NOTE 1: Summary of Significant Accounting Policies

Nature of the Business

The Wet Seal, Inc. and its subsidiaries ("the Company") is a national specialty retailer operating stores selling trend right and contemporary apparel and accessory items designed for female customers aged 15 to 39 years old. The Company operates two nationwide, primarily mall-based, chains of retail stores under the names "Wet Seal" and "Arden B." The Company's success is largely dependent upon its ability to gauge the fashion tastes of its customers and to provide merchandise that satisfies customer demand.

The Company's fiscal year ends on the Saturday closest to the end of January. The reporting periods include 52 weeks of operations ended January 28, 2012 (fiscal 2011), January 29, 2011 (fiscal 2010) and January 30, 2010 (fiscal 2009).

Principles of Consolidation

The consolidated financial statements include the accounts of The Wet Seal, Inc. and its subsidiaries, which are all wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Basis of Presentation

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).

Estimates and Assumptions

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses. Actual results could differ from those estimates.

The Company's most significant areas of estimation and assumption are:

•

determination of the appropriate amount and timing of markdowns to clear unproductive or slow- moving inventory;

•

estimation of future cash flows used to assess the recoverability of long-lived assets;

•

estimation of ultimate redemptions of awards under the Company's Arden B division customer loyalty program;

•

determination of the revenue recognition pattern for cash received under the Company's Wet Seal division frequent buyer program;

•

estimation of expected customer merchandise returns;

•

estimation of expected gift card, gift certificate, and store credit breakage;

•

determination of the appropriate assumptions to use to estimate the fair value of stock-based compensation for purposes of recording stock-based compensation;

•

estimation of the net deferred income tax asset valuation allowance; and

•

estimation, using actuarially determined methods, of self-insured claim losses under workers' compensation and employee health care plans.

Cash and Cash Equivalents

The Company considers all highly liquid debt instruments purchased with an initial maturity of three months or less to be cash equivalents. Cash equivalents are carried at cost, which approximates their fair market value. As of January 28, 2012, cash equivalents principally consist of investments in money market funds invested in U.S. Treasury securities and U.S. government agency securities. Cash accounts at banks are currently insured by the Federal Deposit Insurance Corporation on all noninterest-bearing transaction accounts through December 31, 2012, regardless of the balance of the account.

Short-term Investments

The Company's short-term investments consisted of interest-bearing corporate bonds that were guaranteed by the U.S. Government under the Temporary Liquidity Guarantee Program, had maturities that were less than one year and were carried at amortized cost plus accrued income. Short-term investments were carried at amortized cost due to the Company's intent to hold to maturity. Short-term investments on the consolidated balance sheets were $50.7 million at January 29, 2011. During fiscal 2011, the Company's short-term investments matured and the Company recovered the entire amortized cost basis of the securities.

Merchandise Inventories

Merchandise inventories are stated at the lower of cost or market. Market is determined based on the estimated net realizable value, which generally is the merchandise selling price. Cost is calculated using the retail inventory method. Under the retail inventory method, inventory is stated at its current retail selling value and then is converted to a cost basis by applying a cost-to-retail ratio based on beginning inventory and the fiscal year purchase activity. The retail inventory method inherently requires management judgments and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margins.

Markdowns are recorded when the sales value of the inventory has diminished. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise, and fashion trends. When a decision is made to permanently markdown merchandise, the resulting gross margin reduction is recognized in the period the markdown is recorded. Total markdowns, including permanent and promotional markdowns, on a cost basis, in fiscal 2011, 2010, and 2009 were $86.4 million, $84.2 million, and $78.6 million, respectively, and represented 13.9%, 14.5%, and 14.0% of net sales, respectively.

The Company accrued for planned but unexecuted markdowns, including markdowns related to slow moving merchandise, as of January 28, 2012, and January 29, 2011, of $4.3 million and $2.7 million, respectively. To the extent the Company's estimates differ from actual results, additional markdowns may be required that could reduce the Company's gross margin, operating income, and the carrying value of inventories.

Equipment and Leasehold Improvements

Equipment and leasehold improvements are stated at cost. Expenditures for betterment or improvement are capitalized, while expenditures for repairs and maintenance that do not significantly increase the life of the asset are expensed as incurred.

Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets. Furniture, fixtures, and equipment are typically depreciated over three to five years. Leasehold improvements and the cost of acquiring leasehold rights are amortized over the lesser of the term of the lease or 10 years.

Long-Lived Assets

The Company evaluates the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors that are considered important that could result in the necessity to perform an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a projection or forecast that indicates continuing losses or insufficient income associated with the realization of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend. This evaluation is performed based on estimated undiscounted future cash flows from operating activities compared with the carrying value of the related assets. If the undiscounted future cash flows are less than the carrying value, an impairment loss is recognized, measured by the difference between the carrying value and the estimated fair value of the assets, based on discounted cash flows using the Company's weighted average cost of capital. The Company has considered all relevant valuation techniques that could be obtained without undue cost and effort and has determined that the discounted cash flow approach continues to provide the most relevant and reliable means by which to determine fair value in this circumstance.

At least quarterly, the Company assesses whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable. The Company's evaluations during fiscal 2011, 2010, and 2009 indicated that operating losses or insufficient operating income existed at certain retail stores, with a projection that the operating losses or insufficient operating income for those locations would continue. As such, the Company recorded non-cash charges of $4.5 million, $4.2 million, and $2.3 million during fiscal 2011, 2010, and 2009, respectively, within asset impairment in the consolidated statements of operations, to write down the carrying values of these stores' long-lived assets to their estimated fair values.

Deferred Financing Costs

Costs incurred to obtain financing are amortized over the terms of the respective debt agreements using the interest method. In addition, deferred financing costs associated with the Company's secured convertible notes (the "Notes") were expensed immediately upon the conversion of portions of such notes into Class A common stock. Amortization of deferred financing costs, which was included within interest expense in the consolidated statements of operations, was $0.1 million, $0.2 million, and $0.1 million in fiscal 2011, 2010, and 2009, respectively.

Discount on Secured Convertible Notes

As discussed further in Note 5, upon issuance of its Notes, the Company recorded the Notes net of a discount of $45.0 million. The Company amortized this discount over the seven-year term of the Notes using the interest method. In addition, the unamortized portion of the discount on the Notes was expensed immediately upon conversions of portions of the Notes into Class A common stock. Amortization of this discount, which was included within interest expense in the consolidated statements of operations, was $2.1 million and $0.6 million in fiscal 2010 and 2009, respectively. During fiscal 2010, investors converted the remaining Notes balance, and there are no longer any Notes outstanding as of January 28, 2012.

Revenue Recognition

Sales are recognized upon purchases by customers at the Company's retail store locations. Taxes collected from the Company's customers are recorded on a net basis. For e-commerce sales, revenue is recognized at the estimated time goods are received by customers. Customers typically receive goods within four days of being shipped. Shipping and handling fees billed to customers for e-commerce sales are included in net sales. For fiscal 2011, 2010 and 2009, shipping and handling fee revenues were $3.0 million, $3.2 million and $2.9 million, respectively, within net sales on the consolidated statements of operations.

The Company has recorded accruals to estimate sales returns by customers based on historical sales return results. Its sales return policy allows customers to return merchandise within 21 days of original purchase. Wet Seal retail store merchandise may be returned for store credit only and Arden B retail store merchandise may be returned for cash refund or store credit within seven days of the original purchase date, and for store credit only thereafter. For Wet Seal and Arden B e-commerce sales, merchandise may be returned within 21 days for a full refund. Actual return rates have historically been within management's estimates and the accruals established. As the accrual for merchandise returns is based on estimates, the actual returns could differ from the accrual, which could impact net sales. The accrual for merchandise returns is recorded in accrued liabilities on the consolidated balance sheets and was $0.2 million and $0.3 million at January 28, 2012, and January 29, 2011, respectively.

The Company recognizes the sales from gift cards, gift certificates and store credits as they are redeemed for merchandise. Prior to redemption, the Company maintains an unearned revenue liability for gift cards, gift certificates and store credits until the Company is released from such liability. The Company's gift cards, gift certificates and store credits do not have expiration dates; however, over time, a percentage of gift cards, gift certificates and store credits are not redeemed or recovered ("breakage"). Based upon historical redemption trend data, the Company determined that the likelihood of redemption of unredeemed gift cards, gift certificates and store credits three years after their issuance is remote and adjusted its unearned revenue liability quarterly to record breakage as additional sales for gift cards, gift certificates and store credits that remained unredeemed three years after their issuance. Based upon an analysis completed by the Company during the second fiscal quarter of 2009, historical redemption patterns indicated that the likelihood of redemption of unredeemed gift cards, gift certificates and store credits greater than two years after their issuance is remote. As a result, beginning in the second quarter of fiscal 2009, the Company adjusted its unearned revenue liability to recognize the change in estimated timing of when breakage of gift cards, gift certificates and store credits is recognized from greater than three years after their issuance dates to greater than two years after their issuance dates. The Company's net sales in the second quarter of fiscal 2009 included a benefit of $1.2 million due to this change in estimate to reduce its unearned revenue liability for estimated unredeemed amounts. The Company's net sales for fiscal 2011, fiscal 2010 and fiscal 2009 included a benefit of $1.1 million, $1.4 million and $2.2 million, respectively, to reduce its unearned revenue liability for estimated unredeemed amounts. The unearned revenue for gift cards, gift certificates and store credits is recorded in accrued liabilities in the consolidated balance sheets and was $5.5 million and $5.1 million at January 28, 2012 and January 29, 2011, respectively. If actual redemptions ultimately differ from the assumptions underlying the Company's breakage adjustments, or the Company's future experience indicates the likelihood of redemption of gift cards, gift certificates and store credits becomes remote at a different point in time after issuance, the Company may recognize further significant adjustments to its accruals for such unearned revenue, which could have a significant effect on the Company's net sales and results of operations.

The Company maintains a frequent buyer program, the fashion insider card, through its Wet Seal division. Under the program, customers receive a 10% to 20% discount on all purchases made during a 12-month period and are provided $5-off coupons that may be used on purchases during such period. The annual membership fee of $20 is nonrefundable. Discounts received by customers on purchases using the frequent buyer program are recognized at the time of such purchases.

The Company recognizes membership fee revenue under the frequent buyer program on a straight-line basis over the 12-month membership period. From time to time, the Company tests alternative program structures, and promotions tied to the program, and may decide to further modify the program in ways that could affect customer usage patterns. As a result of this program testing and potential further modifications, the Company believes it is appropriate to maintain straight-line recognition of membership fee revenue. The Company may, in the future, determine that recognition of membership fee revenue on a different basis is appropriate, which would affect net sales. The unearned revenue for this program is recorded in accrued liabilities in the consolidated balance sheets and was $5.3 million and $3.8 million at January 28, 2012, and January 29, 2011, respectively.

The Company maintains a customer loyalty program through its Arden B division. Under the program, customers accumulate points based on purchase activity. Once a loyalty program member achieves a certain point level, the member earns awards that may be redeemed for merchandise. Unredeemed awards and accumulated partial points are accrued as unearned revenue and awards redeemed by the member for merchandise are recorded as an increase to net sales.

The Company converts into fractional awards the points accumulated by customers who have not made purchases within the preceding 18 months. Similar to all other awards currently being granted under the program, such fractional awards expire if unredeemed after 60 days. The unearned revenue for this program is recorded in accrued liabilities on the consolidated balance sheets and was $1.3 million and $1.3 million at January 28, 2012, and January 29, 2011, respectively. If actual redemptions ultimately differ from accrued redemption levels, or if the Company further modifies the terms of the program in a way that affects expected redemption value and levels, the Company could record adjustments to the unearned revenue accrual, which would affect net sales.

Cost of Sales

Cost of sales includes the cost of merchandise; markdowns; inventory shortages; inbound freight; payroll expenses associated with buying, planning and allocation; inspection cost; processing, receiving and other warehouse costs; rent and other occupancy costs; and depreciation and amortization expense associated with the Company's stores and distribution center.

Leases

The Company recognizes rent expense for operating leases on a straight-line basis (including the effect of reduced or free rent and rent escalations) over the lease term. The difference between the cash paid to the landlord and the amount recognized as rent expense on a straight-line basis is recognized as an adjustment to deferred rent in the consolidated balance sheets. Also, cash reimbursements received from landlords for leasehold improvements and other cash payments received from landlords as lease incentives are recorded as deferred rent and are amortized using the straight-line method over the lease term as an offset to rent expense.

Store Preopening Costs

Store opening and preopening costs are charged to expense as they are incurred.

Advertising Costs

Costs for advertising related to visual merchandising, consisting of in-store signage, promotions, and e-commerce marketing, are expensed as incurred. Total advertising expenses were $4.6 million, $3.6 million, and $2.4 million in fiscal 2011, 2010, and 2009, respectively.

Vendor Discounts

The Company receives certain discounts from its vendors in accordance with agreed-upon payment terms. These discounts are reflected as a reduction of merchandise inventories in the period they are received and charged to cost of sales when the items are sold.

Income Taxes

The Company accounts for income taxes by recognizing deferred tax assets, which include, among other things, net operating loss carryforwards and tax credits, and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities, using enacted tax rates in effect in the years the differences are expected to reverse. Deferred income tax expense or benefit results from the change in net deferred tax assets or deferred tax liabilities.

The Company records net deferred tax assets to the extent it believes these assets will more likely than not be realized. In making such determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations. In the event the Company had a change in expectations regarding its ability to realize its deferred income tax assets in the future, it would make an adjustment to the valuation allowance, which would affect the provision for income taxes.

Comprehensive Income (Loss)

Employers are required to recognize the over or under funded status of defined benefit plans and other postretirement plans in the statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. Other comprehensive income in the consolidated balance sheets is the difference between the carrying value of the accrued liability under the Company's supplemental employee retirement plan and the carrying value (see Note 11).

Insurance/Self-Insurance

The Company uses a combination of insurance and self-insurance for its workers' compensation and employee health care programs. A portion of the employee health care plan is funded by employees. Under the workers' compensation insurance program, the Company is liable for a deductible of $0.25 million for each individual claim and an aggregate annual liability of $1.4 million. Under the employee group health plan, the Company is liable for a deductible of $0.175 million for each individual claim and an aggregate monthly liability of $0.5 million. The monthly aggregate liability is subject to adjustment based on the number of participants in the plan each month. For both of the insurance plans, the Company records a liability for the costs associated with reported claims and a projected estimate for unreported claims considering historical experience and industry standards. The Company adjusts these liabilities based on historical claims experience, demographic factors, severity factors, and other actuarial assumptions. A significant change in the number or dollar amount of claims could cause the Company to revise its estimates of potential losses, which would affect its reported results. The following summarizes the activity within the Company's accrued liability for the self-insured portion of unpaid claims and estimated unreported claims:


	January 28, 2012			January 29, 2011			January 30, 2010
	(in thousands)
Balance at beginning of year	$	1,468		$	1,826		$	2,111
Accruals		6,841			4,965			4,303
Payment of claims		(6,383	)		(5,323	)		(4,588	)

Balance at end of year	$	1,926		$	1,468		$	1,826

Stock-Based Compensation

The Company accounts for share-based compensation arrangements in accordance with applicable accounting standards, which require the measurement and recognition of compensation expense for all share-based payment awards to employees and directors based on estimated fair values. Refer to Note 2 for further information.

Derivative Financial Instruments

As of January 30, 2010, the Company's only derivative financial instrument was an embedded derivative associated with the Company's Notes (see Note 5). The Company accounted for its only derivative financial instrument at fair value on its consolidated balance sheets. The gain or loss as a result of the change in fair value of the embedded derivative was recognized in interest expense in the consolidated statements of operations and was not significant for any period presented. During fiscal 2010, the balance of the Notes was converted. As a result, no embedded derivative remained in the Company's consolidated balance sheets as of January 28, 2012 and January 29, 2011.

Recently Adopted Accounting Pronouncements and New Accounting Pronouncements Not Yet Adopted

In January 2010, the Financial Accounting Standards Board (the "FASB") issued guidance and clarifications for improving disclosures about fair value measurements. This guidance requires enhanced disclosures regarding transfers in and out of the levels within the fair value hierarchy. Separate disclosures are required for transfers in and out of Level 1 and 2 fair value measurements, and the reasons for the transfers must be disclosed. In the reconciliation for Level 3 fair value measurements, separate disclosures are required for purchases, sales, issuances, and settlements on a gross basis. The new disclosures and clarifications of existing disclosures were effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements, which were effective for interim and annual reporting periods beginning after December 15, 2010. Effective January 31, 2010, the Company adopted the new and updated guidance for disclosures, aside from that deferred to periods after December 15, 2010, and this did not significantly impact its consolidated financial statements. The Company adopted the remaining guidance on disclosures effective January 30, 2011, and this did not significantly impact its consolidated financial statements.

In May 2011, the FASB issued guidance on the application of fair value accounting where its use is already required or permitted by other standards within GAAP. The amendments change the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. Amendments include those that clarify the FASB's intent regarding the application of existing fair value measurement and disclosure requirements, and change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. For many of the requirements, the FASB does not intend for the amendments to result in a change in the application of the requirements. This guidance is effective during interim and annual periods beginning after December 15, 2011. The Company does not believe the adoption of this guidance will have any effect on its consolidated financial statements.

In June 2011, the FASB issued amended guidance on the presentation of comprehensive income. The amendments provide an entity with an option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011, and should be applied on a retrospective basis. The Company has not yet selected which presentation option it will apply. The adoption of this guidance will affect the presentation of its consolidated financial statements.