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<div style="font-size:10.0pt;font-family:Times New Roman;"> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b>1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES</b></font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Basis of Presentation.</i></b></font><font size="2"> References to the "Company," "we," "us," and "our" in this Form 10-K are references to Zale Corporation and its subsidiaries. We are, through our wholly owned subsidiaries, a leading specialty retailer of fine jewelry in North America. At July 31, 2013, we operated 1,064 specialty retail jewelry stores and 630 kiosks located mainly in shopping malls throughout the United States, Canada and Puerto Rico.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> We report our operations under three segments: Fine Jewelry, Kiosk Jewelry and All Other. Fine Jewelry is comprised of our three core national brands, Zales Jewelers®, Zales Outlet® and Peoples Jewellers® and our two regional brands, Gordon's Jewelers® and Mappins Jewellers®. Each brand specializes in fine jewelry and watches, with merchandise and marketing emphasis focused on diamond products. Zales Jewelers® is our national brand in the U.S. providing moderately priced jewelry to a broad range of guests. Zales Outlet® operates in outlet malls and neighborhood power centers and capitalizes on Zale Jewelers'® national marketing and brand recognition. Gordon's Jewelers® is a value-oriented regional jeweler. Peoples Jewellers®, Canada's largest fine jewelry retailer, provides guests with an affordable assortment and an accessible shopping experience. Mappins Jewellers® offers Canadian guests a broad selection of merchandise from engagement rings to fashionable and contemporary fine jewelry.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> Kiosk Jewelry operates under the brand names Piercing Pagoda®, Plumb Gold™, and Silver and Gold Connection® through mall-based kiosks and is focused on the opening price point guest. Kiosk Jewelry specializes in gold, silver and non-precious metal products that capitalize on the latest fashion trends.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> All Other includes our insurance and reinsurance operations, which offer insurance coverage primarily to our private label credit card guests.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> We also maintain a presence in the retail market through our ecommerce sites,</font> <font size="2"><i>www.zales.com, www.zalesoutlet.com, www.gordonsjewelers.com, www.peoplesjewellers.com</i></font> <font size="2">and</font> <font size="2"><i>www.pagoda.com</i></font><font size="2">.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> We consolidate all of our U.S. operations into Zale Delaware, Inc. ("ZDel"), a wholly owned subsidiary of Zale Corporation. ZDel is the parent company for several subsidiaries, including three that are engaged primarily in providing credit insurance to our credit customers. We consolidate our Canadian retail operations into Zale Canada Holding, L.P., which is a wholly owned subsidiary of Zale Corporation. All significant intercompany transactions have been eliminated.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Cash and Cash Equivalents.</i></b></font><font size="2"> Cash and cash equivalents include cash on hand, deposits in banks and short-term marketable securities at varying interest rates with original maturities of three months or less. Also included in cash equivalents are proceeds due from credit card transactions with settlement terms of less than five days. Under our credit card processing agreements, a portion of these proceeds are held back to serve as collateral for disputed charges. The credit card proceeds held back as of July 31, 2013 and 2012 were not material. The carrying amount of our cash equivalents approximates fair value due to the short-term maturity of those instruments.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Merchandise Inventories.</i></b></font><font size="2"> Merchandise inventories are stated at the lower of cost or market. Substantially all U.S. inventories represent finished goods which are valued using the last-in, first-out ("LIFO") retail inventory method. Merchandise inventory of our Canadian brands, Peoples Jewellers and Mappins Jewellers, is valued using the retail inventory method. Under the retail method, inventory is segregated into categories of merchandise with similar characteristics at its current average retail selling value. The determination of inventory cost and the resulting gross margins are calculated by applying an average cost-to-retail ratio to the retail value of inventory. At the end of fiscal year 2013, approximately 16 percent of our total inventory represented raw materials and finished goods in our distribution centers. The inventory related to our manufacturing program and distribution center is valued at the weighted-average cost of those items. The LIFO charge was $4.6 million, $22.4 million and $17.0 million for the years ended July 31, 2013, 2012 and 2011, respectively. The cumulative LIFO provision reflected in the accompanying consolidated balance sheets was $63.0 million and $58.3 million at July 31, 2013 and 2012, respectively. Domestic inventories, excluding the cumulative LIFO provision, were $690.5 million and $664.1 million at July 31, 2013 and 2012, respectively. Our Canadian inventory totaled $140.0 million and $136.0 million at July 31, 2013 and 2012, respectively.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> Consignment inventory and the related contingent obligations are not reflected in our consolidated financial statements. Consignment inventory has historically consisted of test programs, merchandise at higher price points, or merchandise that otherwise does not warrant the risk of outright ownership. Consignment inventory can be returned to the vendor at any time. At the time consigned inventory is sold, we record the purchase liability in accounts payable and the related cost of merchandise in cost of sales. We had $149.1 million and $118.4 million of consignment inventory on hand at July 31, 2013 and 2012, respectively.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> We are required to determine the LIFO cost on an interim basis by estimating annual inflation trends, annual purchases and ending inventory levels for the fiscal year. Actual annual inflation rates and inventory balances as of the end of any fiscal year may differ from interim estimates. We apply internally developed indices that we believe accurately and consistently measure inflation or deflation in the components of our merchandise (i.e., the proper weighting of diamonds, gold and other metals and precious stones) and our overall merchandise mix. We believe our internally developed indices more accurately reflect inflation or deflation in our own prices than the U.S. Bureau of Labor Statistics producer price indices or other published indices.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> We also write-down the carrying value of our inventory for discontinued, slow-moving and damaged inventory. This write-down is equal to the difference between the cost of inventory and its estimated market value based upon assumptions of targeted inventory turn rates, future demand, management strategy and market conditions. If actual market conditions are less favorable than those projected by management or management strategy changes, additional inventory write-downs may be required and, in the case of a major change in strategy or downturn in market conditions, such write-downs could be significant.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> Shrinkage is estimated for the period from the last inventory date to the end of the fiscal year on a store-by-store basis. Such estimates are based on experience and the shrinkage results from the last physical inventory. Physical inventories are taken at least once annually for all store locations and the distribution centers. The shrinkage rate from the most recent physical inventory, in combination with historical experience, could impact our shrinkage reserve.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Impairment of Long-Lived Assets.</i></b></font><font size="2"> Long-lived assets are reviewed for impairment by comparing the carrying value of the assets with their estimated undiscounted future cash flows. If the evaluation indicates that the carrying amount of the asset may not be recoverable, the potential impairment is measured based on a projected discounted cash flow method, using a discount rate that is commensurate with the risk inherent in our current business model. Assumptions are made with respect to cash flows expected to be generated by the related assets based upon the most recent projections. Any changes in key assumptions, particularly store performance or market conditions, could result in an unanticipated impairment charge. For instance, in the event of a major market downturn or adverse developments within a particular market or portion of our business, individual stores may become unprofitable, which could result in a write-down of the carrying value of the assets in those stores.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Goodwill.</i></b></font><font size="2"> In accordance with Accounting Standards Codification ("ASC") 350,</font> <font size="2"><i>Intangibles–Goodwill and Other</i></font><font size="2">, we test goodwill for impairment annually, at the end of our second quarter, or more frequently if events occur which indicate a potential reduction in the fair value of a reporting unit's net assets below its carrying value. We calculate estimated fair value using the present value of future cash flows expected to be generated using a weighted-average cost of capital, terminal values and updated financial projections. If our actual results are not consistent with estimates and assumptions used to calculate fair value, we may be required to recognize a goodwill impairment. See Note 5 for additional disclosures related to goodwill.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Revenue Recognition.</i></b></font><font size="2"> We recognize revenue in accordance with ASC 605,</font> <font size="2"><i>Revenue Recognition</i></font><font size="2">. Revenue related to merchandise sales, which is approximately 90 percent of total revenues, is recognized at the time of sale, reduced by a provision for sales returns. The provision for sales returns is based on historical rates of return. Repair revenues are recognized when the service is complete and the merchandise is delivered to the guests.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> Premium revenues from our insurance businesses relate to credit insurance policies sold to guests who purchase our merchandise under the customer credit programs. Insurance premium revenues from credit insurance subsidiaries were $10.9 million, $10.5 million and $10.0 million for the fiscal years ended July 31, 2013, 2012 and 2011, respectively. These insurance premiums are recognized over the coverage period and included in revenues in the accompanying consolidated statements of operations.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> We offer our Fine Jewelry guests lifetime warranties on certain products that cover sizing and breakage with an option to purchase theft protection for a two-year period. ASC 605-20,</font> <font size="2"><i>Revenue Recognition–Services</i></font> <font size="2">("ASC 605-20"), requires recognition of warranty revenue on a straight-line basis until sufficient cost history exists. Once sufficient cost history is obtained, revenue is required to be recognized in proportion to when costs are expected to be incurred. Prior to fiscal year 2012, the Company recognized revenue from lifetime warranties on a straight-line basis over a five-year period because sufficient evidence of the pattern of costs incurred was not available. During the first quarter of fiscal year 2012, we began recognizing revenue related to lifetime warranty sales in proportion to when the expected costs will be incurred, which we estimate will be over an eight-year period. A significant change in estimates related to the time period or pattern in which warranty-related costs are expected to be incurred could adversely impact our revenues. The deferred revenue balance as of July 31, 2011 related to lifetime warranties is being recognized prospectively, in proportion to the remaining estimated warranty costs. The change in estimate related to the pattern of revenue recognition and the life of the warranties was the result of accumulating additional historical evidence over the five-year period that we have been selling the lifetime warranties.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> Revenues related to the optional theft protection are recognized over the two-year contract period on a straight-line basis. We also offer our Fine Jewelry guests a two-year watch warranty and our Fine Jewelry and Kiosk Jewelry guests a one-year warranty that covers breakage. The revenue from the two-year watch warranty and one-year breakage warranty is recognized on a straight-line basis over the respective contract terms.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Gross Margin.</i></b></font><font size="2"> Gross margin represents net sales less cost of sales. Cost of sales includes cost related to merchandise sold, receiving and distribution, guest repairs and repairs associated with warranties.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Selling, General and Administrative.</i></b></font><font size="2"> Included in selling, general and administrative ("SG&A") are store operating, advertising, merchandising, costs of insurance operations and general corporate overhead expenses.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> On July 9, 2013, we entered into a Private Label Credit Card Program Agreement (the "ADS Agreement") with an affiliate of Alliance Data Systems Corporation ("ADS") to provide financing to our U.S. guests to purchase merchandise through private label credit cards beginning no later than October 1, 2015. The ADS Agreement will replace our current agreement with Citibank which expires on October 1, 2015. In July 2013, we received a $38.0 million commencement payment upon signing the ADS Agreement. The commencement payment will be amortized over the initial term of the ADS Agreement as a reduction of merchant fees beginning on the commencement date of the agreement.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Operating Leases.</i></b></font><font size="2"> Rent expense is recognized on a straight-line basis, including consideration of rent holidays, tenant improvement allowances received from the landlords and applicable rent escalations over the term of the lease. The commencement date of the rent expense is the earlier of the date when we become legally obligated for the rent payments or the date when we take possession of the building for construction purposes.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Capital Leases.</i></b></font><font size="2"> We enter into capital leases related to vehicles for our field management. The vehicles are included in property and equipment in the accompanying consolidated balance sheets and are depreciated over a four-year life.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Depreciation and Amortization.</i></b></font><font size="2"> Leasehold improvements are stated at cost and are amortized using the straight-line method over the estimated useful lives of the assets or remaining lease life, whichever is shorter, which generally range from 5 to 10 years. Fixtures and equipment are amortized using the straight-line method over the estimated useful lives of the assets, which range from 3 to 15 years. Original cost and related accumulated depreciation or amortization is removed from the accounts in the year assets are retired. Gains or losses on dispositions of property and equipment are recorded in the year of disposal and are included in SG&A in the accompanying consolidated statements of operations. Repairs and maintenance costs are expensed as incurred.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Stock-Based Compensation.</i></b></font><font size="2"> Stock-based compensation is accounted for under ASC 718,</font> <font size="2"><i>Compensation–Stock Compensation</i></font><font size="2">, which requires the use of the fair value method of accounting for all stock-based compensation, including stock options. Share-based awards are recognized as compensation expense over the requisite service period.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Stock Repurchase Program.</i></b></font><font size="2"> During fiscal year 2008, the Board of Directors authorized share repurchases of $350 million. As of July 31, 2013, $23.3 million was remaining under our stock repurchase program.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Preferred Stock.</i></b></font><font size="2"> At July 31, 2013 and 2012, 5.0 million shares of preferred stock, par value of $0.01, were authorized. None were issued or outstanding.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Self-Insurance.</i></b></font><font size="2"> We are self-insured for certain losses related to property insurance, general liability, workers' compensation and medical claims. Our liability represents an estimate of the ultimate cost of claims incurred as of the balance sheet dates. The estimated liability is not discounted and is established based upon analysis of historical data and actuarial estimates. While we believe these estimates are reasonable based on the information currently available, if actual trends, including the severity or frequency of claims, medical cost inflation, or fluctuations in premiums differ from our estimates, our results of operations could be impacted.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Advertising Expenses.</i></b></font><font size="2"> Advertising is generally expensed when the advertisement is utilized and is a component of SG&A. Production costs are expensed upon the first occurrence of the advertisement. Advertising expenses were $83.6 million, $94.5 million and $76.5 million for the fiscal years ended July 31, 2013, 2012 and 2011, respectively, net of amounts contributed by vendors. Prepaid advertising at July 31, 2013 and 2012 totaled $4.9 million and $0.7 million, respectively, and is included in other current assets in the accompanying consolidated balance sheets.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Vendor Allowances.</i></b></font><font size="2"> We receive cash or allowances from merchandise vendors primarily in connection with cooperative advertising programs and reimbursements for markdowns taken to sell the vendor's products. We have agreements in place with each vendor setting forth the specific conditions for each allowance or payment. The majority of these agreements are entered into or renewed annually at the beginning of each fiscal year. Qualifying vendor reimbursements of costs incurred to specifically advertise vendors' products are recorded as a reduction of advertising expense. All other allowances or cash payments received are recorded as a reduction to the cost of merchandise. Vendor allowances included in advertising expense totaled $1.9 million, $3.1 million and $1.0 million for the fiscal years ended July 31, 2013, 2012 and 2011, respectively. Vendor allowances included in cost of sales totaled $10.1 million, $5.2 million and $3.7 million for the years ended July 31, 2013, 2012 and 2011, respectively.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Income Taxes.</i></b></font><font size="2"> Income taxes are accounted for under the asset and liability method prescribed by ASC 740,</font> <font size="2"><i>Income Taxes</i></font><font size="2">. 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. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the tax rate changes are enacted. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets unless it is more likely than not such assets will be realized.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> We file income tax returns in the U.S. federal jurisdiction, in various states and in certain foreign jurisdictions. We are subject to U.S. federal examinations by tax authorities for fiscal years ending on or after July 31, 2009. We are subject to audit by taxing authorities of most states and certain foreign jurisdictions and are subject to examination by these taxing jurisdictions for fiscal years ending on or after July 31, 2008.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Sales Tax.</i></b></font><font size="2"> We present revenues net of taxes collected and record the taxes as a liability in the consolidated balance sheets until the taxes are remitted to the appropriate taxing authority.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Foreign Currency.</i></b></font><font size="2"> Translation adjustments result from translating foreign subsidiaries' financial statements into U.S. dollars. Balance sheet accounts are translated at exchange rates in effect at the balance sheet date. Income statement accounts are translated at average exchange rates during the period. Resulting translation adjustments are included in the accompanying consolidated statements of comprehensive income (loss).</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"> During the fiscal year ended July 31, 2013 and 2011, the average Canadian currency rate appreciated by less than one percent and approximately six percent, respectively, relative to the U.S. dollar. During the fiscal year ended July 31, 2012, the average Canadian currency rate depreciated by approximately one percent relative to the U.S. dollar. The changes in the Canadian currency rates did not have a material impact on the Company's net earnings (loss) during the fiscal years ended July 31, 2013, 2012 and 2011. As a result of fluctuations in the Canadian dollar, we recorded losses totaling $0.7 million and $1.7 million and a gain totaling $1.4 million during the fiscal years ended July 31, 2013, 2012 and 2011, respectively, primarily associated with the settlement of Canadian accounts payable.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Discontinued Operations.</i></b></font><font size="2"> In connection with the sale of the Bailey, Banks & Biddle brand in November 2007 and subsequent bankruptcy filed by the buyer, Finlay Fine Jewelry Corporation, on August 5, 2009, we remain contingently liable for certain leases for the remainder of the respective lease terms. As of July 31, 2013, the lease reserve related to the one remaining lease totaled $0.6 million.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Concentrations of Business and Credit Risk.</i></b></font><font size="2"> During both fiscal years 2013 and 2012, we purchased approximately 22 percent of our finished merchandise from five vendors (excluding finished merchandise produced by our internal manufacturing organization) with no single vendor exceeding ten percent. In fiscal years 2013 and 2012, approximately 13 percent and 16 percent, respectively, of our merchandise requirements were assembled by our internal manufacturing organization. If purchases from these top vendors were disrupted, particularly at certain critical times during the year, our sales could be adversely affected in the short term until alternative supply arrangements could be established. As of July 31, 2013 and 2012, we had no significant concentrations of credit risk.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Use of Estimates.</i></b></font><font size="2"> Our accounting and financial reporting policies are in conformity with U.S. generally accepted accounting principles. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. For example, unexpected changes in market conditions or a downturn in the economy could adversely affect actual results. Estimates are used in accounting for, among other things, inventory valuation, goodwill and long-lived asset valuation, LIFO inventory retail method, legal liability, credit insurance liability, product warranty, depreciation, workers' compensation, taxes and contingencies. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary.</font></p> <p style="TEXT-ALIGN: justify; FONT-FAMILY: times;"><font size="2"><b><i> Reclassification.</i></b></font><font size="2"> Certain prior year amounts have been reclassified in the accompanying consolidated balance sheets to conform to our fiscal year 2013 presentation.</font></p> </div>
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