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Cash at beginning of year 1,345 3,728 12,153
Cash at end of year $ 3,728 $12,153 $40,550

Supplemental Cash Flow Information
Interest paid $ 8,420 $ 6,410 $ 6,594
Taxes paid $ 942 $ 2,444 $ 5,884
..................................................................................................................................................
See notes to financial statements.
942 Case: Donna Karan International Inc.




212 Part 4 Additional Cases




Donna Karan International, Inc.”Notes to Financial Statements,
Dec. 29, 1996

1. Basis of Presentation and Significant Accounting Policies

Business
Donna Karan International Inc. (“DKI”) and subsidiaries (together with DKI, the “Com-
Donna Karan International




pany”), which operate in one business segment, design, contract for the manufacture of,
market, and distribute fashion apparel, accessories, and beauty products. Its sales are
principally to department and specialty stores located throughout the United States. A sig-
ni¬cant amount of the Company's products are produced in Asia, through arrangements
with independent contractors. As a result, the Company's operations could be adversely
affected by political instability resulting in the disruption of trade from the countries in
which these contractors are located, or by the imposition of additional duties or regula-
tions relating to imports.
The Company's business is impacted by the general seasonal trends that are character-
istic of the apparel industry, and it generally experiences lower net revenues and net
income in the ¬rst half of each ¬scal year as compared to the second half of the ¬scal
year.
Several of the Company's customers have engaged in leveraged buyouts or transac-
tions in which they incurred signi¬cant amounts of debt, and certain customers have
operated or are currently operating under the protection of the Federal bankruptcy laws.
The Company does not factor its accounts receivable and maintains credit insurance to
minimize the risk of bad debts.
The Company had one customer which accounted for approximately 12.4%, 12.3%,
and 12.8% of sales for the years ended January 1, 1995, December 31, 1995 and
December 29, 1996 respectively. During the year ended December 31, 1995, another
customer accounted for 11.1% of sales.

Initial Public Offering
Effective July 3, 1996, the Company sold 10,750,000 shares of its common stock in an
initial public offering (“the Offering”). Net proceeds of the Offering, after deducting
underwriting discounts and commissions, and professional fees aggregated $236.0 mil-
lion. Proceeds of the Offering were used to retire distribution notes and accrued interest
thereon totaling approximately $116.4 million, to repay the Predecessor Company's (as
de¬ned below) term loans and the revolving line of credit which totaled approximately
$76.8 million, to pay a certain one-time bonus under an employment agreement which
amounted to $5.0 million (which is included in selling, general and administrative
expenses) and to pay a one-time fee under a license agreement which amounted to $4.6
million (which is included in cost of sales). The remaining $33.2 million was used for
other general corporate purposes. The distribution notes were issued in April 1996 to the
principals, and certain of their af¬liates, of the Predecessor Company, and represented
an estimate of the cumulative undistributed taxable income (on which taxes previously
943
Case: Donna Karan International Inc.




213
Part 4 Additional Cases




had been paid) of the Predecessor Company since its inception through the anticipated
closing date of the Offering.

Basis of Presentation
DKI was incorporated in Delaware in April 1996. In connection with the Offering, the
former principals of the Predecessor Company and certain of their af¬liates simulta-
neously contributed to DKI all of the outstanding stock and partnership interests in the
Predecessor Company, in exchange for common stock of DKI (the “Reorganization”).




Donna Karan International
The ¬nancial statements of the Predecessor Company are being presented on a com-
bined basis because of their common ownership. The combined ¬nancial statements
have been prepared as if the entities had operated as a single consolidated group since
their respective dates of organization. Because DKI conducted no business prior to the
Reorganization, it was not included in the results of operations of the Predecessor Com-
pany.
Amounts included for common stock on the accompanying balance sheet of the Prede-
cessor Company represent the combined par or stated value of the outstanding shares of
the various corporations included in the Predecessor Company.

Statement of Income Presentation
The statement of income of the Company for the year ended December 29, 1996
re¬‚ects the results of operations of the Predecessor Company for the period January 1,
1996 through July 2, 1996 and the results of operations of the Company from July 3,
1996 (the date of the consummation of the Offering) through December 29, 1996.
Selected statement of income data for the year ended December 29, 1996 are as fol-
lows (the date of the Offering has been deemed to be July 1, 1996):
Year Ended
January 1 to July 1 to December 29, 1996
(in thousands) June 30, 1996 December 29, 1996 Consolidated

Net revenues . . . . . . . . . . . . . . . . . . . $277,226 $335,614 $612,840
Gross pro¬t . . . . . . . . . . . . . . . . . . . . 90,006 110,770 200,776
Operating income. . . . . . . . . . . . . . . . 12,563 739 13,302
Other income (expense) . . . . . . . . . . . (4,569) (876) (5,445)
Income (loss) before income taxes . . . . 7,994 (137) 7,857
Provision (bene¬t) for income taxes . . . 445 (17,624) (17,179)
Net income $ 7,549 $ 17,487 $ 25,036


Pro Forma Adjustments (Unaudited)
The pro forma ¬nancial information on the income statement presents the effects on
the historical ¬nancial statements of certain transactions as if they had occurred in 1995.
These adjustments are: (i) increased royalty expense to be paid to a corporation owned
by two of the Company™s principal stockholders and their af¬liated trusts pursuant to a
licensing agreement of $12.8 million and $7.2 million in 1995 and 1996, respectively;
(ii) reduced levels of compensation for two of the Company™s executives pursuant to their
employment agreements of $2.3 million and $1.5 million in 1995 and 1995, respec-
tively; (iii) reduction in interest costs assuming the application of the proceeds from the
944 Case: Donna Karan International Inc.




214 Part 4 Additional Cases




Offering to reduce the actual outstanding indebtedness under the Company™s credit
agreement of $6.2 million and $3.5 million in 1995 and 1996, respectively; (iv) reduc-
tion in amortization of deferred ¬nancing costs which would have been written off in con-
nection with repayment of outstanding indebtedness under the Company™s credit
agreement of $0.6 million and $0.8 million in 1995 and 1996, respectively; (v) increase
in income taxes of $11.3 million and $20.7 million in 1995 an 1996, respectively, as if
the Company had been subject to Federal and additional state income taxes for the entire
period (see Note 15); and (vi) adjustments of $20.3 million in 1995 to re¬‚ect the sale of
Donna Karan International




the 70% interest in the operations of Donna Karan Japan as if it had occurred on January
2, 1995. The gain on the sale has been excluded, and as a result of this sale, the Com-
pany™s statement of income has been adjusted to re¬‚ect the Company™s accounting for
their interest in Donna Karan Japan using the equity method of accounting for the period
from January 2, 1995 until March 31, 1995, the date of the sale (see Note 8).

Fiscal Year
The Company's ¬scal year consists of the 52- or 53-week period ending on the Sunday
nearest December 31.

Inventories
Inventories are stated at the lower of cost (¬rst-in, ¬rst-out method) of market.

Depreciation and Amortization
Depreciation of machinery, equipment and ¬xtures, including amounts accounted for
under capital leases, is computed using straight-line and accelerated methods based on
their estimated useful lives which range from ¬ve to seven years. Leasehold improvements
are amortized using the straight-line method based on the lease term, and in certain
instances include the anticipated renewal period. The Company's share of the cost of con-
structing in-store shop displays is capitalized and amortized using the straight-line
method over their estimated useful lives of four years. The Company's share of the cost of
constructing full-price, free-standing retail stores under license agreements is capitalized
and amortized using the straight-line method over their estimated useful lives of eight
years. At December 31, 1995 and December 29, 1996, the unamortized balance of
these costs of $2,034,000 and $10,848,000, respectively, is included in “Deposits and
other noncurrent assets” in the accompanying balance sheets. Amortization expense of
these costs for the years ended December 31, 1995 and December 29, 1996 amounted
to approximately $0.4 million and $1.4 million, respectively. Major additions and better-
ments are capitalized and repairs and maintenance are charged to operations in the
period incurred.

Advertising
The Company expenses the production costs of advertising upon the ¬rst showing of
the related advertisement which is generally less than six months after the production
costs are incurred. At December 31, 1995 and December 29, 1996, advertising costs
totaling $1,334,000 and $1,288,000, respectively, were included in “Prepaid expenses
and other current assets” in the accompanying balance sheets. Advertising, marketing,
and public relations expenses, including costs related to the Company's Creative Services
945
Case: Donna Karan International Inc.




215
Part 4 Additional Cases




Department, for the years ended January 1, 1995, December 31, 1995 and December
29, 1996 were $35,409,000, $33,831,000 and $53,191,000, respectively.

Revenue Recognition
Sales are recognized upon shipment of products or, in the case of sales by Company-
owned outlet stores, when payment is received. The Company provides for estimated
returns at the time of sales. Income from licensing agreements is recognized when earned
and is included in net revenues.




Donna Karan International
Statements of Cash Flows
For purposes of the statements of cash ¬‚ows, the Company considers all highly liquid
investment with a maturity of three months or less when purchased to be cash equiva-
lents.

Use of Estimates
The preparation of ¬nancial statements in conformity with generally accepted account-
ing principles requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets and liabili-
ties at the date of the ¬nancial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those estimates.

2. Inventories

Inventories consist of the following (in thousands):
December 31, December 29,
1995 1996

Raw materials . . . . . . . . . . . $ 16,369 $ 16,780
Work in process . . . . . . . . . 11,697 11,030
Finished goods . . . . . . . . . . 57,589 72,870
$ 85,655 $100,680



4. Borrowings

Long-term debt consists of the following (in thousands):
December 31, December 29,
1995 1996

Revolving credit facility $ 7,961 $ ”
Term Loan A 15,000 ”
Term Loan B 20,000 ”
Term Loan C 10,000 ”
Capital lease obligation 577 318
$53,538 $ 318
Less current portion (7,759) (282)
$45,779 $ 36
946 Case: Donna Karan International Inc.




216 Part 4 Additional Cases




At December 31, 1995, the Company had a credit facility, as amended, which con-
sisted of a $60,000,000 term loan (term loans A, B and C) and a revolving line of credit
available for the issuance of letters of credit, acceptances, or direct borrowings up to
$105,000,000. Direct borrowings under the revolving line of credit bore interest at 1.5%
over the lead bank™s prime rate and were limited to a borrowing base calculated on eligi-

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