income, excluding significant or infrequently occurring items, and tax expense for the remaining quarterly periods of the year. The estimated annual effective tax rate is then applied to year-to-date pre-tax income to determine the estimated year-to-date and quarterly tax expense. The income tax effects of infrequent or unusual items are recognized in the quarterly period in which they occur. As the year progresses, the Company continually refines its estimate based upon actual events and earnings. This continual estimation process periodically results in a change to the Company’s expected annual effective tax rate. When this occurs, the Company adjusts the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date income tax provision equals the estimated annual rate.

The Company evaluates the future realization of its deferred tax assets quarterly. The Company reviews each material tax jurisdiction for which a deferred tax asset has been recorded. The Company’s analysis includes a review of past results, future income, the tax life of net operating loss carryforwards and tax credits. The Company assesses whether a valuation allowance should be established based on the consideration of all available evidence using a “more-likely-than-not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. All evidence is evaluated in forming a conclusion whether a valuation allowance, if any, needs to be recorded. A cumulative loss in recent years is significant negative evidence in considering whether deferred tax assets are realizable.

The accounting for the uncertainty in income tax positions prescribes a minimum recognition threshold a tax position must meet before recognition in the financial statements. The evaluation of a tax position is a two-step process. The first step is a recognition process to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. In evaluating whether a tax position has met the more-likely-than-not recognition threshold, it is presumed that the position will be examined by the appropriate taxing authority that has full knowledge of all relevant information. The second step is a measurement process whereby a tax position that meets the more-likely-than-not recognition threshold is calculated to determine the amount of benefit/expense to recognize in the financial statements. The tax position is measured at the largest amount of benefit/expense that is greater than 50% likely of being realized upon ultimate settlement.

Any tax position recognized would be an adjustment to the effective tax rate. The Company recognizes interest expense and penalties on income tax liabilities in income tax expense on its Consolidated Statement of Earnings/Loss. The Company recognizes its uncertain tax positions in either accrued income taxes, if determined to be short-term, or other liabilities if determined to be long-term, on its Consolidated Balance Sheet. For federal tax purposes, the Company’s 2008 through 2010 tax years remain open for examination by the tax authorities under the normal three year statute of limitations, however, the 2006 and 2007 tax years remain open for examination for limited issues. Generally, for state tax purposes, the Company’s 2007 through 2010 tax years remain open for examination by the tax authorities under a four year statute of limitations.

Assets and liabilities of certain foreign operations are translated into U.S. dollars at current exchange rates. Income and expenses are translated into U.S. dollars at average rates of exchange prevailing during the period. Adjustments resulting from translating foreign functional currency financial statements into U.S. dollars are taken directly to a separate component of stockholders’ equity. Foreign currency transaction gains and losses are generated by the effect of foreign exchange on recorded assets and liabilities denominated in a currency different from the functional currency of the applicable foreign operations and are included in selling, general and administrative expenses.

For certain of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, outstanding borrowings under the bank lines of credit, current portion of long-term debt, accounts payable and accrued liabilities, the carrying amounts approximate fair value due to their short maturities. In addition, the Company has long-term debt with financial institutions. The fair value of long-term debt is measured by obtaining the current interest rate from the financial institutions and then comparing that to the actual interest rate owed on the debt. At December 31, 2011, the fair value of the long-term debt is estimated at $147,000.

Accounting Standards Codification (“ASC”) No. 820, “Fair Value Measurements and Disclosures” establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

U.S. Government Corporations and Agency securities and Corporate Notes and Bonds are measured at fair value by obtaining (a) a bullet (non-call) spread scale that is created for each issuer going out to forty years (these spreads represent credit risk and are obtained from the new issue market, secondary trading and dealer quotes), (b) an option adjusted spread model which is incorporated to adjust spreads of issues that have early redemption features and (c) final spreads are added to the U.S. Treasury curve and a special cash discounting yield/price routine calculates prices from final yields to accommodate odd coupon payment dates. Evaluators maintain quality by surveying the dealer community, obtaining benchmark quotes, incorporating relevant trade data and updating spreads daily.

The Company’s counterparty (“Counterparty”) to a majority of its forward exchange contracts is a major financial institution. These forward exchange contracts are measured at fair value by the Counterparty based on a variety of pricing factors, which include the market price of the derivative instrument available in the dealer-market.

Sales denominated in currencies other than the U.S. dollar, which are primarily sales to customers in Europe, expose the Company to market risk from material movements in foreign exchange rates between the U.S. dollar and the foreign currency. The Company’s primary risk exposures are from changes in the rates between the U.S. dollar and the Euro and between the Euro and the Pound Sterling. In 2011 and 2010, the Company entered into forward foreign exchange contracts to exchange Euros for U.S. dollars and Pound Sterling for Euros. The extent to which forward foreign exchange contracts are used is modified periodically in response to management’s estimate of market conditions and the terms and length of specific sales contracts.

The Company enters into forward foreign exchange contracts in order to reduce the impact of foreign currency fluctuations and not to engage in currency speculation. The use of derivative financial instruments allows the Company to reduce its exposure to the risk that the eventual net cash inflow resulting from the sale of products to foreign customers will be materially affected by changes in exchange rates. The Company does not hold or issue financial instruments for trading purposes. The forward foreign exchange contracts are designated for firmly committed or forecasted sales. These contracts settle in less than one year.

The forward foreign exchange contracts generally require the Company to exchange Euros for U.S. dollars or Pound Sterling for Euros at maturity, at rates agreed upon at the inception of the contracts. The Company’s counterparties to derivative transactions are major financial institutions with an investment grade or better credit rating; however, the Company is exposed to credit risk with these institutions. The credit risk is limited to the unrealized gains in such contracts should these counterparties fail to perform as contracted.

Sales are recognized when title passes and the risks and rewards of ownership have passed to the customer, based on the terms of sale. Title passes generally upon shipment. In some instances, product is shipped directly from the Company’s supplier to the customer. In these cases, the Company recognizes revenue when the product is delivered to the customer according to the terms of the order. Revenues may fluctuate in cases when customers delay accepting shipment of product for periods up to several weeks. Provisions for estimated sales returns and allowances are made at the time of sale based on historical rates of returns and allowances and specific identification of outstanding returns not yet received from customers. However, actual returns and allowances in any future period are inherently uncertain and thus may differ from these estimates. If actual or expected future returns and allowances were significantly greater or lower than established reserves, a reduction or increase to net revenues would be recorded in the period this determination was made.

The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The Company estimates potential losses based on its knowledge of the financial condition of certain customers and historical level of credit losses, as well as an assessment of the overall retail conditions. Historically, losses have been within the Company’s expectations. If the financial condition of the Company’s customers were to change, adjustments may be required to these estimates. Furthermore, estimated losses are provided resulting from differences that arise from the gross carrying value of the Company’s receivables and the amounts which customers estimate are owed to the Company. The settlement or resolution of these differences could result in future changes to these estimates.

Shipping and handling costs billed to customers are included in revenues and the related costs are included in selling, general and administrative expenses in the Consolidated Statements of Earnings/Loss. Shipping and handling costs included in selling, general and administrative expenses totaled $4,311,000, $3,260,000 and $3,093,000 for the years ended December 31, 2011, 2010 and 2009, respectively.

Cost of goods sold includes the landed cost of inventory (which includes procurement costs of the Company’s Asian purchasing office and factory inspections, inbound freight charges, broker and consolidation charges and duties), production mold expenses and inventory and royalty reserves. Cost of goods sold may not be comparable to those of other entities as a result of recognizing warehousing costs within selling, general and administrative expenses. These warehousing costs were $16,511,000, $13,610,000 and $13,489,000 for the years ending December 31, 2011, 2010 and 2009, respectively.

Selling, general and administrative expenses include salaries and benefits, advertising, commissions, travel expenses, bad debt expense, shipping and handling costs, data processing expenses, legal fees, professional fees, rent and other office expenses, product development activity expenses, depreciation and amortization, bank fees, utilities, repairs and maintenance expenses, gains/losses on foreign currency transactions/revaluations, gains/losses on ineffective hedges and other warehousing costs.

Advertising costs are generally expensed as incurred and are included in selling, general and administrative expenses. Advertising costs also include athlete endorsement fees, which are amortized over the contractual terms of the agreements. Advertising expenses amounted to $47,244,000, $43,547,000 and $19,148,000 for the years ended December 31, 2011, 2010 and 2009, respectively. The Company engages in cooperative advertising programs with its customers. The Company recognizes this expense, based on the expected usage of the programs, in advertising expense.

Basic earnings per share excludes dilution and is computed by dividing net (loss)/earnings available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if options to issue common stock were exercised.

Because the Company had a net loss for the years ended December 31, 2011, 2010 and 2009, the number of diluted shares is equal to the number of basic shares at December 31, 2011, 2010 and 2009, respectively. Outstanding stock options would have had an anti-dilutive effect on diluted EPS for the years ended December 31, 2011, 2010 and 2009. Outstanding stock options with either exercise prices or unrecognized compensation cost per share greater than the average market price of a share of the Company’s common stock also have an anti-dilutive effect on diluted EPS and were as follows (shares in thousands):

The Company measures the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized over the period during which an employee is required to provide service in exchange for the award – the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The Company determines the grant-date fair value of employee stock options using the Black-Scholes option-pricing model adjusted for the unique characteristics of these options.

During 2011, the Company and one of its international distributors entered into a mutual settlement and termination agreement in which the Company agreed to an early termination of this distributor’s contracts for $3,000,000. This amount was received on February 8, 2011 and is included in Other Income in the Company’s Consolidated Statements of Earnings/Loss. The contracts with this distributor were terminated as a result of this distributor not performing in accordance with their contracts, and there was no litigation. The loss of this distributor did not have a significant impact on the Company’s revenues or gross margin. The Company secured another distributor for this region during the fourth quarter of 2011.

Accounting Standards Update (“ASU”) 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs,” ensures that U.S. generally accepted accounting principles are aligned with International Accounting Standards. ASU 2011-04 does not modify the requirements for when fair value measurements apply, but rather clarifies how to measure and disclose fair value. ASU 2011-04 clarifies the following:

Any revisions resulting from a change in valuation technique or its application will be accounted for as a change in accounting estimate. If an entity changes a valuation technique and related inputs as a result of applying the amended guidance, then the entity must disclose the change and quantify its total effect, if practicable. ASU 2011-04 is effective prospectively for interim and annual periods beginning after December 15, 2011. Early adoption is not permitted. The Company does not expect ASU 2011-04 will have a material impact on its financial position and results of operations, however, it may change certain fair value disclosures.

ASU 2011-05, “Presentation of Comprehensive Income,” improves the comparability of financial reporting and ensures that U.S. generally accepted accounting principles are aligned with International Accounting Standards. ASU 2011-05 requires entities to present all nonowner changes in stockholders’ equity either as a single continuous statement of comprehensive income or as two separate but consecutive statements. The components of other comprehensive income (“OCI”) have not changed, nor has the guidance on when OCI items are reclassified to net income, however, entities are required to present all reclassification adjustments to OCI to net income on the face of the statement of comprehensive income. Similarly, ASU 2011-05 does not change the guidance to disclose OCI components gross or net of the effect of income taxes, provided that the tax effects are presented on the face of the statement in which OCI is presented or disclosed in the notes to the financial statements. ASU 2011-05 is effective for interim and annual periods beginning after December 15, 2011, however, presentation of reclassification adjustments has been deferred with ASU 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassification of Items Out of Accumulated Other Comprehensive Income in ASU 2011-05.” ASU 2011-05 should be applied retrospectively and early adoption is permitted. The Company does not expect ASU 2011-05 will have a material impact on its financial position and results of operations, however, it may change certain disclosures.

ASU 2011-08, “Testing Goodwill for Impairment,” intends to simplify goodwill impairment testing. ASU 2011-08 permits an entity to first assess qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount. If this qualitative assessment determines that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, then the entity must review goodwill for impairment in a two step process, as discussed in Note A.8. ASU 2011-08 is effective for interim and annual periods beginning after December 15, 2011.