The Company recognizes rent expense on a straight-line basis over the lease term as defined in SFAS No. 13.13,“Accounting for Leases”. Our lease agreements generally provide for scheduled rent increases during the lease term or rent holidays, including rental payments commencing at a date other than the date of initial occupancy. We include any rent escalation and rent holidays in our straight-line rent expense. In addition, we record landlord allowances for normal tenant improvements as deferred rent, which is included in other noncurrent liabilities in the consolidated balance sheets. This deferred rent is amortized over the lease term as a reduction of rent expense. Also, leasehold improvements are amortized using the straight-line method over the shorter of their estimated useful lives or the related lease term. See Note 1 to the Consolidated Financial Statements for further information on the Company’s accounting for its leases.

The Company primarily invests in property and equipment in connection with the opening and remodeling of stores and in computer software and hardware. The Company periodically reviews its store locations and estimates the recoverability of its assets, recording an impairment charge, if necessary, when the Company decides to close the store or otherwise determines that future undiscounted cash flows associated with those assets will not be sufficient to recover the carrying value. This determination is based on a number of factors, including the store’s historical operating results and cash flows, estimated future sales growth, real estate development in the area and perceived local market conditions that can be difficult to predict and may be subject to change. In addition, the Company regularly evaluates its computer-related and other long-lived assets and may accelerate depreciation over the revised useful life if the asset is expected to be replaced or has limited future value. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts, and any resulting gain or loss is reflected in income for that period.

The Company is primarily self-insured for health care, workers’ compensation and general liability costs. These costs are significant primarily due to the large number of the Company’s retail locations and employees. The Company’s self-insurance liabilities are based on the total estimated costs of claims filed and estimates of claims incurred but not reported, less amounts paid against such claims, and are not discounted. Management reviews current and historical claims data in developing its estimates. The Company also uses information provided by outside actuaries with respect to workers’ compensation and general liability claims. If the underlying facts and circumstances of the claims change or the historical experience upon which insurance provisions are recorded is not indicative of future trends, then the Company may be required to make adjustments to the provision for insurance

The Company records liabilities for uncertain tax positions principally related to state income taxes. These liabilities reflect the Company’s best estimate of theits ultimate income tax liabilitiesliability based on factsthe tax code, regulations, and circumstances. Changespronouncements of the jurisdictions in factsand/orwhich we do business. Estimating our ultimate tax liability involves significant judgments regarding the application of complex tax regulations across many jurisdictions. Despite our belief that our estimates and judgments are reasonable, differences between our estimated and actual tax liabilities could exist. These differences may arise from settlements with individual states related to previously filedof tax returnsaudits, expiration of the statute of limitations, or the evolution and application of the various jurisdictional tax codes and regulations. Any differences will be recorded in the period in which they become known and could resulthave a material effect on the results of operations in material adjustments to the estimated liabilitiesperiod the adjustment is recorded.

While the Company’s recognition of revenue is predominantly derived from routine retail transactions and does not involve significant judgement, revenue recognition represents an important accounting policy of the Company. As discussed in Note 1 to the Consolidated Financial Statements, the Company recognizes sales at the point of purchase when the customer takes possession of the merchandise and pays for the purchase, generally with cash or credit. Sales from purchases made with Cato credit, gift cards and layaway sales are also recorded when the customer takes possession of the merchandise. Gift cards, layaway deposits and merchandise credits granted to customers are recorded as deferred revenue until they are redeemed or forfeited. A provision is made for estimated product returns based on sales volumes and the Company’s experience; actual returns have not varied materially from amounts provided historically.

Credit revenue on the Company’s private label credit card portfolio is recognized as earned under the interest method. Late fees are recognized as earned, less provisions for estimated uncollectible fees.

The Company has consistently maintained a strong liquidity position. Cash provided by operating activities during fiscal 20052006 was $70.9$58.7 million as compared to $79.9$70.9 million in fiscal 2004.2005. These amounts have enabled the Company to fund its regular operating needs, capital expenditure program, cash dividend payments and any repurchase of the Company’s Common Stock and to prepay the term loan used to finance the 2003 repurchase of the Company’s Class B Common Stock from the Company’s founders as described below.common stock. In addition, the Company maintains $35 million of unsecured revolving credit facilities for short-term financing of seasonal cash needs, none of which was outstanding at January 28, 2006.February 3, 2007.

Cash provided by operating activities for these periods was primarily generated by earnings adjusted for depreciation, deferred rent,taxes, and changes in working capital. The decrease of $8.9$12.2 million for fiscal 20052006 over fiscal 20042005 is primarily due to a higher payables reduction in accounts payable attributable to tighter inventory management, an increaseoffset by a decrease in prepaid expenses, other assets and deferred income taxes offset by the increase in net earnings of $10.0$6.6 million.

The Company believes that its cash, cash equivalents and short-term investments, together with cash flows from operations and borrowings available under its revolving credit agreement, will be adequate to fund the Company’s proposed capital expenditures, dividends, purchase of treasury stock and other operating requirements for fiscal 20062007 and for the foreseeable future beyond twelve months.future.

At January 28, 2006,February 3, 2007, the Company had working capital of $139.1$176.5 million compared to $133.8$139.1 million at January 29, 2005.28, 2006. Additionally, the Company had $1.9 million invested in privately managed investment funds at January 28, 2006,February 3, 2007, which are reported under other noncurrent assets of the consolidated balance sheets.

At January 28, 2006,February 3, 2007, the Company had an unsecured revolving credit agreement, which provided for borrowings of up to $35 million. The revolving credit agreement is committed until August 2008. This agreement replaced a prior revolving credit agreement which was due to expire in August 2006. The credit agreement contains various financial covenants and limitations, including the maintenance of specific financial ratios with which the Company was in compliance as of January 28, 2006.February 3, 2007. There were no borrowings outstanding under these credit facilities during the fiscal year ended January 28, 2006February 3, 2007 or the fiscal year ended January 29, 2005.28, 2006.

On August 22, 2003, the Company entered into a new unsecured $30 million five-year term loan facility, the proceeds of which were used to purchase Class B Common Stock from the Company’s founders. Payments arewere due in monthly installments of $500,000 plus accrued interest based on LIBOR. On April 5, 2005, the Company repaid the remaining balance of $20.5 million on this loan facility with no early prepayment penalty. With the early retirement of this loan, the Company hashad no outstanding debt as of February 3, 2007 or January 28, 2006.

The Company had approximately $4.5 million and $2.8 million at February 3, 2007 and $3.5 million at January 28, 2006, and January 29, 2005, respectively, of outstanding irrevocable letters of credit relating to purchase commitments.

Expenditures for property and equipment totaled $27.5 million, $28.5 million $25.3 million and $20.6$25.3 million in fiscal 2006, 2005 2004 and 2003,2004, respectively. The expenditures for fiscal 20052006 were primarily for store development, store remodels and investments in new technology. In fiscal 2006,2007, the Company is planning to invest approximately $45$30 million in capital expenditures. This includes expenditures to open 90 new stores, relocate 2520 stores and close up to 1015 stores. In addition, the Company plans to remodel 15 stores and has planned for additional investments in technology scheduled to be implemented over the next 12 months.

Net cash used in investing activities totaled $26.0$40.0 million for fiscal 20052006 compared to $66.3$26.0 million used for the comparable period of 2004.2005. The decreaseincrease was due primarily to the reductionan increase in purchases of short-term investments, offset by an increase of sales of short-term investments.

On May 26, 2005, the Board of Directors approved athree-for-two stock split in the form of a stock dividend of the Company’s Class A and Class B Common Stock effective June 27, 2005. Additionally, on May 26, 2005,25, 2006, the Board of Directors increased the quarterly dividend by 11%15% from $.175$.13 per share to $.195$.15 per share, or an annualized rate of $.78 per share on a pre-split basis. On a post-split basis, the annualized rate is $.52 per share. Prior year basic and diluted earnings per share have been adjusted for thethree-for-two stock split.

The Company does not use derivative financial instruments. At January 28, 2006,February 3, 2007, the Company’s investment portfolio was primarily invested in governmental and other debt securities with maturities less than 36 months. These securities are classified asavailable-for-sale and are recorded on the balance sheet at fair value, with unrealized gains and temporary losses reported net of taxes as accumulated other comprehensive income. Other than temporary declines in fair value of investments are recorded as a reduction in the cost of investments in the accompanying Consolidated Balance Sheets.

The following table shows the Company’s obligations and commitments as of January 28, 2006,February 3, 2007, to make future payments under noncancellable contractual obligations (in thousands):

In December 2004,Effective January 29, 2006, the FASB issued SFASCompany began recording compensation expense associated with stock options and other forms of equity compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004)123R,Share-Based Payment, “Share Based Payment” (SFAS 123(R)). SFAS 123(R) is a revisionas interpreted by SEC Staff Accounting Bulletin No. 107. Prior to January 29, 2006, the Company had accounted for stock options according to the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” which supersedes Accounting Principles Board (APB)(“APB”) Opinion No. 25, “AccountingAccounting for Stock Issued to Employees”, and amendsrelated interpretations, and therefore no related compensation expense was recorded for awards granted with no intrinsic value at the date of the grant. The Company adopted the modified prospective transition method provided under SFAS No. 95, “Statement123R, and, consequently, has not adjusted results from prior periods to retroactively reflect compensation expense. Under this transition method, compensation cost associated with stock options recognized in fiscal 2006 included: 1) quarterly amortization related to the remaining unvested portion of Cash Flows.”all stock option awards granted prior to January 29, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123(R) requires companiesNo. 123; and 2) quarterly amortization related to recognizeall stock option awards granted subsequent to January 29, 2006, based on the

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.” This Interpretation prescribes the recognition threshold a tax position is required to meet before being recognized in the income statementfinancial statements. The Interpretation also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods and disclosure of uncertain tax positions. The Interpretation is effective for an amount equal tofiscal years beginning after December 15, 2006. The Company is in the fair valueprocess of evaluating the impact of the share-based payment issued. This applies to all transactions involvingadoption of this Interpretation on the issuance of equity by a company in exchange for goods and services, including employees. Company’s consolidated financial statements.

In March 2005,September 2006, the SEC issued Staff Accounting Bulletin No. 107108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements” (SAB 107) outlining108). SAB 108 addresses how the SEC Staff’s interpretationeffects of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB 108 requires an entity to quantify misstatements using a balance sheet and income-statement approach and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. The adoption of SAB 108 is effective for fiscal years ending on or after November 15, 2006. The adoption of SAB 108 did not have a material impact on the Company’s financial statements.

In September 2006, FASB issued SFAS 157, “Fair Value Measurements.” SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements and, accordingly does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is in the process of evaluating the impact that the adoption of SFAS 123(R). This interpretation provides their views regarding interactions between SFAS 123(R) and certain SEC rules and regulations and provides interpretations of the valuation of share-based payments for public

We have completed integrated audits of The Cato Corporation’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of January 28, 2006, and an audit of its 2003 consolidated financial statementsFebruary 3, 2007, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of The Cato Corporation and its subsidiaries at February 3, 2007 and January 28, 2006, and January 29, 2005, and the results of their operations and their cash flows for each of the three years in the period ended January 28, 2006February 3, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Itemitem 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statementsupplemental schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of January 28, 2006February 3, 2007 based on those criteria established inInternal Control — Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 28, 2006,February 3, 2007 based on those criteria established inInternal Control — Integrated Frameworkissued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.