10. Income Taxes

Income taxes are accounted for under the asset and liability method.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards.  In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of its deferred tax assets will not be realized.  Losses incurred during the second quarter of 2011 caused the Company to conclude that its ability to utilize certain tax credits in one state was no longer more likely than not, necessitating a charge to income tax expense and a reduction in deferred tax assets of $0.7 million in connection with the establishment of a valuation allowance.

Companies are required to apply their estimated full-year tax rate on a year-to-date basis in each interim period.  However, if the estimated full-year tax rate is not reliably predictable, it should not be applied to interim financial results.  In the Company’s case, a small change in the current year’s pretax earnings/losses would result in a material change in the estimated annual effective rate, producing significant variations in the customary relationship between income tax expense and pretax accounting income in interim periods.  Accordingly, the Company recorded tax expense for the interim periods of 2011 based on the actual year-to-date results.  The effective income tax rate for the thirty-nine weeks ended October 29, 2011 includes the benefit of various tax credits, partially offset by the aforementioned valuation allowance for state tax credits.  Deferred tax assets as of October 29, 2011 still include the portion of state tax credits that are expected to be utilized in the future.  However, if operating results deteriorate in the future, these tax credits may also require a valuation allowance, which would result in a charge to income tax expense and a reduction in deferred tax assets of $0.5 million.